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CONTENTS
1. Chapter 1
Chapter 2

Introduction
Financial Intermediaries and
Financial Innovations

Depository Institutions: Activities

& Characteristics
Chapter 5
Central Banks and the creation
Of Money

1
4

2. Chapter 4

7
12

3. Chapter 7

Insurance Companies

15

4. Chapter 8

Investment Companies and

Exchange Traded Funds
Pension Funds

21
27

Primary Markets and

Underwriting of Securities
Secondary Markets

30
32

Treasury and agency Securities

Markets

34

Common Stock Markets in the

United States of America

39

8. Chapter 19

International Stock Markets

47

9. Chapter 23

The Mortgage Market

54

Financial Futures Markets

60

Chapter 9

5. Chapter 14
Chapter 15
6. Chapter 16
7. Chapter 18

10. Chapter 26

INTRODUCTION (Chapter 1)
There are two types of Markets i.e. the Product market& the
Factors of production Market; Financial Market is part of latter.
Financial Assets: Asset is a possession having value in exchange.
Value of tangible assets depends on some physical properties,
whereas that of intangible assets represents legal claims to some
future benefit.
Financial assets are intangible, having a claim to future cash. The
issuer undertakes to pay future cash to the investor (the owner).
Debt versus Equity Instruments:
Debt instruments have fixed amount of claims and priority over the
Equity instruments (Residual Claim). The claim under the latter
depends on the performance of the investment.
Some securities like preferred stock & convertible bonds can fall
under both the categories.
The Price of a FINANCIAL ASSET & Risk
The price of a financial asset is equal to the present value of its
expected future cash flow. The risks involved in the matter are the
inflation risk, the default risk and the foreign Exchange risk.
Financial Assets versus Tangible Assets
In business both, financial as well as tangible assets, generate cash
flow for the owner and ownership of tangible assets is financed by
issuance of financial assets.
The Role of Financial Assets. They have two roles i.e.
transfer of funds from savers to investors and
Risk separation and distribution.

FINANCIAL MARKETS
Markets where financial assets are exchanged (traded)
Role of Financial Markets
In addition to bringing together the savers & investors and
separation & diversification of risk, the financial markets perform
the following three economic functions:
The interaction of buyers and sellers determine the prices of
assets. This is the price discovery process
It offers liquidity & even premature financial assets can be
encashed
It reduces the cost of transaction by eliminating the search
and information costs.
Classification of Financial Markets
By nature of claim, Debt/Equity market
By maturity of claim, Money /capital market
Seasoning of claim, Primary/Secondary market
Immediate/future delivery, cash or spot/Derivative market
Organizational
structure,
Auction/Over-the-counter/
intermediated market
GLOBALIZATION OF FINANCIAL MARKETS
Financial markets throughout the world have integrated into an
international financial market because of:
a) Deregulation and liberalization of markets & participants,
b) Technological advancement in financial operations, and
c) Increased institutionalization of financial markets.
From the perspective of a particular country the Global markets,
can be classified into internal or national (including domestic and
foreign markets) and external or international market.

Motivation for using foreign markets

Domestic market may not be fully developed,
Opportunities might exist for obtaining lower cost,
Geographical diversification of funding source
Publicity for the name of the corporation, and
Presence of a subsidiary, parent or affiliate.
DERIVATIVE MARKETS
Contracts or obligations to buy/sell in future. The future price
depends upon the value of the asset, its expected future value and
the rate of interest.
Types of Derivative instruments
Future/Forward Contracts are agreements between two parties to
transact a financial asset at a predetermined price at a specified
future date.
An Option Contract gives the owner of the contract, a right to buy
(or sell) a financial asset at a specified price from (or to), another
party.
The buyer has to pay a price to the seller called the option price.
When the right to buy is acquired, the option is called call option;
and in case of option to sell it is called a put option.
The Role of Derivative Instruments
The use of derivative instruments mitigates financial risks; some
examples being:
Protection against a future rise in interest,
Protection against a decline in the prices of stocks,
Protection against fluctuations in the exchange rates.
The three advantages of Derivative market over the spot market are
(a) lower transaction cost, (b) Faster speed of completion of
transaction, and(c) greater liquidity.

FINANCIAL INTERMEDIARIES
and
FINANCIAL INNOVATION
(Chapter 2)

Financial Intermediaries help in diverting savings into

investments.
Recent innovations have helped in globalization of business.
A recent innovation in the financial market is sale of securities
backed by traditional assets like car loans, mortgages etc.
FINANCIAL INSTITUTIONS
Financial Institutions act as (a) financial intermediaries, (b)
Brokers, Dealers & Agents, (c) Underwriters and (d) Captive
Finance Companies.
Role of Financial Intermediaries
Financial intermediaries transform savings into investments.
Advances of a bank are its direct investments, whereas they are
indirect investments of depositors, who provide the raw material.
This transformation involves, at least, one of the following
economic functions:
Maturity intermediation: Financial institutions accept deposits
at call and various maturities; similarly they make loans of short
term as well as long term maturities. They do commit longer-term
investments (counting on successive deposits) at a relatively lesser
rate than an individual investor.
Reducing Risk via diversification:
Reducing the costs of Contracting and information
processing: Commercial Banks & Investment Companies etc. get
acquainted with the market conditions and they have standardized
forms etc. So they can achieve better results at lower costs in
choosing financial assets for their constituents.

Providing a Payments Mechanism.

Asset/Liability Management.
The depository institutions endeavor to earn profit through the
spread between what they pay to the depositors and what they earn
from their borrowers. Insurance business is also somewhat similar.
Pension funds and Investment companies are different.
Nature of Liabilities.
Type-1 Liabilities: Amount & Time of cash outlay is known e.g.
payment of interest/Principal on CDs, GIC (insurance plans) etc.
Type-2 Liabilities: Amount of cash outlay is known but the time is
not certain, like life insurance policy.
Type-3 Liabilities: Amount of cash outlay is not certain but the
time is certain, like certificates of deposits with return on the same
attached to Bank Rate etc. (instead of being fixed).
Type-4 Liabilities: Both, amount & time of cash outlays are not
known, like property and liability insurance policies etc.
Each financial institution has to manage its affairs in such a
manner to be able to meet its contractual obligations.
FINANCIAL INNOVATIONS. Financial innovations have been
categorized differently by different agencies, some of which are:
Market broadening instruments, Risk Management Instruments,
and Arbitraging instruments and processes.
Price-risk transferring innovations, Credit-risk transferring
instruments, liquidity generating innovations, Credit generating
instruments and Equity generating instruments.
New financial products best suited to the circumstances of time
and Strategies to use these products.
Motivation for Financial Innovations:
Volatile interest rates, inflation, equity prices & exchange rates;
Progress in computer & telecommunication; Sophistication &

training of professionals; Competition; Incentive to face existing

regulation tax laws and Changing global pattern of financial wealth
Asset Securitization as a Financial Innovation. Securitization is
the collection or pooling of loans and the sale of securities backed
by these loans. It is different from traditional banking and can
involve more than one institution for lending capital, e.g.
insurance, servicing, and collection etc.
Benefits to issuers:
Diversification and reduced cost of funding
Management of regulatory capital
Generation of servicing fee
Management of interest rate volatility
Benefits to investors:
Investment is backed by a diversified pool of loans
Credit enhancement
Lesser mediation cost, therefore higher returns
Benefits to borrower
The loan being fully securitized is more liquid and can be sold
in the market, therefore low lending rate also.
Implications of Securitization for Financial Markets.
As against the traditional financial intermediaries, securitization
provides direct financing between the borrowers and the investors,
therefore, the mediation cost is lower.
Credit enhancement reduces the risk of default and is therefore
more acceptable to the investors.
Offering of various maturities enables, securitization to compete
with the traditional competitors shifting its risk to the lenders.
Social Benefits.

DEPOSITORY INSTITUTIONS
Activities and Characteristics (Chapter 4)
Commercial Banks, Savings & Loan Associations, Savings Banks
and Credit Unions are depository institutions, which accept
deposits for investment in loans and securities.
Their source of income is return from loans, securities & Fees.
Maintenance of checking deposits by thrift institutions is recent.
The banking system plays an important role in an economy,
besides implementing Government monetary policies.
Asset/Liability problem of depository institutions
The spread income of these institutions should be sufficient
enough to meet operating expenses & earn some profit on capital.
But the generation of this spread involves the following risks:
Credit or Default Risk, Regulatory risk and Interest rate Risk.
Liquidity Concerns
Liquidity & profitability of depository institutions has a very
delicate relationship. They should be liquid enough to honor all
checks drawn on them & provide additional loans. This can be
done through: additional deposits, borrowings from federal
agency/other financial institutions against existing securities,
raising short term funds in the money market and sale of securities.
(The existing portfolio of loans can also be curtailed, if needed)
COMMERCIAL BANKS
There are State Chartered & Federal Government chartered banks
(national banks). All national banks must be members of the
Federal Reserve System & Bank Insurance Fund (BIF), which is
administered by FDIC. Joining of the Federal Reserve System by
State Chartered banks is optional but their deposits must be
insured by BIF. The member banks of Fed hold 75% of total US
deposits. Reserve requirements of Fed apply to all banks.

Bank Services
Individual Banking includes services provided to individuals
Institutional Banking includes services provided to financial/
non financial corporations, government entities, commercial real
estate financing, leasing and factoring etc.
Global Banking includes corporate financing, capital market &
foreign Exchange products. The activities relating to underwriting,
letters of credit etc fall under this category.
Bank Funding
Deposits consist of Demand, Savings, Time (including
negotiable as well as non negotiable) liabilities.
Reserve requirements of FED, which are different for different
types of deposits, have to be kept in view while making loans.
Temporary shortage of reserve requirements can be corrected
through borrowings from the Federal Funds market.
Borrowings at the Fed discount window. Temporary borrowing
from this window against permissible collaterals is available at
Feds discount rate, which is kept changing to implement monetary
policies.
Other non-deposit Borrowings include Repurchase Agreements
in the money market and long-term floating-rate notes and bonds
in the capital market.
Regulation
Regulation on interest rates. Regulation on payable interest
rates has almost been withdrawn except the demand deposits.
After 1966 the interest rates crossed the ceiling fixed by
Regulation Q, which resulted in disintermediation causing outflow
of funds from banks etc to other avenues with better prospects.
The banks developed new matching instruments, and opened
branches abroad to circumvent the restrictions of Regulation Q.
By 1980 ceilings on interest rates on time deposits and CDs phased
out with only a few exceptions.
Geographical Restrictions. Some States do not allow opening of
branches of bigger banks within their jurisdiction for the fear of

elimination of the smaller banks, and thereby competition. Others

allow only unit banks, with no branches.
Permissible Activities for Commercial Banks. Previously the
banks were forbidden from all those activities which were not
closely related to banking in the eyes of Fed. Certain Investment
banking activities, like underwriting of stocks & Securities, acting
as Dealers in securities in the secondary market (except US
Government obligations and Municipal bonds etc) were not
allowed. Banks could not maintain a securities firm nor affiliated
with one engaged in issues, underwriting, public sale and
distribution of stocks, shares and debentures etc.
Certain restrictions did also encompass the insurance area.
Later legislation/Court rulings help evade some restrictions, which
were finally removed by Gramm-Leach Blily Act of 1999.
Capital Requirements for Commercial Banks. The low ratio of
equity capital to total assets of banks creates concerns about their
solvency. The Contra & other such liabilities, which do not form a
part of the balance sheet, enhance these concerns.
Prior to 1989 capital requirements were based only on total assets.
Now the risk profile is also taken into account while determining
the capital requirement.
Capital has been segmented into two i.e. the core capital (the
actual equity) and supplementary Capital (loan loss reserves,
equity contracts etc).
Similarly there are two tiers of assets, the actual & the ones
calculated on the basis of risk. A credit risk of 0%, 20%, 50% &
100% is attached to each asset & its actual value worked out from
the book value in accordance with the weighted risk.
The minimum core capital & total capital requirement is 4% and
8% of the actual assets & assets calculated on the basis of risk,
respectively.
Latter on attempts were made to incorporate interest rate risk also
in setting capital requirements, but measurement of this risk was

10

never worked out. Instead only guidelines were provided to banks

to evaluate the adequacy & effectiveness of their interest rates.
SAVINGS AND LOAN ASSOCIATIONS
S&Ls came into being for financing homes. They are either
mutually owned or have a corporate stock ownership.
S&Ls can be chartered under State or federal government statutes.
At the federal level they were previously regulated by FHLBB but
after creation of the Office of Thrift Supervision (OTS), its
Director is the primary regulator.
Now S&Ls are also subject to reserve requirements of Fed. The
Savings Association Insurance Fund (SAIF), which is administered
by FDIC, provides deposit insurance.
Assets
Traditionally investments were allowed only in mortgages and
Govt. backed securities.
Maturity mismatch & volatile interest rates caused widespread
disaster; therefore the list of permissible investments was revised
to include consumer/non consumer loans and Municipal Bonds.
Despite their edge in mortgage loans, the S&Ls lacked expertise in
commercial & corporate loans; therefore they started investing in
corporate bonds, specially the Junk Bonds (or go go funds) with
high yield. This was prohibited latter on.
For operational liquidity and regulatory requirements of FDIC,
S&Ls invest in short term assets like short term govt. & corporate
securities, federal funds, CDs etc.
Funding
Before 1981 Pass-Book & Time deposits were the main source.
S&Ls had permission to offer even higher interest to depositors.
They had to expand their sphere of activity in deposits after
deregulation of interest rates & introduce new products like NOW.
Regulation
Federal S&Ls are chartered under the Home Owners Loan Act of
1933 & supervised by OTS. Respective states supervise the state

11

chartered S&Ls. The Savings Association Insurance Fund provides

insurance cover to depositors up to $ 1,00,000.00
Regulation of S&Ls relates to the maximum payable interest,
geographical operations, permissible accounts & Investments,
capital adequacy requirements and liquidity requirements.
The concept of maximum payable interest has been phased out.
Feds deposit reserve requirements now apply to S&Ls, in
return for permission to offer NOW accounts.
They can now raise funds from even the money market.
After 1981 S&Ls can acquire thrifts in other states.
Capital adequacy standard for S&Ls has a third additional tier
of tangible capital in addition to core & supplementary capitals.
The S & L Crises
The reason was short borrowing and long lending.
Surge in the interest rates in 70s & 80s caused the debacle. Funds
drifted out of S & Ls because they could not compete with the
prevailing market rates. In an effort to save S&Ls from collapse
the managers offered competitive rates, which were not viable and
therefore further deteriorated the situation.
SAVINGS BANKS (Previously known as MSBs)
They are similar to S&Ls, but are older and concentrated in the
North Eastern States of USA. Their total deposits are less than
S&Ls but the individual units are larger.
Their main investment is in mortgages, which is proportionately
less than that of S&Ls but more than the commercial banks.
CREDIT UNIONS
CUs can be state or federally chartered. Members have a common
bond. They accept deposit from & make loans only to members.
CUs are self-help bodies where only Treasurer is a paid
employee.
The share of members is insured by the National Credit Union
Share Insurance Fund up to $1,00,000.00. The state chartered
Unions can opt joining NCSIF or some state agency.

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National Credit Union Administration administers federal unions.

Central Liquidity Union provides short term loans for liquidity.
CENTRAL BANKS and THE CREATION OF MONEY(Chapter 5)
Central Bank and the Money Creation in United States
The Federal Reserve System, created in 1913, is responsible for
management of the US monetary and banking system. It is
managed by a seven member Board of Governors & is an
absolutely independent entity.
Instruments of Monetary Policy: How the Fed influences the
Supply of Money
Reserve Requirements: All bank deposits cannot be converted
into loans. The portion not available for advances is the required
reserve ratio, which can be kept as cash or deposit in Fed.
In 1980 Congress assumed this responsibility through an Act and
fixed a ratio of 12% for transactional accounts & 3% for Time
Deposits. The same Act authorized Fed to change the ratio on
checking accounts between 8% & 14%, and raise it to even 18%
under special conditions. In 1992 the Fed reduced reserve ratio to
10% for banks with balance of checkable accounts at $46.8(M) or
above & 3% for the smaller units.
Banks short of reserves can borrow excess reserves from banks.
Open Market Operations: The sale/purchase of govt. securities
by the Fed in open market. The Federal Open Market Committee
decides about the required volume of money supply in its monthly
meetings. The policy is implemented through the trading desk of
Federal Reserve Bank of New York.
Open Market Repurchase agreements: In repurchase
agreements the Fed buys certain securities from a security dealer,
who agrees to repurchase the same at higher price at a future date.
The difference in price is the return to Fed & cost to the dealer. In
reverse repo the Fed sells & agrees to repurchase. The Purpose of
repo & reverse repo is an alteration of Banks reserves.

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Discount Rate: The rate of interest at which the Fed makes

loans to the member banks is the discount rate. An increase in
discount rate discourages loans and vice versa.
Different Kinds of Money
Money is a measure of wealth i.e. $, Rupee etc; it is a medium of
exchange i.e. currency & checks drawn on demand deposits: some
assets, though not immediate medium of exchange, can be so
converted promptly & at negligible cost i.e. Time deposits etc.
Money and Monetary Aggregates
Monetary aggregates measure the amount of money available to
the economy at any time.
Monetary Base: It is the currency in circulation plus reserves in
the banks,
M-1: The narrow measure of money supply. It includes all
instruments that serve as medium of exchange like, currency &
Demand deposits,
M-11: It takes into account all instruments that substitute for
money as a store of value. It includes M-1 plus savings deposits
and smaller time deposits of medium maturity,
M-111: M-11 plus long term time deposits, commercial papers
and bankers acceptance etc.
Velocity of money is the relation of money supply to the GNP,
the average transactions carried out by a $.
The Money Multiplier: The Expansion of Money Supply
Four players are involved in creation and changing of money
supply i.e. the Fed, Banks, Savers and borrowers. The Fed
determines the reserve, which the banks observe. The borrowers
deposit their borrowings in their accounts with banks, which
creates further cushion for banks to make fresh loans equal to the
permissible extent (which is deposit minus reserve requirement)
The Impact of Interest Rates on the Money Supply

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During the period of high interest rates, normally the banks do not
hold more than the required reserves, because if not invested these
funds loose higher opportunity cost. Similarly in an effort to earn
interest the depositors keep all their funds with banks, which
increase their reserves and therefore lending ability.
The Money Supply Process in an open Economy
An open economy, like the US, means one where foreign firms
can hold and deal in the local currency. This can and does
influence the exchange rate of dollar.
Frequent changes in the exchange rate are never desirable;
therefore, Fed intervenes in the market through sale and purchase
of foreign currencies. At times it pumps-in dollar against foreign
currencies and at others it withdraws dollars in exchange for
foreign currencies.
INTERNATIONAL CENTRAL BANKS
European Central Bank. It was created in 1999, replacing
Central Banks of 11 countries participating in the European
Economic and Monetary Union.
ECB has a transparent policy. Its activities are made public through
monthly reports & press conferences.
The earliest issue confronted by ECU was the weakness of Euro.
Its monetary policies are centered on inflation in the Euroland &
besides its own measures; ECB is trying to persuade National
governments for deregulation, tax, pension and labor reforms.
Bank of England: Two primary functions are setting and
executing monetary policy & stability of financial system,
domestic & International. In 90s it acquired rights for setting
interest rates & the Treasury started managing government debts.
The BoEs Monetary Policy checks inflation through interest rates
& supports govt. policy of growth & employment.
12 agencies of BoE assess the economy.
Bank of Japan: It became independent in 1998 & composition
of its Policy Board (PB) was changed. An economic report, based
on business survey, is provided before PBs monthly meeting.

15

The new law is designed to ensure independence of BoJ &

adequate communication between it & the Government.
The purpose of Monetary Policy is development through price
stability. The main instruments of the policy are official discount
rate, open market operations and reserve requirements.
INSURANCE COMPANIES (Chapter 7)
Insurance is a contract to pay sums, contingent upon future events.
It involves acceptance of risks by insurance companies in return
for insurance premium. A major decision in the process is, whether
the premium commensurate the risk?
Premiums are collected before payments become due, and,
therefore, invested. Ins. Cos. have two sets of income, premiums
and the return from investments. Their expenditure consists of
payments on insurance policies & operating expenses.
Types of Insurance
Life Insurance: The risk of death is insured.
Health Insurance: The risk insured is cost of medical treatment.
Earlier only indemnity insurance was available, which involved
reimbursement of medical expenses to the health care providers,
co-payments & minimum reimbursable limit etc.
Absence of constraints, made this insurance expensive, therefore,
many forms of managed health care were developed, imposing
restrictions on the choice of health providers by the insured. But
no generally acceptable method has yet been evolved.
Property and causality Insurance: The risk insured is damage
to property.
Liability Insurance: The risk insured is litigation/lawsuits.
Disability Insurance: The risk insured is inability to earn. own
occ for white collared professional & any occ for blue-collar
workers. This type can either be guaranteed renewable or noncancelable. It can also be short-term or long-term.
Long-term Care Insurance: Provision of custodial care to the
aged, who cannot take care of themselves

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Structured Settlements: Fixed guaranteed periodic payments,

resulting from a settlement on disability insurance or other policy.
Investment oriented Products: The risk of guaranteeing payable
interest on investments with a company from 1 to 20 years e.g.
Guaranteed Investment Contract.
Annuity: It is a mutual fund in an insurance wrapper. Usually
a guarantee from the insurance company that the investor will get
back nothing less than what he invests. Because of premium,
annuity is slightly more expensive, but the income from it, if not
withdrawn, is not taxable, as against the taxable income from
mutual funds. Annuities can either be fixed or variable based on
the earnings & performance of the portfolio.
Insurance Companies versus Types of Products
Traditionally, Life & Health Insurance Companies have been
separate & distinct from Property & Causality Insurance
Companies. A few multiline Ins Cos operate in both the areas.
A recent trend is towards separation of Life, Health & Disability
Insurance business & specialization by different companies in
each of these fields.
Fundamentals of Insurance Industry
Receipt of premium on insurance are certain, but payments, being
contingent upon potential future events, are highly uncertain.
On account of time lag & uncertainty, purchasers of policies prefer
viable companies; hence the importance of performance of
investment portfolio for profitability.
Regulation of the Insurance Industry
Insurance business is state regulated. Companies, with publicly
traded stocks, are also regulated by SEC.
The National Association of Insurance Commissioners developed
some regulations which, though not binding, are used as a model.

17

The soundness of an insurance company depends upon a positive

relationship between its receipts & contingent payments, which
are not certain. They are, therefore, required to maintain a surplus,
or reserves, which is defined differently by different agencies.
It is obvious that the quantum of reserves, being indicators of
reliability of a company, attract more business.
Structure of Insurance Companies
An insurance Company has three components, which have been
segmented with specialization & passage of time.
Design & Financial guarantee. Some companies have started
using external actuaries for product development; and reinsurance
for financial backing.
Distribution. Brokers & Internet etc are replacing agents.
Investment. It is also being outsourced to professionals.
Forms of Insurance Companies: Stock & Mutual
In Stock Cos, owners keep eye on dividend & escalation of
capital only, therefore, short-term strategies (which make them
more efficient & thrifty). Mutual Cos have reduced their expenses
after demutualization & going public.
In Mutual Cos., the owners care for the Cos ability to pay on
maturity of policies, therefore, long-term strategies. Profits can be
passed on to policyholders via reduced premiums. Long-term
investments generate higher profits.
On the other hand, lack of short-term strategies, which suit the
shareholders, can even result in long-term ill health. Their ability
to generate additional capital is restricted to limited public debt.
A recent development is the mutual holding co., which, itself, is
not an insurance company. It forms a Stock Insurance Co. & keeps
51% of its shares. It has some of the advantages of both the types.
Individual versus Group Insurance

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Group Insurance Policies pertain to employees or educational,

medical or professional associations. They include term-life,
whole-life, medical, disability, and investment products etc.
There are different distribution systems for the two.
Types of Life Insurance
Term Insurance: It is for a specific term & if the insured dies
during that term, the beneficiary receives the amount; otherwise it
has no cash value. No borrowing is permissible. The premium can
either be level or annual renewable.
Cash Value or Permanent Life Insurance: It builds up a cash
value within the policy, which can be withdrawn or borrowed. The
policy holder overpays during early life & under pays thereafter.
Guaranteed Cash Value Life Insurance: A minimum cash
value is guaranteed each year. In non-participating policies, the
guaranteed cash value is generated whereas in participating
policies it can go beyond this amount, depending upon the
performance of the investment portfolio.
Variable Life Insurance: The policy owners can allocate their
premiums & cash value to various investment portfolios of the Co.
Thus no guarantee of cash value & death benefits, which depend
upon performance of selected portfolios.
Flexible premium policies------Universal Life: The hallmark
of Universal life is the flexibility of premium. There must be some
initial premium to build up cash value, which is set up as cash
value fund. Investment income is credited to this fund & premium
debited to it. The cash value fund should also be sufficient enough
to generate the required premium.
Variable universal life Insurance: It combines the features of
variable life & universal life policies, i.e. choice of investment &
flexible premium.
Survivorship (Second to Die) Insurance: Joint insurance of two
people, usually couples, where the death benefits become due after

19

the death of the second or surviving insured. Normally premiums

are lesser on this type of insurance.
General Account & separate account products
General Account Products are based upon the overall investment
portfolio of an insurance company. Products written by the Co.
itself have the general account guarantee & are liability of the Co.
Separate account products are based upon selection of the policy
holder & do not have Companys guarantee.
Participating Policies.
Performance of separate account products is restricted to
performance of the selected investment portfolio. Similarly the
performance of certain general account products is also not related
to the performance of general account portfolio e.g. Disability
Income Insurance Policies.
A participating product can pay even higher dividends than
guaranteed, depending upon the performance of the general
account investment portfolio.
Insurance Company Investment Strategies:
Time & amount of claims are not certain, especially in the case
of Property & Causality insurance.
Portfolios of Life Ins. Cos. have more yield generating
securities like private placements, commercial mortgage, and less
common stock, municipal bonds & longer maturity bonds.
Common Stock Cos. hold relatively more bonds for regular
income instead of volatile capital growth of stocks.
Life Insurance Cos. have many tax benefits.
Changes in the Insurance Industry
The Deregulation of the Financial System. The 50 year old
anti-affiliation restrictions on commercial banks, investment

20

banks & insurance companies were removed in1999, which

accelerated their affiliations & mergers.
Internationalization of Insurance Industry. Us Ins. Cos. have
acquired & entered into agreements with international Ins. Cos. &
vice versa. The US financial market is more attractive to the
international Ins Cos because of its rapid growth, attractive income
potential & less regulated environment.
Demutualization. Conversion of Mutual Ins. Cos. to Stock Cos.
The changes have to be approved by the State Insurance
Regulatory Department.
Evolution
of
Insurance,
Investment
and
Retirement Products
Previously Insurance, Investment and Pension plans
had distinct products, which are becoming
increasingly overlapped & hybrid.
The 401 (k) and IRA are hybrids of retirement &
Investment, often distributed by Ins. Cos. The
qualified plans are tax deferred plans.
401 (k) Plans. These plans are primarily offered
by financial institution (or others) to employers. The
employers offer it to the employees for investment in
a specific or diversified portfolio. The contributions of
the employees & matching contribution by the
employers being tax free have certain limitations.
IRAs (Individual Retirement Accounts). They
are usually employee/investor sponsored with a few
exceptions. Assets accumulate free of taxes with
certain limits on the amounts that can be invested.
When contributions are tax deductible, distributions
are taxable; when contributions are after tax,
distributions are not taxable.

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Withdrawals from IRAs prior to attaining the age of

59 1/2 are subject to a 10% IRS penalty.
In rollover or conduit IRAs (which are employer
sponsored) the accumulated contribution can be
shifted from one employer to another employer on
leaving a job.
SEP (Simplified Employee Pension) is an IRA most
suited to self employed or small business owners. O
to 15% of earned income can be contributed in this
program up to a maximum of $30,000.00.
Contributions are tax deductible to business.
SIMPLE (Saving Incentive Matching Program for
Employees). The employer should either match
contribution of the employee of 1% to 3% or make a
non-elective contribution of 2%.
INVESTMENT
FUNDS

COMPANIES

&

EXCHANGE-TRADED

Types of Investment Companies.

a) Openend Funds: The Investors own a pro rata
share of portfolio, the investment manager actively
manages it, price of each share (net asset value) is
equal to total market value of the portfolio (-)
liabilities (-:-) number of shares, the published NAVs
are the closing ones & all transactions into/out of
fund are priced at the days closing NAV.
b)Closed-end Funds: Shares are floated only once.
Latter on they are transacted via normal channels.
The prices of shares depend upon supply & demand.
But, at times, there are provisions in the charter of
these funds suggesting measures (like buying back
the shares or conversion of the fund into openended) to improve the situation if the price slips
below the NAV.

22

The sale of shares to public involves costs of

issuance (including sale commission of 7%);
therefore, the amount invested by these funds is
lesser than shares sale proceeds.
c) Unit Trusts: They specialize in bonds & have a
fixed number of certificates. After assembly unit is
entrusted to a trustee, who does not trade in the
bonds, but holds them till redemption. Bonds are sold
only in the event of a dramatic decline in issuers
credit. It has a fixed termination date.
The trust investor is aware of the specific portfolio of
bonds which the trustee cannot alter.
All unit trusts charge a sale commission of 3.5 to
5.5% in addition to purchase charges of the bonds by
the sponsor.
Growth of Mutual Funds
In 90s investors started preferring ownership of
financial assets instead of real estate/tangible ones,
with emphasis on indirect ownership & expert
management. This resulted in a boost to mutual
funds, in numbers & assets.
Tax deferred investments like IRAs etc was another
reason.
Fund Sales Charges & Annual operating
Expenses
Sales Charge: There used to be two types i.e.
through an intermediary involving a load, (initially a
front-end-load, reducing the initial investment) &
direct offer no-load funds.
The apprehensions of no-load funds overtaking load
funds were falsified by dependence of investors on
advice & opinion of the agents, innovations like backend-loads; level loads & contingent deferred sales
charge.

23

Many mutual fund families offer their funds with

three types of loads depending upon the types of
shares. The maximum allowable load is 8.5%, which
can be reduced with volume.
Annual Operating Expenses: (The expense ratio)
Management Fee or investment advisory fee for
management of fund. If advisor is separate from
sponsor it is passed on to him. It varies with the
requisite input.
Distribution costs called 12b-1 fee, cannot exceed
1% of the assets of the fund. It includes some
compensation
for
the
agent,
manufacturer,
marketing & advertisement.
Other expenses include costs of custody,
distribution of cash/securities etc, public accountant
fee & directors fees.
All cost information is included in prospectus of the
fund.
Economic Motivation for Funds
Mutual funds reduce, risk through diversification of
portfolio, cost related to investment & management
of portfolio & also provide liquidity by being able to
be sold at any day.
Types of funds by investment objective
Mutual funds satisfy the varying needs of investors
through their category of assets, management style
& the market segment that they deal in. Some funds
specialize in stocks, bonds, money market
instruments & others; with many sub-divisions. There
are passive & active funds, depending upon whether
they perform as per the index or try to out perform it.
There are index funds and funds of funds etc.
The Concept of a family of funds

24

A group of funds offering a choice of many funds with

different investment objectives. Movement of funds
by an investor from one fund to another is free or at
nominal cost. Load etc policies might be similar, but
the management company can devise different fee
structures for such transfer of funds from one to
another.
In addition to internal advisors, the families can also
utilize the services of external professionals
Mutual Fund Industry Concentration
Top 5 fund families have 42% of total assets & top
ten 56%. Significant growth was witnessed in 90s but
change in proportional assets of the big 5, 10 or 25
was insignificant despite numerous mergers &
acquisitions; the number of fund complexes
increased from 464 to 629 & industrys total
investment in equities from 20% to 50%.
Regulation of Funds
Securities Act of 1933 regulates the new issues, by
providing information about the issuers to avoid
fraud
The Securities Act of 1934 deals with trading of
securities in the secondary market, after their
issuance.
Investment Cos. with 100 or more share holders
must get registered with SEC under the provisions of
Investment Co. Act of 1940. It checks their selling
abuses & ensures provision of accurate information
to the investors, along with some tax advantages for
the registered investment advisors.
Investment advisors Act of 1940 specifies
registration requirements of firms or individuals
dealing with investment,

25

There are laws restricting insider dealings,

inaccurate & misleading advertisements, Fees &
expenses of funds, rules about readability of
prospectus, etc
Taxation of Mutual Funds
Mutual funds distributing 90% of their investment
income to share holders are exempt from corporate
tax. Share holders have to pay normal tax on their
receipts from these funds.
Capital gain tax liability is created even for new
investors.
Structure of a fund
Board of Directors, representing the share holders,
consisting of inside & independent persons,
The Mutual Fund, under Investment Company Act
1940,
An investment advisor, for managing the fund,
A distributor or broker dealer registered under
Securities Act of 1934
Other service providers, both internal & external
for accounting, custodianship, transfer, marketing &
legal etc.
Recent Changes in the Mutual Fund Industry
Distribution Channels. During 90s sales through
third parties like Employer pension plans, Banks &
Life
Insurance
Companies
were
successfully
implemented, in addition to the traditional channels
of direct sales & sales through brokers.
Supermarkets. 1992 onwards fee based
Supermarkets have started providing one source
access to many fund families on no-load basis.

26

Wrap Programs. Fee-based, no-load managed

accounts, wrapped in a service package of advice &
assistance on mix.
Fee-Based Financial Advisors. Independent
financial planners who charge annual fee based on
volume of assets.
Variable Annuities. Mutual funds in an
Insurance wrapper with slightly more costs but tax
advantages.
Changes in the Costs of purchasing Mutual
Funds. In 90s competition reduced costs, both load
and distribution cost, for the share-holders.
Mix and Match. In view of choice of investors &
competition of Supermarkets, distributors now do not
restrict themselves to single or limited funds.
Domestic Acquisitions in the US Fund Market.
There has been a lot of activity to increase the scale
or consolidate.
Internationalization of US Funds Business. It
has been in both directions, but acquisitions of US
funds by foreigners have been greater in view of
better prospects.
Alternatives to Mutual Funds.
Exchange-Traded
Funds.
Exchange
traded
Investment Cos. are an answer to criticism over
pricing of shares & capital gains. The fund advisor
endeavors to maintain such a portfolio which should
replicate the return of index through limit on orders,
stop orders, orders to sell short and buy on margin
etc. But some deviation from NAV is possible.
Segregated (Separately Managed) Accounts.
Initially available for large investments, but now this

27

facility is available even for relatively smaller

amounts at higher costs.
Folios. A recent Internet based facility for
investment into pre-selected portfolios, which can
also be altered
Commercial Banks and Mutual Funds
Commercial banks manage their own funds as well
as deal in other funds. Their performance in the
former has been dismal, but they have done well in
distribution.
International Investment Companies
United Kingdom.
- Unit Trusts & Open ended Investment
Companies. (Collective Investment Cos). Both are
open ended funds, former involving beneficial
interest in the Trust & the latter shares. They pool
funds together for economies of scale; are managed
by professionals; assets being held by independent
Trustee Cos, who also monitor transactions &
management.
Unit Trusts have different prices for sales &
purchases with built-in charges whereas OEICs have
same price for sales & purchases with charges being
shown separately.
Only a registered fund can advertise to the public.
The Financial Services Authority has laid certain
conditions for authorization of collective investment
schemes. Both types are popular, their main
investment being in equity funds.
- Investment Trusts. Closed-ended companies
listed on the London Stock Exchange, with a board of
directors etc. They have a spread between
sale/purchase prices.

28

Germany. German mutual funds are public (retail,

being Equity/Bond funds) or non-public (institutional,
large volume). Adoption of Euro created many
opportunities for foreign experts collaboration, but
without much progress.
The growth of industry is substantial, but is still far
behind USA, France UK etc, concentrated in a few
large companies.
German banks & Insurance Companies do participate
in the activity but mostly as partners with the
managing firms.
The German Mutual Funds have a distinctive
structure. The Management Company, a limited
liability company, manages the pool of funds of
investors, through a contract, under the supervision
of a German Bank. The board of this company also
monitors the management of funds.
The funds need be registered & accept the
government guidelines about contract between the
firm & investors. The Federal Supervisory Agency for
Banking must approve the contract & select a bank
to act as custodian to safeguard the interests of
investors, book-keeping and accounting. The German
supervisory authorities monitor marketing aspect.

PENSION FUNDS (Chapter 9)

Pension plans endeavor to provide a solution to the
problem of living beyond ones income-producing
years. Private business entities, Federal/State/Local
Governments, unions or private individuals can
sponsor pension plans. Certain requirements qualify

29

these Plans for tax exemptions & the growth of these

funds despite limitations can be attributed to
employers contribution, being tax deductible,
followed by that of employees & the funds earnings
being tax exempt.
Types of Pension Plans.
Defined Benefit Plan. Pension benefits are predecided with certain conditions. The sponsor
guarantees retirement benefits, makes investment
choices & bears the investment risks. He can also
purchase an annuity.
The Pension Guaranty Corporation ensures vested
benefits.
Defined Contribution Plan. Contributions are
defined as a percentage of salary or employers
profits. Employees select the investment options
(mutual funds) & performance of plan plus
contributions determine the payable amount.
It is growing at a fast pace because of its simplicity.
Cash Balance Pension Plan. A hybrid of the two,
being basically defined benefits with some features
of defined contribution. It is based on fixed annual
employer contribution and guaranteed minimum
annual investment return. An account of each
participant is maintained where the employer
contributes an amount as a percentage of pay plus a
fixed amount of interest. The promised benefits are
fixed & balances in the account can be monitored.
Cash balances are portable from job to job, with
uniformity of benefits each year (unlike defined
benefits plan with bulk benefits at the end); therefore
they are popular with youngsters who do not stick to
one job. Even older workers have been given a
choice to choose between the two.

30

Investments
About 75% of assets of public & corporate defined
benefit plans are in US stocks & Bonds & 15% in
international Equities & Bonds. The Union Plans have
only 5% in international equities & Bonds.
Exemption of qualified pension plans form taxes,
curtails diversion of their funds to tax exempt bonds
etc.
Regulation.
(Employees
Retirement
Income
Security Act)
The plans must be properly funded through
contribution.
Everybody associated with management of funds
must act like prudent men in deciding investment
portfolios
It has established vesting standards like
entitlement to 25% pension after 5 years & 100%
after 10 years etc
The pension Benefit Guaranty Corporation (Penny
Benny) was established to ensure vested pension
benefits.
Periodic reporting & Stts. are required to be
submitted.
Managers of Pension Funds
They can be managed through in-house staff, some
money management firm or both. The Participants
themselves select portfolio in defined Contribution
Plans.
Insurance
companies,
Trust
departments
of
Commercial Banks, Investment Banks, Dealers,
Brokers, private money management firms, foreign
financial institutions & even consultants manage
these plans.

31

Management fee can vary from 0.75% to 0.01%

Social Security. Total contribution is 12.4%, per
employee on a 50/50 basis with a limit on maximum
income. The scheme is under-funded & works on goas-you-go-system. Investments are made only in
Treasury Securities. Presently receipts are greater,
but position will be reversed by 2015 & assets would
become Zero by 2037. Several proposals have been
put forward to modify the Social Security system.
Over view of Retirement Planning
Lack of confidence in Social Security, and preference
of employers to defined contribution plans have
given a boost to the latter plus IRAs & personal
savings.
Pension funds around the World.
Almost all countries have pension plans which keep
changing with time. The most important reason for
these changes is an increase in the number of
dependents of these programs.
Germany. The German pension plan is in the
public sector run on pay-as-you-go system. A decline
in German population is expected but longevity is
projected to increase faster. The present system,
running with 76% contributions & 24% Federal
Budget will become highly insufficient.
Hence many proposals for pension reforms including
private pension funds, company pension funds etc.
Japan. It has public as well as corporate plans. The
problem of aging of population is greater. Defined
benefits plans are in vogue in the private sector. Low
investment returns of a corporation coupled with
increase in number of recipients, due to aging, has
left many corporations with under-funded plans.

32

Defined contribution plans like 401(k) are being

contemplated.

PRIMARY MARKETS AND THE UNDERWRITING

OF SECURITIES. (Chapter 14)
The traditional process for issuing new
securities
Advising the issuer on terms & timings of issue
(also called origination).
Underwriting involves buying of securities or their
guaranteed sale, either as firm commitment (Standby) or best efforts.
The gross price spread is the fee of the underwriter.
Syndicates formed to underwrite because of issues
size/risk.
Distribution involves sale of shares to the public. In
addition to the Syndicate, a selling group is formed
who can purchase securities at concessional rates.
The spread is shared by underwriter, the syndicate
and the selling group.
Investment Bankers
Restrictions on investment activities of commercial
banks were withdrawn in 1999. Presently investment
banking is done by Commercial Banks & Security
Houses.

33

Laws with regard to investment banking are different

in different countries.
Regulation of the Primary Market
Securities Act of 1933 governs issuance of Securities
& SEC regulates underwriting activities. The Act
requires filing of a registration statement with the
SEC, containing two parts i.e. the Prospectus &
information about nature of securities & the issuers.
Preliminary prospectus can be distributed during
waiting period, but the issue cannot be sold before
approval.
Misrepresentations can expose the issuers &
underwriters
to
punishments
including
imprisonments.
Under Rule 415 of SEC certain securities can be
offered to public once or more within two years under
a single registration document.
Variations in the Underwriting Process
Bought Deal. It is an offer to a potential issuer of
debt securities for purchase of the whole, or a part of
intended issue at a certain rate of interest &
maturity, a day or a few hours before the issue. The
deal is bought on acceptance of bid. It can in turn be
offered to other investors, investment bankers or
own customers.
The underwriting firms with sufficient funds can avail
the opportunities of varying interest rates under Rule
415 of SEC
Auction Process. (Also called Competitive
bidding) The issuer announces the terms of issue &
interested parties submit their bid for the entire
issue. The one with lowest cost to issuer wins the
deal. Partial bids are also accepted in order of
suitability to the issuer. Where cost is the same &

34

only parts of two or more bids make the total/balance

amount, they are accepted proportionally. There can
be single-price or multiple-price-auctions.
Competitive bidding & electronic bidding is more
popular with Municipal bonds than corporate issues.
The investment bankers argue that issuers do not get
best price through this process because of limited
competition, whereas they provide better return
despite their fees.
Preemptive Rights Offering. Issuance of new
share to existing share holders in proportion to their
shares at a price below market price. These shares
are underwritten under standby arrangements.
Private placement of Securities
Securities Act 1934 has been interpreted to allow
private placements of funds to some institutional
investors like insurance Co., pension funds etc. The
investment bankers help design such securities.
Initially resale of these securities was not allowed for
2 years; however SEC Rule 144A of 1990 eliminated
this condition.
SECONDARY MARKETS (Chapter 15)
Functions of Secondary Markets
A secondary market reveals the standing of
securities to the investors & the issuers & therefore
keeps them alert. It offers liquidity.
Trading Locations
Organized
Stock
Exchanges,
Over-the-counter
market. London Stock Exchange is like an over-the
counter market where the members are at various
locations & they communicate through electronic &

35

computer facilities. NASDAQ &

Exchanges are other such examples.

Tokyo

Stock

Market Structures
In continuous markets prices are determined as an
interaction of supply & demand continuously.
In call markets orders are batched & grouped
together for simultaneous execution at same price.
Orders are held back & then executed in bulk like
auction. Till recently the Paris stock market was a call
market.
Currently some markets are a mix of the two.
Perfect markets
Large number of buyers & seller with no one in a
position to alter price, commodity traded is
homogenous, with no transaction costs (frictions).
Financial markets do have some frictions & special
features like short selling etc.
Role of Brokers and Dealers in Real Markets
Brokers are agents of investors; they provide
technical assistance to investors in sale/ purchase of
securities against commission. They do not
themselves take positions like dealers.
Dealers as Market Makers.
The dealers themselves deal in financial assets and
take positions. They buy assets to add to their
inventory & sell the same to capitalize on an
available price spread. Their activities correct
temporary imbalances in the number of buy/sell
orders & supply immediacy/ short-run price stability.
The dealers, in some market structures have access
to information about the flow of orders or limit

36

orders, which enable them to provide price

information to investors.
Similarly in some market structures the dealers also
act as auctioneers. The market makers on organized
Stock Exchanges in the US organize trading, and play
the role of auctioneer in call markets where they do
not take positions.
The charges of dealers for their services depend
upon their costs and the risks involved in their trade.
Market Efficiency.
Operational Efficiency. Costs of transaction
services represent the degree of efficiency. Initially
costs used to be high & fixed with poor efficiency.
Latter on costs were liberalized on account of
competitive & negotiated commission. Similarly the
spread was also rationalized.
Pricing Efficiency. Information about securities
determines their price. Investors either pursue active
policy of capitalizing on mispricing, involving
transaction costs and risks; or the policy of holding a
cross section of securities.
Electronic Trading.
Bonds is a principal business; larger capital
requirements & volatility of business with consequent
greater risks and lesser profitability have changed
the trend. The traditional dealers have retreated to
leave room for electronic trading. It provides
liquidity, price discovery & efficiency.
TREASURY AND AGENCY SECURITY MARKETS
(Chapter 16)

Treasury Securities are considered to have no credit

risk & their interest rate as the benchmark. The
issuance of these securities has been curtailed

37

because of declining deficit of US govt., which has

started buying back the longer-term securities. The
Securities of Govt. sponsored enterprises (Agency
Securities) are replacing the former as new benchmark interest rates.
Treasury Securities
It is the largest single debt in the world, being most
active & liquid with very narrow spread. The Fed
issues only receipts instead of certificates. Interest is
subject to Federal Income tax but exempt from State
& Local taxes.
Types of Treasury Securities.
They have two categories of discount & coupon
securities. Treasury bills maturity is below one year;
Treasury notes
2 to 10 years & Treasury bonds more than 10 years.
Treasury inflation-protection securities (TIPs) are
notes & bonds. The principal amount is linked to
Consumer Price Index for All Urban Consumers (CPIU) & calculated biannually. The predefined interest
rate of coupon is applied on the new principal. The
adjustment is taxed each year. Disinflation can
reduce the principal amount, but the Treasury has so
devised TIPs that in such an eventuality, the higher
of the adjusted or par value is to be paid.
Primary Markets
The Treasury determines the amount, time &
maturity etc.
Auction Cycles. Bills are auctioned weekly,
quarterly
and
bi-annually;
coupon
securities
comprising 2 year & 5 year notes monthly; 10 year
notes & 30 year bonds quarterly.

38

Occasionally even the outstanding issues are

reopened with an increased outstanding amount.
Determination of the result of an auction.
Auction is conducted on competitive bidding basis
after deducting the non-competitive bids & bids of
Fed. The last, i.e. the highest accepted bid is the stop
yield.
Primary Dealers. The Fed deals only with its
designated primary dealers or recognized dealers in
open market operations, because they have
adequate capital with reasonable volume of dealings
in Treasury Securities.
On application for primary dealership, the position &
volume of a firm is ascertained by the Fed. On
satisfaction it is placed on Feds reporting list with
the status of a reporting firm. After satisfactory
service as a reporting firm for some time it is
designated as Primary Dealer.
Submission of bids. Till recently primary dealers
& large commercial banks would submit bids for
themselves & their customers. Others could bid only
for themselves against large cash deposits as
guarantee. But 1991 onwards only qualified brokerdealers are allowed to bid for their customers. The
process of submission of bids has been computerized
& is accessible only to the qualified dealers.
The Secondary Market.
The secondary market for a vast majority of Treasury
securities is over-thecounter. Normal settlement
period is the next business day. The most recent
auction of a given maturity is called on-the-run or
current issue. The issue replaced by on-the-run is offthe-run.

39

When-Issued Market. It is trading in Treasury

securities between the dates of announcement of
auction until the issue date.
Government Brokers. When the dealers trade
with each other it is through the interdealer brokers
or the government brokers who display highest bids
& lowest offers on their screens, keeping names of
dealers confidential.
Bid and Offer quotes on Treasury Bills.
Instead of price they are quoted on a bank discount
basis & the yield on the same basis is computed as
per the following formula: Y=D/F*360/t, where
Y=Annualized yield on a bank discount basis
D= dollar discount= diff between face value and
price
F= Face value
t= number of days remaining to maturity.
Bid & Offer Quotes on Treasury coupon
Securities. They are traded on a dollar price basis in
price units of 1/32 0f 1%. A price quote of 92-14
refers to 92 and 14/32. A plus sign following 32nd
means that a 64th is added to the price.
Regulation of the Secondary Market.
As against the stock market an elaborate system of
trading in the Treasury market does not exist. There
is no system of a reliable display of bids and
quotations for the general public. The sale of US
government Securities being exempt from SEC
jurisdiction has further aggravated the matter. The
NASD has set guidelines for a reasonable bid-ask
spread, but lack of disclosures to customers leaves
them helpless.

40

Dealer Use of the Repurchase Agreement

Market
Repo is availment of a loan from the Repo market
against pledge of Treasury Securities with an
agreement to repurchase them within a specified
period of time at an express rate of interest. It can be
an overnight, term or open repo. Reverse repo is a
mirror image of repo, where securities are obtained
against a loan on similar terms.
Parties to repo are exposed to credit risk, which has
resulted in cautiousness about credit worthiness of
counterparties.
Repo rate is not uniform. Basically Federal fund rate
determines it, but it can vary from transaction to
transaction depending upon the nature of collateral
(hot or special).
A note on terminology in the Repo market
It is quite confusing in the matter of transactions of
Fed. Reverse repo is called system repo. The same
on behalf of foreign central banks is called customer
repo. An actual repo is called matched sale.
Some more examples of Wall Street jargon in repo
are:
Lending securities against cash is reversing out;
lending cash against securities is reversing in;
financing securities using them as collaterals is repo
securities; Investment in repo is to do repo; lending
on the basis of security is buying collateral &
financing a security with repo is selling security.
Stripped Treasury Securities.
Purchase of Treasury bonds; their deposit in a bank
for safe custody; issuance of receipts representing
interest in each coupon of the same and a receipt for
amount of the bond itself. This is coupon stripping.

41

These receipts were issued under various trade

marks, lacked liquidity on account of competition of
issuers. The risk in the matter was limited to
insolvency of custodian bank.
Latter, a group of dealers joined hands in issuing
such receipts named as Treasury Receipts without
trademarks.
Ultimately the Treasury started issuing such
securities called Separate Trading of Registered
Interest and Principal of Securities (STRIPS). Those
representing coupon payments & principal are
coupon strips and principal strips respectively.
This distinction has been necessitated due to
different treatment to returns from the two types in
calculating taxes.

Federal Agency Securities

Two type of issues i.e. federally related institutions &
Government sponsored enterprises (GSEs).
Federally related institutions. (Govt.-0wned
agencies) They are exempt from SEC registration.
Normally they do not issue securities directly, except
Tennessee Valley Authority and Govt. National
Mortgage Association. All securities except that of
TVA and Private Export Funding Corporation are
backed by the US Govt.
Government Sponsored enterprises. Privately
owned, publicly chartered entities created for
assistance in some important sectors of economy.
They issue securities direct in the market. Five GSEs

42

issue Securities i.e. Federal Farm Credit System,

Federal Home Loan Bank System, Federal National
Mortgage Association, Federal Home Loan Bank
Corporation & Student Loan Marketing Association.
Only the securities of Farm Credit Financial
Assistance Corp. have the backing of govt., others
involve credit risk.
GSEs securities are of two type i.e. debentures &
asset backed securities. They can be callable or noncallable.
Non-US Government Bond Markets
Besides Japan many European countries issue Bonds,
the Yield on German bonds is the benchmark. They
are mostly fixed interest bonds. The British Gilts are
either convertible or linked to the general index of
retail price, their maturities varying from short-term
to 2024. Similarly Canadian & Australian govts. have
issued bonds linked to inflation.
Methods of Distribution.
Regular Auction: Winning bidders allocated at bidyield
Regular Auction Calendar: Award at stop yield.
Ad hoc Auction System: Amount & Maturity
disclosed at
auction.
Tap System: Auction of outstanding from a
previous issue.
Common Stock Markets in the United States
(Chapter 18)

Stock Markets indicate the standing of companies &

their prospects. They have globalized due to
institutionalization, changes in govt. regulation &
innovations.
Characteristics of Common Stock.

43

They represent an ownership interest in a

corporation; a right to its earnings and a pro rata
share of the remaining equity in liquidation. There
are two types of shares i.e. ordinary and preferred.
Where Stock Trading Occurs
Organized exchanges through the auction system &
Over-the-Counter through negotiated system. The
former is also called central auction specialist system
& the latter multiple market-maker system. A third
system called the electric communication system has
also emerged & is growing.
NYSE & American Stock Exchange (AMEX) are two
national exchanges which trade stocks of US as well
as non-US Cos.
Regional Stock Exchanges deal in shares of US based
Cos.
The major OTC market is NASDAQ owned & operated
by NASD. It is a national market. NASDAQ & AMEX
merged in 1998. There are four types of markets for
trading of stocks:
1. Trading of listed stocks on exchanges.
2. Trading in the OTC market of stocks not listed on
an exchange,
3. Trading in the OTC market of stocks listed on an
exchange
4. Private
transactions
between
institutional
investors who deal directly without intermediary
broker-dealer.
EXCHANGES
They are formal organizations, approved by SEC, who
deal in listed stocks. Only members can trade
through purchase of a seat. Two kinds of stock are
listed on regional stock exchanges i.e. I) stocks of
Cos which could not qualify for listing on a national

44

Exchange or those which could qualify but chose not

to get listed and II) stocks enlisted on one of national
exchanges.
THE NYSE. Trading is a continuous auction
process at a designated location (post) on the floor,
where brokers buy & sell orders. Designated
specialists are market makers for each stock. Orders
(bids & offers) arrive at each post through brokers &
SuperDot, an electronic delivery system. In addition
to specialists, other member firms also deal for
themselves & their customers through brokers.
Commission brokers, who are employees of security
houses, also deal for their firms & its customers.
Other transactors include independent floor brokers
and registered traders.
NYSE Specialist. A dealer or market-maker
assigned by NYSE to conduct auction process &
maintain orderly market in one or more designated
stocks. He can act as a broker/ dealer. Orders for
designated stocks arrive at their posts electronically
or through brokers & are executed. They themselves
trade in designated stocks for maintaining an orderly
market (with price continuity & reasonable depth).
Orders which are not routed through specialists are
traded on the floor. The limit orders, if not
executable immediately, are referred to specialists
who record them for execution at appropriate time.
This process is confidential.
Diversity of participants at NYSE has helped provide
variety & depth to it.
NYSE-assigned specialists have four major roles:
They trade for themselves only when buyers
&
sellers are
temporarily
absent
or their orders have been satisfied

45

As agents they execute orders of brokers & limit

orders
As catalysts they help to bring buyers & sellers
together.
As auctioneers they quote current bid-ask prices.
Specialists cannot transact in securities in which they
are registered unless it is for a fair & orderly market.
But being responsible for balancing buy & sell orders,
they can participate in the opening session.
When imbalance between buy & sell orders occurs &
a fair & orderly market cannot be maintained, the
specialist can close the market for that stock until
the determination of balanced price.
NYSE trading officials oversee their activities & their
approval is necessary for delays or discontinuation of
trading etc.
Capital requirements for the specialists do exist. Of
late they have started consolidating; some have
been acquired by public companies & others have
themselves gone public.
Commissions. Prior to 1975 commissions were
fixed, but afterwards they became negotiable under
pressure from institutional buyers.
The OTC Market.
It is the market for unlisted stocks.
NASDAQ Stock Market. A telecommunication
network. It is a virtual trading floor, which provides
price quotations to participants on NASDAQ listed
stocks.
NASDAQ market Tires: NASDAQ National Market &
NASDAQ small capitalization market, the former
being the dominant OTC market in USA. Securities

46

must meet stringent listing requirements. Financial

criteria for the two are different.
Occasionally cos. shift from NASDAQ to NYSE, but
some Cos. have stayed back despite qualifying for
NYSE.
NASD is a non-profit organization; NASDAQ is forprofit but does not shift its profit upstream. NASD
sold its main shares to broker-dealers & companies
whose shares are traded on NASDAQ. NASD is
planning sale of all its shares to NASDAQ.
Other OTC Markets. Securities not listed on NYSE
or NASDAQ are traded on the following two markets:
I.
OTC Bulletin. It is
owned & operated by NASDAQ & regulated by
NASD. It includes securities not traded on NYSE,
AMEX or NASDAQ.
II.
Pink Sheets. Prior to
NASDAQ dealer quotations were disseminated on
pink papers, therefore the OTC securities were
called Pink Sheet Stocks. Weekly publishing of these
sheets is still in vogue in addition to an electronic
version.
The Third Market. Trading of NYSE listed stocks
in the OTC market, basically for avoiding fixed fees
prior to 1975. The orders are executed through the
market participants but booked by non-member
dealers.
Alternative Trading SystemThe Fourth
Market.
Direct trading of stocks between two customers
without the broker. These systems are operated by
brokers brokers via the NASD members through
two types of systems:

47

1. Electronic Communication Networks (ECNs).

They are privately owned broker-dealers who
operate within the NASDAQ system. The limitbook like orders, containing bids & offers, are
disseminated for continuous trading at reduced
prices to the subscribers & participants.
2. Crossing Networks. These networks process
batches to aggregate orders for execution
typically via computers.
Rule 144 A Securities. It permits the issue of
non-registered securities & their trade in the
secondary market by qualified institutions.
American Depository Receipts. Negotiable
receipts issued in US by US banks certifying deposit
of specific number of foreign shares with an overseas
branch of the bank or another bank for safe custody
in country of origin.
The Role and Regulation of Dealers in
Exchange and OTC markets.
The specialist is the sole market maker in an
exchange; whereas the number of market-makers in
OTC market is greater with greater competition. A
study in the matter regarding efficiency & economy
in costs disclosed negative & positive points of both
the types.
Trading Mechanics
Types of orders and Trading Priority Rules.
A market order is executed at the best available
price. When prices are similar precedence is given to
time & in case of simultaneous time, better price
gets precedence. Similarly public orders are given
priority over orders of members.

48

A limit order designates a price; execution of these

orders can be delayed for availability of asked price.
A stop order can be executed only when the market
moves to a designated price. Here it becomes a
market order.
A stop-limit-order is a hybrid of limit & stop orders.
Market if touched order. It becomes a market order
on reaching the designated market price.
A fill or kill order must be executed as soon as it
reaches the trading floor otherwise it is cancelled.
An open order is valid till its cancellation.
A round order is typically for a lot of 100; an odd one
lesser.
A block trade at NYSE is for 10,000 shares of a
particular stock or total market value of $ 200,000 or
above.
The exchanges have systems for routing orders of
specified sizes through computers to the specialists.
Short Selling. Sale of securities by investor, not
owned at the time of sale. Stock Exchanges permit
short sales if the short sale price is higher than the
last sale; or if it is equal to the last sale price, then
the last sale price should be higher than the one
preceding it.
Margin Transactions.
A transaction in which an investor borrows to buy
shares, using the shares as collateral. The broker
provides the funds & his charges include interest plus
service charges.
Setting initial Margin Requirements. Legally
the brokers can lend only a specified percentage of
the market value of securities.
Maintenance Margin. The investor is required to
maintain a specified minimum margin (equity) in his

49

account in proportion to the market value of the

shares against which a loan has been availed.
Margin practices also exist for short selling.
Transaction Costs.
Explicit Costs. The commission of the broker,
custodial costs & transfer fees.
Implicit Costs. They include:
- Impact Costs. Larger sale/purchases can affect
costs.
- Timing Costs. Time taken during the completion
of a
transaction.
- Opportunity Cost. It is the cost of securities not
traded or missed or partially completed trades.
Trading Arrangements for Retail and
Institutional Investors.
Institutions transact comparatively larger orders, at
lower commissions and their orders are executed
swiftly. Holdings of institutions increased during last
50 years & household declined, perhaps due to their
holdings through intermediaries.
Retail
Stock
Trading.
1975
onwards
commissions on stock trading have declined; and
introduction & utilization of new technologies has
made the trade more efficient.
Institutional Trading. Increased institutional
trading in stocks has resulted in increased facilities
for them including block trades & Program trades
(en-block purchase of shares of many companies). A
so-called upstairs market has been developed by the
major institutional investors & major securities firms
where they can communicate with each other
through electronic display system etc.

50

- Block Trades. NYSE trades about 50% of its

business through block-trades. New techniques have
been developed to cope with this situation. The block
execution departments of major brokerage firms
operate through the upstairs offices, & also contact
other firms in case of need.
- Program Trades. (Also called a basket trades) It has
been defined as a trade in at least 15 companies
shares with a minimum volume of $1 million.
A major application of the program trade is
allocation/ reallocation/balancing of assets, through
deployment of new cash or reallocation from one
sector to another.
The second application pertains to stock index
futures. When price of an index in futures contracts
increases beyond certain limits & despite cost of
transactions, an opportunity is created for making
profit, the entire kitty is sold in future contract &
replaced with fresh stocks against cash.
The best alternate arrangements for commission
should be chosen, & steps taken to avoid frontrun by
brokerage firms.
The dealer can conduct the program trade either on
agency basis or as a principal. The former involves
commission and uncertain price along with the
danger of frontrunning. A modified model of this
deal, agency incentive arrangement, specifies the
benchmark price of the group of stocks. Execution on
principal basis involves deployment of own capital by
the brokerage firm in the entire sale & purchase. On
account of market risk it involves higher commission.
Price Limits and Collars
The minimum price limit below which trading is not
conducted in a stock exchange. This temporary

51

pause is also intended to give the market a

breather.
Stock Market Indicators
They include Dow Jones Industrial Average, S&P 500,
NYSE Composite Index, NASDAQ Composite Index
etc. Normally they rise & fall in similar patterns, &
can be classified in three groups. 1) Produced by
stock exchanges based on the traded stocks, 2)
produced by organizations based on subjective
selection & 3) objective selection based on market
capitalization.
Pricing Efficiency of the Stock Market
Security prices must reflect all available information
relevant to their valuation. There are three forms of
pricing efficiency
The weak form. Price reflects the past price &
trading history of a security. It is said that those who
select securities on this basis cannot do better than
the market.
The semi-strong form. The price of a security
fully reflects all public information, price history &
trading pattern. Selection of securities on the basis of
analysis of financial statements, quality of
management & economic environment of a company.
Studies have produced conflicting reports.
The Strong form. It reflects all information about
a security both the apparent & that of the insiders.
Historically money managers & financial experts
have performed in accordance with market whereas
insiders have done well.
Implications of investing in Common Stock.
Active strategies try to out-perform the market
whereas passive strategies do not. The market
portfolio captures the pricing efficiency. The chosen

52

portfolio should be an appropriate fraction of the

market portfolio, weighing each security on the basis
of relative market capitalization.
International Stock Markets (Chapter 19)
Purpose of investing abroad includes diversification
besides profits. Some American securities are listed
on foreign stock exchanges; New American securities
have also been issued for financing overseas
subsidiaries. Simultaneous offer of securities in
several countries is Euroequity.
Overview of Major International Stock
Markets and Indexes. Morgan Stanley Capital
International Indexes are most widely used which
indicate that worldwide market capitalization of USA
is the highest, whereas that of Japan in Europe & Far
East is the highest.
Multiple Listing on National market. Listing of
shares of companies in several overseas exchanges
is on the increase, despite varying policies of foreign
countries in the matter. Diversity, fear of takeover by
a domestic concern & boosting sales, name/fame are
the main driving forces. On account of arbitrage it is
not possible to have different prices of shares in
different exchanges.
Trading costs in International Stock Markets.
Trading costs are different in different countries,
which affect the investment returns accordingly.
Global Diversification: Correlation of World
Equity Markets. Returns from international capital
markets do not always increase & decrease in
unison. The largest influence on the prices of local
stocks is local conditions. Hence the need for
diversification.
Studies
have
revealed
that
international stock markets behave differently from

53

one another; geography & political alliance influence

their correlations and their movements are still, fairly
integrated. But two factors increase correlation first
being the overall behavior of investors in crises and
second the uniform behavior of the global sectors of
various economies.
Major International Stock Markets.
After the 1975 reforms of US Stock market, there
have been numerous reforms in the stock markets of
the world.
United Kingdom. All exchanges of GB merged
into one in 1973 & the Dublin Stock Exchange
separated in 1995. The remaining portion is now
known as London Stock Exchange, one of the leading
equity markets of the world. LSE deals in shares of
local & foreign companies, private fixed-interest
securities as well acts as a primary & secondary
market for British Government securities.
Operations: The Big Bang significantly changed
the operations of LSE. Floor trading system was
replaced by screen trading. Another change
facilitated automatic execution of orders when bid &
offer prices match. Registered market makers are
also required to display their bid & offer prices to the
market along with corresponding maximum sizes
through out the trading day.
Reforms: Decline in the status of British
securities
market,
its
delayed
response
to
internationalization & technological developments
called for financial reforms in 1986. Commissions
were liberalized and the rule of prohibiting non-stock
exchange members from investing in the companies
of stock exchange members was abolished. The

54

erstwhile rigid division between agents & jobbers

gave way to the concept of dual capacity.
Germany
Frankfurt Stock Exchange, the first to become
operational after World War II, was renamed as
Deutsche Borse AG in 1992. It is owned by German
International Banks, official ledger brokers and other
regional stock exchanges.
There are eight independent stock exchanges, which
cooperate closely for uniform pricing mechanism.
Equity trading is concentrated in Frankfurt where
floor trading & electronic trading co-exist.
In 1990 Deutche TerminBorse (DTB), a fully
computerized exchange was formed for trading
equity options & Futures. DTB & the Swiss derivatives
exchange merged in 1998 to form Eurex, the worlds
derivatives exchange.
In German banking laws sale/purchase of securities
for others can only be done by banks.
In 1997 Exchange Electronic Trading (Xetra), a
modern, cost efficient & order driven trading system
with automatic matching was introduced. All orders
are recorded with full conditions & they can be kept
pending up to one year.
Japan
TSE was established in 1878. 1980s onwards many
steps have been taken for deregulation &
globalization. Depending upon size, turnover and
share ownership the listed shares have been divided
into first section & second section.
Operations: TSE is a continuous auction market.
Based on orders placed by regular members before

55

the start of session, prices are established. Latter on,

the Saitori members, who only act as intermediaries
between regular members & maintain record of
orders, match the same.
The trading floor was closed in 1999 & transactions
take place on Computer-Assisted Order Routing &
Execution System only through authorized security
dealers who are members of Japan Security Dealers
Association.
Reforms:
Financial
markets
were
highly
regulated till 70s. Reforms at the pattern of British
Big Bang were initiated in 1996 because of
internationalization of financial markets & Japans
inability to compete. The purpose of these reforms
was to make Japans financial market fair, free,
global & less susceptible to domestic political
pressures.
China.
Till 2001 Chinese stock market had two types of
shares, A restricted to Chinese investors & B
reserved for foreign investors. A was the larger
market but limited to state- owned companies, with
limited access to private companies.
B was started in 1991 to attract foreign capital,
despite government listing requirements. But it did
not develop as expected by the government because
of involvement of Chinese in trading in B market
instead of foreigners, their relative lower prices.
Moreover, inadequate accounting standards led to
quoting of these shares in the Hong Kong market.
The Red Chips i.e. shares of Hong Kong companies
with strong Chinese ties, were also traded in Hong
Kong.

56

Ultimately Chinese ownership of B shares was

allowed in 2001, with permission to Chinese
investors to transfer foreign currencies into a trading
account for this purpose. All the Chinese companies,
whether public or private, were also allowed to sell
A or B shares.
This resulted in increased access to Chinese
investors to B shares & Chinese companies to A
Shares.
Recent
European
Stock
Market
Reorganizations.
In addition to globalization of stock markets, the
creation of European Monetary Union & the
emergence of Euro have made the stock market
more competitive within Europe.
London Stock Exchange. Once most active in
Europe. The Stock Exchange Automated Quotation
system was launched in 1985 for pan-European
stocks. Similarly the order-driven Stock Exchange
Trading Service was developed for the largest 100
stocks in 1997, which was later on expanded to 200
stocks.
It wanted to merge with Deutche Boerse but the talks
failed.
OM Gruppen who had acquired the Stockholm Stock
Exchange wanted to acquire LSE, which was not
agreed to.
Deutch Borse. After failure of its attempts to
merge, the FSE transformed itself & emerged as a
system provider in addition to becoming Europes 2nd
largest exchange. It introduced the Xetra trading
system in addition to sponsoring two other
exchanges i.e. it owns 50% shares in Eurex, the

57

largest derivative exchange and DBs Neuer Mart,

which trades high technology companies.
DB offered 27% of its shares to public in its IPO
raising an amount of $ 1 Billion.
Euronext. Created with merger of Paris, Brussels
& Amsterdam exchanges to form a pan-European
market. Though the three markets are legally
different, with slightly different trading rules but they
have a common trading system. Volume & market
capitalization wise, it is No. 1 & 2 respectively in
Europe. Paris stock exchange has also sold its
advanced trading technology to many foreign
markets. Technologically DB & Paris Bourse are
known to be the best exchanges of Europe.
Other European Stock Market Activities. In
2001 NASDAQ took-over 58% shares of EASDAQ, a
pan-European electronic market place for small but
fast growing young companies. Renamed as NASDAQ
Europe it was to be linked to trading systems of
NASDAQ in US & Japan, for dealings in pan-European
stocks.
NASDAQ also announced a partnership with London
International Financial Futures & Options Exchange in
2001 to introduce single stock futures in US. Though
US investors have been barred from such trading,
regulations permitting the same are expected.
NASDAQ, NYSE & Euronext are planning to go public.
New European Exchanges. In 90s smaller
markets on the pattern of NASDAQ started emerging
in Europe. Neuer Market & EASDAQ are examples of
such developments.
New Japanese Exchanges. Out of the three very
small markets for emerging companies, NASDAQ
Japan is the most important. All issues are traded via

58

auction process, but later on they will be divided into

two; based on trading volume, market capitalization
etc. Smaller will be traded via market-making system
and larger through either of the two. All the current
issues have been classified as small.
The OTC market adopted market-making system in
1998. There are 28 market-makers trading 30% of
listed issues.
Ownership and Control of National Stock
Exchanges.
In US Stock exchanges are SEC regulated but
privately owned & competitive. They set membership
& listing criteria & commissions are negotiable. The
exchanges in Japan, UK, Canada, Hong Kong and
Australia are similar except that in Japan the Ministry
of Finance approves listed securities, though the
exchange sets a limit on the number of member.
Some stock exchanges have traditionally been public
or quasi-public institutions, with govt control over
appointment of brokers, commission etc. France,
Belgium, Spain etc are examples, where significant
changes occurred after 1980s, replacing individual
brokers with corporations, making commission
negotiable etc. But the govt approval is still required
in many areas.
In some other countries transactions can take place
only through the banks.
Trading Procedures and Computerization
Many markets use call auction procedure to set an
opening price & then allow prices to be determined
on a continuous basis. The advent of computer & its
associated advantages have brought many changes
in the worlds equity market. Many call markets have
been converted into continuous markets.

59

Dealers in Major Markets

In continuous US markets there are two forms of
dealings, i.e. through the specialist or the
competitive dealer system like OTC NASDAQ market
where there can be several dealers for one stock.
The specialist system also appears in Montral,
Toronto & to some extent in Amsterdam.
The rest of the continuous trading exchanges employ
competitive dealer system whereas Japan has a
saitori.
Block Trades have the upstairs market.
Stock Market Indexes
Each stock market has an index which measures the
movement of prices of the listed shares. Some
indexes are produced by the stock exchanges
themselves; others are produced by outsiders. Some
indexes show movements in the prices of all the
listed shares on a stock exchange, while others show
movements of selected stocks. There are many
indexes for the US stock exchanges, the London
Stock Exchange, the Tokyo Stock exchange etc,
prepared from different angles. Some indexes even
cover the equity market around the world.
Free Float. That portion of stocks of a company or
corporation which are available for transactions.
Those stocks which are not available for transaction
i.e. stocks held by the government or stocks of other
corporations owned & held by other corporations
(Cross holding) are not available for transactions.
Global Depository Receipts.
GDRs are issued by banks as evidence of ownership
of the underlying stock of a foreign corporation that
the bank holds in trust. Generally the corporations
themselves sponsor such GDRs to enable trade of

60

their stock in a foreign country without complying

with its regulatory issuing requirements.
The Mortgage Market (Chapter 23)
What is Mortgage?
It is the pledge of
immovable property to secure payment of a debt.
Non-payment, as per agreement, can result in
seizure of property. In addition to conventional
mortgages, the concept of insured mortgages also
exist, where insurance is provided either by private
insurers or government agencies like Federal Housing
Administration (FHA), Veterans Administration (VA)
and Rural Housing Service (RHS).
Mortgage Origination. Original lenders like
Thrifts, Commercial banks, Mortgage bankers,
Insurance companies & Pension Funds are the
originators. Income of the originators consists of
origination fee, application fee, processing fee plus
the profit, if any, in sale of mortgage in the
secondary market. Other sources of income include
the service fee or retention of mortgage as
investment.
Mismatching maturities of assets & liabilities coupled
with reduced tax benefits have induced thrifts &
banks to be contented with fees etc only, instead of
investment.
The Mortgage Origination Process. It starts
with an application containing details of the
applicant, the property & choice of the type of
mortgage.
Approval is considered on the basis of Payment-toincome (PTI) ratio and the Loan-to-value (LTV) ratio.

61

Concurrence follows a commitment letter containing

details & asking the applicant to pay the
commitment fee.
The originator can keep the mortgage in its portfolio,
sell it or use it for securitization. If it wants to sell it,
commitments would be obtained from potential
purchasers (the conduits) including two federally
sponsored agencies. The federal agencies have set
standards for conforming mortgages in the areas of
PTI, LTV & maximum loan amount.
The originator sets rate of interest as desired by
purchaser.
The
Risks
Associated
with
Mortgage
Origination. Pipeline risks refer to the risks
associated with originating a mortgage. It has two
components: Price risk & fallout risk.
Price risk refers to adverse changes in rate of interest
during origination. Fallout risks refer to risk
associated with the applicants not completing
mortgage after issuance of letter of commitment.
Main reasons could be adverse change in rates of
interest, unfavorable property inspection report etc.
Price risk can be protected against through a
commitment in the form of a forward contract with
the intending purchaser.
Fallout risk can be protected against through an
optional contract with one of the conduits.
Types of Mortgage Designs
Fixed-Rate, Level-Payments, Fully amortized
Mortgages. Traditional repayment of principal &
interest amount in equal monthly installments over a
period of 15 to 30 years. The interest rate includes
service costs & risk.

62

- Cash Flow Characteristics of the Traditional

Mortgages. The repayment schedule is so designed
that on payment of last installment, both, the
principal as well as the agreed inertest get adjusted.
Major portion of initial monthly installments goes
towards interest with nominal reduction in the
principal; but the position gets reversed later on.
- Prepayments. They represent payments made in
excess of the scheduled principal repayments. The
reasons can include sale of the mortgaged property;
a comparative reduction in the market interest rate;
re-possession of mortgaged property due to default
and destruction of mortgaged property which is
insured.
Normally the borrower repays only the outstanding
amount & he is not penalized for prepayment with
the exception of the prepayment penalty mortgages.
- Deficiencies of Traditional Mortgages. The
mismatch problem arises out of varying maturities of
assets & liabilities and the changes in short-term
rates of interest. It can be resolved through acquiring
long term deposits or designing different sorts of
mortgages.
The tilt problem relates to the higher burden of
repayment installments in the beginning & a
reduction in the same during the latter years due to
inflation. This discourages purchases of houses in
early earning years.
Adjustable-Rate Mortgages. The returns of this
asset match the short-term market rates.
- Characteristics of the Adjustable-rate Mortgage.
It involves periodic resetting of interest rate in
accordance with some index reflecting short term

63

market rates e.g. one year Treasury rate or the 11th

Home Loan Bank Board District.
It suits the lenders; but borrowers can opt for
prepayment.
Period caps & lifetime caps, which are expressed in
percentages, impose limits on resetting of interest.
- Balloon/Reset Mortgages. A long term financing
but the rate is renegotiated at specified future dates.
Or a short term lending, which can extend up to an
agreed longer term on revised rates. The maximum
change can be up to 50 points per year; & the period
of renegotiation can vary from 3 to 7 years as
determined at origination.
- Assessment of Adjustable-Rate Mortgages. They
provide a solution to the problem of mismatch of
maturities. It is said that instead of tying caps to
certain indexes they should be left to private
bargaining. It is also said that ARMs do not address
the tilt problem.
Mortgage Designs to Deal with Inflation.
Inflation & associated problems helped creation of
the following designs to cope with the problems of
apparent difference in interest rates, the value of
property & the tilt effect.
- Graduated-Payment Mortgage. The nominal
monthly payments grow for a few initial years at a
constant rate & remain level afterwards. The interest
rate remains same.
Since rate of inflation cannot be determined; &
interest rate on mortgage is fixed, this type does not
suggest a proper solution to the problems of tilt as
well as mismatch maturities. It also does not deal
properly with inflation.

64

- Price-Level-Adjusted Mortgage. (PLAM)It is like a

traditional mortgage except that the rate is real
instead of the nominal one, specifying the index to
be used. The real value of the monthly installments
due each year & the outstanding balance are
computed in accordance with the movement of the
index. This method has been used in many countries
with high degree of inflation but not in USA.
- Dual-Rate
Mortgage.
(DRM-Inflation-proof
mortgage). Initial payments start lower than the
normal amortized amount & then gradually rise
(normally annually) in accordance with changes in
purchasing power. Thus the annual payments are
level in terms of purchasing power.
The amount owed by borrower is computed on the
basis some floating short-term rate like Treasury Bills
etc., which eliminates the interest & prepayment
risks.
It has very limited application in USA.
Other Mortgage Designs.
- Pre-payment penalty Mortgages. It is a recent
development, based on Federal & State Laws. Some
States permit this on fixed rate mortgages others do
not. The Federal laws overrule the State legislation.
Typically prepayments beyond 20% of original loan
are not permitted during first 3 to 5 years lockout
period. In a 3 years lockout period, penalty equals
lesser of 2% of prepayment beyond 20% or six
months interest on this amount. In 5 years it is 6
months interest on this amount.
Growing-Equity
Mortgage.
The
monthly
repayments increase over time, to pay down the

65

principal faster & shorten the term of mortgage. The

rate remains the same.
- Reverse Mortgages. Conversion of equity into cash;
borrowing against a fully owned home or the one
with very low repayable balance. It also involves
purchase of house with a combination of own funds &
calculated amount of reverse mortgage. The amount
depends upon age of borrower, value of property &
rate of interest.
- High-LTV Loans. They have been designed for
borrowers in conventional non-conforming loans with
less than the required, or no down payments.
Alt-A
Loans.
It
allows
alternate/reduced
documentation in the absence of conforming criteria.
The credit quality of the borrower must compensate
the lack of documentation. Borrowers willingly pay a
premium in rate for the privilege.
- Sub prime Loans. Loans to people with blemished
credit history. They comprise various credit risk
grades, starting from fallen angels at the top &
ending with habitual mismanagement of debts, with
appropriate pricing criteria.
Commercial
Mortgage-Backed
Securities.
Loans for income-producing properties, with recourse
only against the property & not the borrower, both,
for interest and principal.
- Measures used in evaluating the Credit Risk of
Commercial Mortgage Loans. The two ratios are
Debt-to-Value & Debt-to-service-coverage.
- Pre-payment protection to lenders.
1. Prepayment lockout.
2. Defeasance. Provision of sufficient funds for
investment in Treasury securities to replicate

66

the expected cash flows in the absence of

prepayments.
3. Prepayment penalty points.
4. Yield maintenance charge.

Investment Risks. There are four

types of risks:
Credit Risk. The risk of default.
Insurance provides a solution.
LTV
can measure the risk.
- Liquidity Risk. Mortgage loans,
being large & indivisible, are
quite
illiquid.
- Price Risk. A rise in interest rate
decreases the price of a
mortgage
loan.
- Prepayments
and
Cash
Flow
Uncertainty. Prepayments
affect the
certainty of cash flows.

67

FINANCIAL FUTURES MARKET (Chapter 26)

Futures Contracts help in hedging adverse price
movements. There can be commodity futures and
financial futures; the latter comprising stockindex/interest rate/currency futures.
Futures Contracts. Contracts to buy or sell
specific amount of a specific item at a specific future
date & price.
The key elements in futures contracts are futures
price, settlement date, underlying, long position and
short position.
Liquidating a Position. It involves, either taking
an offsetting position before due date, or delivery of
underlying on due date at agreed price.
The role of the Clearinghouse. A corporation
associated with an exchange that guarantees
performance by two parties to a transaction.
Whenever someone takes a position in the futures
market, the clearinghouse takes the opposite
position. It buys every sale & sells every purchase.
Margin Requirements. Exchange set minimum
margin requirements for futures contracts (the
investors equity); each individual firm can set its
own margin above this amount. It can also be an
interest bearing security.
Settlement price i.e. the price considered to be
representative for futures contracts is determined
daily which reflects the investors equity also.

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Maintenance margin. The minimum margin level

for equity of an investor. Any reduction below this
margin calls for variation margin, only in cash. While
investing in securities this margin can be borrowed
from the broker, but not in futures contracts. The
maintenance margin is less than the equity margin,
but when equity falls even below this level, it is
required to be raised to the equity level.
Leveraging Aspect of Futures. A position can
be taken on provision of the required margin only;
even in the absence of the total amount for a futures
transaction.
Market Structure. Futures contract are traded at
the designated location of Futures Exchanges called
Pit; price is determined through open outcry of bids
or hand signals. Trading is restricted to members,
who are of two types; locals and floor brokers. The
former trade for themselves & the later trade for
themselves as well as act as brokers.
Meeting of members at the pit for trading is still the
dominant way of determination of price, despite
introduction of round the clock electronic system.
Daily Price Limits. Exchanges can impose limits
on variation of prices of future contracts over the
closing prices of previous day. These limits cannot be
violated. There are reasons for and against this
controversial discretion.
Futures Vs Forward Contract.
Both are similar with variations in following areas:
Standardization,
dealings
through
organized
exchanges, availability of Clearing House & the
resultant reduced credit risk, existence of secondary

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market, mode of settlement, interim cash flows on

account of margin fluctuations etc.
The Role of Futures in Financial Markets. In
the absence of futures market, investors could alter
their investment portfolio through cash only. The
level of efficiency of the two determines the choice
between them.
The futures market is the easier & less costly market
for altering a portfolio position; therefore it is the one
where price discovery takes place on receipt of some
information, which is later on transmitted to the cash
market.
Speculative dealings in the futures market have
sparked
criticism and conflicting arguments from
the two sides of the divide. Though confirmed that
price volatility of the financial assets dealt in futures
market has increased; it is being justified by one
quarter & criticized by the other.
U.S. Financial Futures Market
Stock Index Futures Market. 1982 onwards
broad based & specialized stock index futures
contracts have been introduced, the most active
being S & P 500.
$ value of a stock index futures contract=price of the
futures contract X the notified multiple. They are
settled in cash.
Interest Rate Futures Markets.
Treasury Bill Futures. These futures contracts
involve delivery of Treasury Bills of the face value of
one million with 13 weeks remaining to maturity on
agreed futures price, at the settlement date.
Eurodollar CD Futures. The underlying is three
months Eurodollar CD of face value of $ one million.
Their settlement is through cash & they are a more

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popular mode of short-term investment than Treasury

Bill Futures.
Treasury Bond Futures. The underlying is a
hypothetical $ 100,000, 20 year, 6% coupon bond.
Rates are quoted in terms of this hypothetical bond,
but the seller has choice between several actual
bonds acceptable for delivery with at least 15 years
to maturity. Since the underlying does not exist,
problems crop up at delivery in determining its actual
value at the date of settlement. Variations in rate of
6% might not provide equitable return to one of the
two parties. Conversion factors take care of this
problem.
The delivery options are also the discretion of the
seller.
Treasury Note Futures. There are three futures
options: 10, 5 and 2 year. The underlying for the 1st is
a $ 100,000, 6%, 10 year hypothetical Note with
maturity not less than 6.5 years or greater than 10
years from the first day of delivery month. The
maturity of 2nd not to be more than 5 yr 3 months,
remaining not greater than 5 yr 3 months & less than
4 yrs 2 months. The 3rd pertains to a note of 200,000,
remaining maturity not above 2 yrs & below 1 yr 9
months.
Agency Future Contract. Since agency securities
are gaining ground & replacing Treasury securities as
interest bench mark, future contracts have started
taking place in the same. The underlying is a 10 year
Agency Note with a face value of $ 100,000 & a
notional coupon of 6%. The note must be uncallable,
with original maturity of not more than 10.25 years &
remaining maturity of at least 6.5 years; the original
issue should be $ 3 billion or above; fixed coupons

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should be payable semi-annually. The delivery

months are March, June, Sept and December.
Bond Buyers Municipal Index Futures. The
underlying is a basket of 40 Municipal Bonds. The
Bond Buyer, a trade publication of municipal bonds
industry manages the index. On receipt of prices
from brokers average price referred to as appraisal
value is determined. It is a cash settlement contract,
with value based upon the value of the basket on the
delivery date.
Financial Futures Markets in Other Countries
Other countries have also developed futures
contracts, mostly designed at the pattern of the US
futures market.
The GAO Study on Financial Derivatives
Some derivative instruments are exchange traded &
others are OTC, created by commercial banks without
having any risk management system. The General
Accounting Officer prepared a report, which
recognized the importance of derivatives, highlighted
the possible threats they pose to the entire financial
system and suggested certain measures for
improvement. The boards of directors & senior
management were advised to set basic standards to
manage risks; frame comprehensive accounting
rules, improve regulations in coordination with
foreign regulators
& regulate derivative activity
instead of suppressing it.
Forward Rate Agreements.
It is an OTC counterpart of exchange traded futures
contracts on short-term rates, typically short-term
LIBOR. Its elements are:

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The Contract rate. It is the rate specified in the

contract at which the buyer & seller agree to pay for
& receive respectively for investing funds.
Reference rate. It is the interest rate used. It could
be three months or six months LIBOR.
Notional amount. It is the notional principal
amount, which is not exchanged between parties.
Settlement rate. The value of the reference rate at
the settlement date. It is the market rate of the
reference rate.
Settlement date. The date at which actual
transaction is to take place.
They are cash settlement contracts & in the case of
difference between contract & settlement rates:
Buyer receives compensation if settlement rate is >
contract rate & vice versa.