FIN301 StudyGuide PDF

Course Development Team
Head of Programme : Dr Tan Chong Hui

Course Developer(s) : Prof Sundaram Janakiramanan
Technical Writer : Diane Quek, ETP
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permission in writing from the Educational Technology & Production, Singapore
University of Social Sciences.
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How to cite this Study Guide (APA):

Sundaram Janakiramanan. (2020). FIN301 Financial instruments, institutions and markets
(study guide). Singapore: Singapore University of Social Sciences.
Release V1.7
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Table of Contents

Table of Contents
Course Guide
1. Welcome.................................................................................................................. CG-2
2. Course Description and Aims............................................................................ CG-3
3. Learning Outcomes.............................................................................................. CG-4
4. Learning Material................................................................................................. CG-5
5. Assessment Overview.......................................................................................... CG-6
6. Course Schedule.................................................................................................... CG-8
Study Unit 1:
Learning Outcomes................................................................................................. SU1-2
Overview................................................................................................................... SU1-3
Chapter 1: The Financial System........................................................................... SU1-4
Chapter 2: Characteristics & Regulation of Financial Markets and
Instruments............................................................................................................. SU1-15
Chapter 3: Efficient Market Hypothesis............................................................. SU1-23
Formative Assessment.......................................................................................... SU1-28
Study Unit 2:
Overview................................................................................................................... SU2-3
Chapter 4: Financial Institutions........................................................................... SU2-4
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Table of Contents
Study Unit 3:
Overview................................................................................................................... SU3-3
Chapter 5: Money Market and Money Market Instruments............................. SU3-4
Chapter 6: Bond Markets and Instruments....................................................... SU3-25
Study Unit 4:
Overview................................................................................................................... SU4-3
Chapter 7: Equity Markets..................................................................................... SU4-4
Chapter 8: Stock Index Related Securities......................................................... SU4-24
Study Unit 5:
Overview................................................................................................................... SU5-3
Chapter 9: Derivatives Market and Instruments................................................ SU5-4
Chapter 10: Options, Credit Derivatives and Swaps....................................... SU5-28
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Table of Contents
Study Unit 6:
Overview................................................................................................................... SU6-3
Chapter 11: Foreign Exchange Market................................................................. SU6-4
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Table of Contents
iv
List of Lesson Recordings
The Financial System................................................................................................. SU1-14
Characteristics and Regulations............................................................................... SU1-22
Efficient Market Hypothesis..................................................................................... SU1-27
Financial Institutions (Commercial Banks)............................................................. SU2-79
Financial Institutions (Investment Banks and Mutual Funds)............................. SU2-79
Financial Institutions (Insurance Companies and Pension Funds)..................... SU2-79
Money Market and Money Market Instruments................................................... SU3-24
Bond Markets and Instruments................................................................................ SU3-49
Equity Markets............................................................................................................ SU4-23
Equity Related Securities........................................................................................... SU4-31
Derivatives Markets and Instruments..................................................................... SU5-27
Options.......................................................................................................................... SU5-55
Credit Derivatives and Swaps.................................................................................. SU5-55
Foreign Exchange Market.......................................................................................... SU6-22
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Course
Guide
Financial Instruments, Institutions

and Markets
FIN301 Course Guide
1. Welcome
Welcome to your study of FIN301 Financial Instruments, Institutions and Markets, a 5 credit
unit (CU) course.
This Study Guide is divided into two sections – the Course Guide and Study Units.
The Course Guide provides a structure for the entire course. As the phrase implies, the
Course Guide aims to guide you through the learning experience. In other words, it may
be seen as a roadmap through which you are introduced to the different topics within
the broader subject. This Guide has been prepared to help you understand the aims and
learning outcomes of the course. In addition, it explains how the various materials and
resources are organised and how they may be used, how your learning will be assessed,
and how to get help if you need it.
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FIN301 Course Guide
2. Course Description and Aims
Financial Markets facilitate transfer of resources from savers and investors to the users
of funds; they provide a forum for trading financial assets, discovery of prices, risk
sharing and risk management, and mechanisms for transfer of ownership, control and
governance. Thus, financial markets and the instruments traded therein play a vital
role in meeting the fundamental economic objectives of mobilising funds, allocating
them efficiently, and monitoring their use. Financial institutions perform a vital role as
intermediaries between savers and the ultimate investors. They are crucial for the efficient
functioning and stability of an economy. This course provides a basic understanding of
the significance of financial markets and financial institutions in the economy.
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FIN301 Course Guide
3. Learning Outcomes
Knowledge & Understanding (Theory Component)
1. Explain the significance and functioning of financial markets in the economy

2. Differentiate between financial markets such as money markets, equity markets,
debt markets, derivative markets and foreign exchange markets; the trading
platforms and trading mechanisms deployed, and the methods of price
discovery
3. Examine the nature of various financial instruments traded in money markets,
bond markets, equity markets, derivatives markets, the foreign exchange
markets and mortgage markets
4. Distinguish between the implications of various forms of market efficiency
5. Appraise the role of financial institutions in the economy
6. Describe the operations of various financial institutions
Key Skills (Practical Component)
1. Discuss the functioning of financial markets, and their role and significance in
the economy
2. Analyse the role and functions of financial instruments traded in financial
markets
3. Illustrate how financial instruments are traded in financial markets
4. Demonstrate the essential knowledge and interpersonal skills to exchange ideas
about instruments, institutions and international markets effectively in a team
5. Demonstrate proficiency in writing about financial instruments, institutions and
markets
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FIN301 Course Guide
4. Learning Material
The following is a list of the required learning materials to complete this course.
Required Textbook(s)
Saunders, A., & Cornett, M. M. (2015). Financial markets and institutions (6th ed.).
McGraw Hill.
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FIN301 Course Guide
5. Assessment Overview
The overall assessment weighting for this course for the Evening Cohort is as follows:
Assessment Description Weight

Allocation
Pre-Course Quiz 1 2%
Assignment 1 Pre-Class Quiz 1 2%
Pre-Class Quiz 2 2%
Assignment 2 Group-Based Assignment / GBA 38%
Class Participation Class Participation 6%
Examination Written Examination 50%
TOTAL 100%
The overall assessment weighting for this course for the Day-time Cohort is as follows:

Allocation
Assignment 1 Pre-Course Quiz 2 2%
Assignment 2 Group-Based Assignment / GBA 38%
Class Participation Class Participation 6%
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FIN301 Course Guide

Allocation
Examination Written Examination 50%
TOTAL 100%
SUSS’s assessment strategy consists of two components, Overall Continuous Assessment

(OCAS) and Overall Examinable Component (OES) that make up the overall course
assessment score.
For SBiz courses, both components will be equally weighted: 50% OCAS and 50% OES.
(a) OCAS: The sub-components are reflected in the tables above and are different for the
day-time and evening cohort. The continuous assignments are compulsory and are non-
substitutable.
(b) OES: The End-of Course Assessment (ECA) is 100% of this component.
To be sure of a pass result, you need to achieve scores of at least 40% in each component.
Your overall rank score is the weighted average of both components.
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FIN301 Course Guide
6. Course Schedule
To help monitor your study progress, you should pay special attention to your
Course Schedule. It contains study unit related activities including Assignments, Self-
assessments, and Examinations. Please refer to the Course Timetable in the Student Portal
for the updated Course Schedule.
Note: You should always make it a point to check the Student Portal for any
announcements and latest updates.
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1
Study
Unit
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Learning Outcomes
At the end of this unit, you are expected to:
• Analyse the components of a financial system

• Distinguish between primary and secondary market
• Contrast money market and capital market
• Analyse the functions served by financial markets
• Explain the structure of financial markets
• Examine the characteristics of financial securities
• Analyse the need for regulation of financial market and instruments and explain
how these are regulated
• Analyse the concept of market efficiency
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Overview
Chapter 1 provides an introduction to the course on financial institutions, instruments

and markets. The first section discusses the financial system, which comprises financial
market, instruments and institutions. This is followed by the function of financial markets
and a basic classification of financial markets.
In Chapter 2, we will discuss the characteristics of and functions served by financial

markets. This will be followed by a discussion on the financial market structure. The
characteristics of financial securities and market regulations will also be explained.
One of the most important concepts in financial markets is that of market efficiency.
Market efficiency deals with the role of information and its impact on the pricing of a
security. In Chapter 3, the concept of an efficient market will be introduced and the various
definitions of efficient markets will be examined.
Read
Chapter 1 of “Financial Markets and Institutions”, Saunders and Cornett, Sixth International
Edition, (2015).
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Chapter 1: The Financial System
1.1 What is Financial System?

The financial system has evolved over many years. The main purpose of developing a
financial system is to ensure an orderly flow of funds from those who have excess funds
at any given time, to those who require these funds. The funds may be required to make
investments in real as well as financial assets to meet the necessary expenses. Those who
have excess funds may have them for a very short period or for long-term periods. The
financial system developed should be such that it provides for orderly flow of funds and
at the same time, protect both parties who transact without suffering heavy losses. This
requires appropriate regulations in relation to the transactions in the system.
The financial system includes the government, businesses and individuals. Consider a
business that requires funds for making an investment in real assets. It can raise the
necessary funds by borrowing money through issue of debt securities called bonds or
through issue of ownership securities called equity securities. If it is to raise money, it
needs to find investors, usually individuals who are willing to provide these funds. Since
it could be very costly and time-consuming for businesses to find investors, the businesses
often use financial intermediaries who will channel the funds from investors to businesses.
In a similar manner, governments may decide to issue debt securities to investors using
intermediaries. Individuals would like to protect themselves from possible risks for which
they may be willing to pay, which has resulted in a financial intermediary called insurance
companies.
Thus, the financial system comprises:
• Individuals
• Governments
• Businesses
• Financial institutions who act as intermediaries
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The major financial institutions are:
• Banks that collect deposits from investors and provide loans to individuals and
businesses. They also provide assistance to companies involved in trade so that the
process of payment in trade transactions is facilitated.
• Investment banks that provide services to businesses in raising funds through issue
of securities.
• Insurance companies that provide protection to individuals and businesses against
known risks and receive premiums from clients.
• Pension funds collect periodic payments from individuals during their
employment to provide benefits during retirement periods.
• Mutual funds and hedge funds which collect money from individuals and invest
this money in securities on behalf of these individuals.
• Exchanges that provide for orderly transactions between investors who are
interested to trade securities.
Since all these financial institutions are dealing with funds collected from individuals, it is
necessary, therefore, to ensure that these institutions are acting in the best interests of these
individuals. Governments have enacted a number of laws and regulations that govern
operations of institutions so that customers to these institutions are protected.
There are two parts to the financial system:
• Financial institutions who act as intermediaries between the sources of funds and
the entities that require them.
• Financial markets where the actual transactions take place between these two
parties.
In this course, we will discuss the various aspects of financial markets and how
transactions take place in these markets. We will also discuss the characteristics of the
various securities that are traded in the financial markets. The role and functions of
financial institutions will also be discussed.
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1.2 Financial Markets

Financial markets allow for funds to flow from entities that have excess funds to those
that require them. In order for the financial market to function efficiently, there should
be sufficient safeguards to ensure that traders are able to transact and are able to fulfil
their obligations. This is done through appropriate regulations. A financial market can be
classified as either a primary or secondary market based on the type of transactions and
as either money market or capital market based on the characteristics of the securities in
the market.
1.2.1 Primary Market

When an issuer of a security issues either directly or through an intermediary to the buyers
of the security, it is called a primary market transaction. The security is created in the
primary market. Most primary market transactions take place using investment bankers
as intermediaries. Some of these primary market issues are also made through auctions,
especially those issued by the government. Primary market issues can be sold to a few
investors only; in which case, it will be called a private placement. There are procedures
for primary market issues to be made by businesses. Primary market instruments include
the first time issue of equity by businesses which are called initial public offerings (IPOs),
issues of additional shares by companies which are called seasoned issues, issue of debt
by businesses which are called corporate debt, issues of debt by government which are
called government debt.
1.2.2 Secondary Market

When securities are issued in the primary market, those who bought these securities may
want to sell them to others who are willing to buy. The secondary market is created for
this exact purpose. The secondary market provides for trading of securities already issued
by the government or businesses among investors.
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There are two categories of secondary markets, namely, over-the-counter market that
allows for trading any security between two investors (usually involving brokers to
complete the transaction) and over-the-counter market transactions are between private
parties and very few regulations govern these transactions. Trading in exchanges, on the
other hand, takes place with rules and regulations imposed by the exchange, and only
those securities that are allowed by the exchange are traded. The exchange will have a
clearing and settlement system through which all transactions are clearly recorded and
exchange of security and cash are affected with efficiency.
The exchange will also require that all pertinent information about all the issues and
businesses are made available to the exchange and investors, so that investors can make
informed decisions about trading these securities. The last transacted price is made
available and thus trading in exchanges exhibits transparency. The main advantage of
trading in exchanges is that it provides liquidity to the investors. Due to the centralised
trading facility in exchanges, the transaction costs of trading tend to be smaller.
All securities such as equity, bonds, other debt securities, shares of mutual fund and
derivative securities are traded in the secondary market.
1.2.3 Money Market

Money markets trade debt securities and instruments with maturity of one year or less.
Those entities that have funds available for short-term will lend to the entities that require
funds for short-term. Governments that need to finance their day-to-day operations will
issue Treasury bills or Government Bills with maturities of 91-days, 182 days or 364 days.
Businesses can issue commercial papers to raise short-term funds for a period of up to
270 days. Due to the short-term nature of the instruments, the default risk as well as the
interest rate risk is small and the return from these instruments also tends to be low.
The major money market instruments are:
• T-bills: Short-term obligations issued by the Government.
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• Repurchase Agreements: Agreements through which a party sells a security with a

promise to buy it back at a specified future date and price.
• Commercial paper: Short-term unsecured promissory notes issued by corporations.
• Negotiable certificates of deposit: These are receipts of fixed-deposits issued
by banks that have specification of interest rate, maturity and tradability
(negotiability).
• Bankers’ acceptances: These are time drafts payable to a seller of goods and
payment guaranteed by a bank.
1.2.4 Capital Market

Securities and instruments that have a maturity of more than one year are traded in the
capital market. The major instruments traded in capital market are common shares and
preference shares issued by corporations, bonds issued by the government or corporations
and collateral debt obligations based on mortgage loans or asset loans.
Whether securities are traded in the money market or capital market, there will be a
primary market where securities are issued to investors and a secondary market where
already issued securities are traded amongst investors. In addition to the money market
and capital market, two other markets are also important. These are foreign exchange
markets and derivatives securities markets.
1.2.5 Foreign Exchange Market

A foreign exchange market facilitates trading of foreign currencies. With globalisation,
trade amongst countries is increasing and many corporations are raising funds not only in
their own country but also in other countries. This increased cross-border trade and capital
flow requires flow of currencies and hence there should be a market where currencies can
be either bought or sold. In general, major banks facilitate foreign currency transactions
by buying and selling currencies with customers. There are two types of foreign exchange
market, namely, spot market and forward market. Currencies for immediate exchange are
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traded in the spot market while currencies for exchange at a future specific time are traded
in the forward market.
The participants in the foreign exchange market would include:
• Importers and exporters of goods and services

• Corporations that raise funds in foreign currencies
• Investors, whether individual or financial institutions, who invest in securities that
are denominated in foreign currencies
The foreign exchange market in any country is regulated by the Central Bank of that
country.
1.2.6 Derivative Security Market

A derivative security market is where securities such as forward, futures, options and
swap contracts are traded. A derivative security is one whose payoffs are related to the
value of another financial security or real asset. In a derivative security transaction, one
party agrees to buy or sell a security or a real asset at a future time, at a specified price
either stated in the contract or at a price determined by the market. The derivatives can
be traded either in over-the-counter markets or in derivative exchanges.
1.3 Internationalisation of Financial Institutions and Financial

Markets
With the pace of globalisation and increasing deregulation of financial institutions,
managing risk and maintaining profits in a rapidly changing and increasingly competitive
global market are of paramount importance. Institutions continue to merge within and
across traditional financial product lines in an attempt to exploit perceived economies of
scale and scope and to prevent others from gaining similar advantages over them. The
pace of innovation of new technology, new financial products and services has continued
unabated. With the rapid pace of information technology, we are on the cusp of many
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technological advances that may change traditional methods of offering financial services
at the wholesale and perhaps eventually at the retail level.
The internationalisation of the financial system is an important trend. The US no longer

dominates the world stage. Internationalisation is reflected in many developments and
trends in the financial system.
The growth in foreign financial markets has five ongoing causes:
• Growing pool of savings in developing economies, e.g., in China, households save

nearly 50% of income
• Better investment prospects in a growing number of countries, e.g., in the BRICS
economies
• Developments in information technology and the Internet have improved
information availability on international markets and securities.
• Falling costs of investing in international securities, such as ADRs, GDRs,
Internationally diversified mutual funds
• Deregulation around the world has allowed investors to purchase more foreign
securities.
Other manifestations of globalisation of the financial system are reflected in:
• International Bond Market & Eurobonds

◦ Foreign bonds
▪ Denominated in a foreign currency
▪ Targeted at a foreign market
◦ Euro Bonds
▪ Denominated in one currency, but sold in a different market
▪ Now larger than US corporate bond market
▪ Over 80% of new bonds are Eurobonds
◦ Eurocurrency Market
▪ Foreign currency deposited outside of home country
▪ Eurodollars are US dollars deposited in, say, London
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▪ Gives US borrowers an alternative source for dollars

• World Stock Markets
◦ US stock markets are no longer always the largest—at one point, Japan’s was
larger. The number of international stock market indexes is quite large. US
Capital Markets have declined in importance, however this is due to rapid
growth in other parts of the world, as developing economies realise their
growth potential.
◦ The US has lost its dominance in many industries: auto and consumer
electronics to name a few.
◦ A similar trend appears at work for US financial markets, as London and
Hong Kong compete. Indeed, many US firms use these markets over the US
The relative decline of US Capital Markets is due to:
• New technology in foreign exchanges

• 9-11 made US regulations tighter
• Greater risk of lawsuit in the US
• Sarbanes-Oxley has increased the cost of being a US-listed public company
1.4 The Financial Sector in Singapore

In just over four decades, Singapore has established a thriving financial centre of
international repute, serving not only its domestic economy, but also the wider Asia
Pacific region and in some instances, the world. Singapore's financial centre offers a broad
range of financial services including banking, insurance, investment banking and treasury
services.
A key aspect of Singapore’s financial centre is its deep and liquid capital markets. With
one of the more well-established capital markets in Asia-Pacific, the Singapore Exchange
(SGX) is the preferred listing location of close to 800 global companies. Today, Singapore
has grown to be the largest Real Estate Investment Trust (REITs) market in Asia ex-Japan
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and also provides an extensive offering of investments in business trusts of shipping,

aviation and infrastructure assets.
Singapore’s bond market has also grown significantly. With an extensive range of both
Singapore government securities and foreign corporate bonds available, Singapore offers
fixed income investors a wide range of investment opportunities.
As one of the top 4 most active foreign exchange trading centres in the world, Singapore is
also the second largest over-the-counter derivatives trading centre in Asia, and a leading
commodities derivatives trading hub.
With total assets under management of around S$1.2 trillion, and which continues to
see steady growth, Singapore is also recognised as one of the premier asset management
locations in Asia.
1.4.1 Why Singapore?

As an international financial centre, Singapore offers financial institutions a pro-
business environment, excellent infrastructure, cost-competitiveness, a highly skilled and
cosmopolitan labour force, and is strategically located in a region of opportunities.
1.4.1.1 Conducive Business Environment

Singapore has long been recognised as one of the best cities for business. In the Swiss-
based international Institution for Management Development's 2010 Competitiveness
Yearbook, Singapore has been ranked as the most competitive country in the world. This
is what a World Bank report had to say about doing business in Singapore. "It takes an
entrepreneur just over 6 working days to get a new business going in Singapore, with
low start-up costs. Overall, taking into account other factors, including business licensing,
taxes, credit legal rights and investor protection, Singapore has about the most business-
friendly regulation in the world."
Investors have also come to appreciate the high levels of transparency and reliability in
business, economic and regulatory affairs in Singapore. A stable political structure with
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parliamentary democracy, a well-established judicial system, and the presence of strong

domestic institutions with good corporate governance practices, have made the Singapore
business environment even more attractive to global investors.
1.4.1.2 Excellent Infrastructure

Singapore's unique location and sophisticated telecommunications network allow
financial institutions here to transact business with any part of the world within the same
working day. International travel out of Singapore is equally convenient, with more than
84 international airlines operating scheduled services through Singapore to more than 180
cities in 57 countries worldwide.
We have a robust and efficient legal and judicial framework and a well-regulated
international financial sector. Singapore is the only Asian country with an "AAA" rating.
1.4.1.3 Cost Competitiveness

Singapore offers financial institutions a competitive tax rate environment. Singapore's
corporate tax rate is one of the lowest in Asia-Pacific. Singapore also offers the advantage
of having a comprehensive network of Double Tax Agreements with more than 60
countries. Singapore also continues to be cost competitive compared with other major
cities.
1.4.1.4 Skilled Workforce & Attraction of Talents

Singapore also has a skilled workforce to meet industry demand. In addition to grooming
the local workforce meet the demand of the industry, Singapore also has an open door
policy to international talent and expertise.
Washington-based risk consultancy agency, Business Environment Risk Intelligence

(BERI), has rated Singapore's workforce as the world's best workers since 1980. According
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to the IMD World Competitiveness Yearbook 2010, Singapore's labour regulations are also
the most business conducive in Asia.
1.4.1.5 Strategic Location in a Region of Opportunities

Singapore is strategically located in a region of opportunities. Located at the heart of
Southeast Asia, Singapore is well placed to serve the fast-growing markets of the Asia-
Pacific region. Financial institutions in Singapore also trade around-the-clock with Asia-
Pacific centres, as well as European and American centres, making Singapore a significant
hub for 24-hour trading in foreign exchange and securities. International travel is equally
convenient. Singapore has grown to be a strategic link and important gateway for global
investors.
Singapore seeks to ensure its relevance and connectivity to growth markets, not just
in Asia but also beyond. As part of this initiative, Singapore has concluded Free Trade
Agreements (FTAs) with major economies, including the United States, China, Japan,
India, Korea, Australia, New Zealand, Switzerland and Jordan. There are ongoing FTA
talks with other countries. These FTAs provide privileged access to the markets of
partner countries. Beyond the immediate region, Singapore is also building linkages with
countries further a-field including the Middle East, capitalising on the growing trade and
investment interests between these two regions.
Lesson Recording
The Financial System
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Chapter 2: Characteristics & Regulation of Financial

Markets and Instruments
2.1 Function of Financial Markets

Effective financial markets are necessary for sustained broad-based economic growth. The
financial markets perform broad functions and possess key characteristics.
2.1.1 Mobilise Savings

The major function of a financial market is to mobilise domestic resources for productive
investment. The financial market provides the principal means to transfer savings from
individuals and companies to private enterprises, farmers, individuals and others in
need of capital for productive investment. Efficient financial market channels resources to
activities that will provide the highest rate of return for the use of funds. These resources
stimulate economic growth as they provide enterprises with the ability to produce more
goods and services and to generate jobs.
Well functioning and well developed financial market encourages savings and allocates
resources to higher yielding investments. Savers can make their surpluses available to
businesses by purchasing financial assets from a variety of debt and equity or make
deposits such as a savings account in banks. The financial market mobilises savings and
increases liquidity by providing asset holders with attractive financial claims in terms of
yield, risk and liquidity. In the absence of developed financial markets, only investments
financed by individual savers or closely-knit groups of individuals would be possible.
Many high yielding investments would not be undertaken and some capital would be
invested in activities yielding low returns.
Well-developed financial markets offer a variety of short-term and long-term savings and
investment instruments through qualified financial intermediaries that help individuals
make reasonable judgements about the risk and rewards of saving or investing their funds.
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These instruments effectively package risk and returns so that the individuals who wish
to participate in appropriate markets can do so taking into account their own perceived
capacity to accept risk.
2.1.2 Price Discovery

The interaction of buyers and sellers in a financial market determines the price of the
traded asset; or, equivalently, the required return on a financial asset is determined. The
inducement for firms to acquire funds depends on the required return that investors
demand, and this feature of financial markets signals how the funds in the economy
should be allocated among financial assets. It is called the price discovery process.
2.1.3 Provide Liquidity

Financial markets provide a mechanism for investors to sell financial assets. This feature
offers liquidity in the financial markets, an attractive characteristic when circumstances
either force or motivate investors to sell. In the absence of liquidity, the owner must hold
a debt instrument until it matures and an equity instrument until the company either
voluntarily or involuntarily liquidates. Although all financial markets provide some form
of liquidity, the level of liquidity is one of the factors that differentiate various markets.
2.1.4 Information
A financial market reduces the search and information costs of transacting. Search costs
represent explicit costs such as money spent to advertise the desire to buy or sell a
financial asset and implicit costs such as the value of time spent in locating a counterparty.
The presence of a financial market reduces search costs. Information costs are incurred
in assessing the investment merits of a financial asset. Information is transmitted to
individuals through price discovery process.
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2.2 Financial Market Structure

There are three main characteristics that define the financial market structure, namely,
trading sessions, execution system and information system.
2.2.1 Trading Session

Trading session refers to time intervals at which trade takes place. This can differ across
markets. Most of the trading in exchanges takes place during fixed time intervals during
the day. Foreign exchange market follows continuous trading and trades are fulfilled
continuously as the orders arrive.
2.2.2 Execution Systems

The execution system defines how the sellers and buyers are matched. There are a number
of execution systems that follow, which are:
• Quote-driven system – In this system, dealers supply all liquidity. Dealers quote
their bid and ask prices. Better prices and larger quotes for larger sizes may be
obtained through negotiation. Brokers or buy-side traders choose which dealer
they trade with. Examples of quote-driven systems are NASDAQ, foreign exchange
markets and over-the-counter markets.
• Order-driven systems – These are auction markets organised by exchanges and
follow order precedence trading rules to match buyers and sellers and a set of
pricing rules to determine the trade prices. Since traders cannot choose with whom
they trade, order-driven markets use clearinghouses.
• Brokered systems – These are organised by brokers who actively search for
matching buyers and sellers. Brokered markets usually arise when the item traded
is somehow unique and when dealers are unwilling to hold inventories. Brokered
market examples include block trading market and real estate market.
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Hybrid systems, which are a mixture of all three, have an order-driven auction market in
which the specialist must provide liquidity. NYSE uses this system.
2.2.3 Information System

Information systems collect, organise, present, store and transmit information about
orders, quotes and trades. Electronic trading systems facilitate collection of information
from market participants. Order routing systems, order presentation systems and order
books are used to transmit, present and manage standing orders. These systems may be
maintained by brokers, dealers or exchanges. Complex orders are often communicated by
telephone. On some exchanges, hand signals may be used to send an order from an order
clerk to a floor trader. In open outcry auctions, traders speak out their bids and offers
on the floor of the exchange. In screen-based trading system, orders are presented on a
computer screen. In board-based trading system, orders are written on a big board. Order
books hold orders that have not yet been executed. An order book may be an electronic
database or a box of trading tickets brokers, exchanges and dealers maintain.
Collected information is distributed to member traders. Market data systems report trades
and quotes to the public. Price and sale feeds, known as ticket tapes, report trade prices
and sizes. Quotation feeds report quotation changes. Trade information is sold to various
data vendors such as Bloomberg, who repackage it for distribution to the public.
A market is transparent when complete information is reported to the public quickly.
2.3 Financial Security

A financial security is a claim on cash flows generated through use of real assets or cash
flows generated by related financial assets for a financial security to be traded.
The security should be constructed taking into account the following:
• Conception
• Concepts and key features
• Context
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• Computations
• Connections with other instruments or markets
2.3.1 Conception
Conception of a financial security refers to the rationale for issue of the securities and what
functions the security serves. Unless the security serves some useful purpose, there will
be no interest in the security.
For example, the governments for the purpose of raising funds for meeting the
expenditures issue government bond and the investors receive periodic payments from
the bonds purchased.
2.3.2 Concepts and Key Features

This refers to the terms under which the security is issued. The terms include the maturity
of the security, payoff to the investors, negotiability, how they are priced and risks
involved.
For example, the government bond could state the maturity as 7 years, payoff to the
investors may be stated as 8% of the face value to be paid every six months and face value
to be paid at maturity.
Negotiability refers to whether the security can be traded or not and if it is traded, where
it will be traded. Government bond may be stated as negotiable with trade taking place in
the over-the-counter market. Pricing refers to how the security’s price can be calculated.
In case of government bonds, pricing will be based on calculating the present value of the
future cash flows.
The risks involved in purchasing the security could involve default risk, interest rate risk
or liquidity risk. For a government bond, default risk is low but it can exist as seen with
Greece in recent times. Interest rate risk may arise if the bond is sold before maturity as
bond price may change when interest rate changes. Liquidity risk may be present if there
is no active trading which is not present usually with government bonds.
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2.3.3 Context
Context refers to how the security is constructed and traded. In case of government bonds,
these are constructed with a stated maturity and payoff pattern and traded in the OTC
market.
2.3.4 Computations
Computations refer to the actual calculation of payoffs, price, yield, return and risk
measures.
2.3.5 Connection with Other Markets

Many securities traded in one market have connection with other markets. For example,
government bonds, although traded in the bond market, is connected to the derivatives
market where futures and options on government bonds may be traded. If these
government bonds are made available to foreign investors, bond market is also connected
with the foreign exchange market. If the yield increases on the bonds, the investors may
switch from stocks to bonds, thus providing connection with stock market.
In addition to these characteristics, it is also important that any new financial security
issued contributes towards market completion. An incomplete market is one in which any
new security would provide additional risk-return combinations that are not provided by
any existing security. In case the payoff from the new security can be replicated by using
the existing securities, there will be no demand for the new security and the new security
will be redundant.
2.4 Regulation of Financial Markets

Government plays a key role in assuring that financial markets operate effectively. The
government should facilitate financial market development and provide a regulatory
environment that encourages the appearance of competitive forces, encourages the use
of variety of debt and equity instruments, promotes the growth of different kinds of
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institutions offering a wide range of financial instruments and services to potential savers
and investors and protects the interests of savers by reducing their risks.
In addition, government should play an important role in the area of private ownership
and property rights. Private ownership and property rights arrangements are important
elements in determining the extent of an individual’s participation in financial markets.
When property rights exist, an individual has exclusive rights to use and derive the income
from assets, to transfer the assets voluntarily to others and to be assured that contracts of
exchange are enforceable.
Unlike markets in goods and services where there is a simultaneous exchange of value,
financial markets involve sale and purchase of assets through transactions that are
separate in time. The product is exchanged for a commitment or promise to act in the
future. Thus assessing and coping with risk is an essential component of every financial
market transaction. The risk can arise because of non-performance of contract.
Government enacts regulations mainly to:
• Reduce the risk for market participants

• Protect private ownership and property rights
• Protect the interests of the market participants
Government regulation includes:
• The type of securities that can be traded;

• How the securities are traded; and
• How the risk for investors is reduced.
In the USA, the Securities and Exchange Commission oversees the regulation on what
type of securities can be traded in stock exchanges. SEC regulation also provides for
full disclosure from issuer of securities as to the purpose of issue as well as other
pertinent information. Futures trading are regulated by Futures Trading Commission,
which oversees the operations of futures exchanges. The stock exchange and futures
exchanges have regulations about who can trade in these exchanges as well as for
managing the risks of investors who trade in these exchanges.
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In Singapore, the Monetary Authority of Singapore is the regulating authority with

Singapore Exchange enacting appropriate regulations.
On the other hand, over-the-counter market transactions are not directly regulated.
However, the International Security Dealers Association (ISDA) is the self-regulating body
in the sense that all members belonging to ISDA have formed their own regulations on
the conduct of the brokers and dealers in securities.
The foreign exchange market is regulated by respective Central Banks of the countries.
Lesson Recording
Characteristics and Regulations
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Chapter 3: Efficient Market Hypothesis
3.1 Concept of Market Efficiency

In the 1950s, researchers started analysing the economic time series. This would predict
the progress of the economy by looking at the various economic variables and would help
in assessing when a boom or trough will occur. The natural offshoot of this was the study
of stock prices over time. If stock prices are based on how the firm is expected to do in
the future, the pattern of booms and troughs of economic cycle should be reflected in the
stock prices.
However, in 1953, Maurice Kendell found that there was no predictable pattern for stock
prices, which seemed to evolve randomly. On any given day, the prices were as likely to
up or go down irrespective of past performance and hence there was no way in which
the price movement could be predicted. The random price movements indicate a well-
functioning or efficient market and not an irrational one.
Consider a simple scenario. Suppose the price of DBS shares which are currently at $20
and the model based on past performance indicates that the price would rise to $22 after
2 days. Obviously, one would buy this stock, as it would result in a gain of 10% over 2
days. However, there may be many investors who may use the same model and all of
them would want to buy the stock at the current time. This would increase the demand
for DBS stock at the current time, which will push the price of DBS to $22 immediately.
This means that the “good” information will be immediately reflected in the stock price.
A forecast of a favourable performance leads to favourable current performance, as all
market participants will try to get into the market before the price increases.
This implies that any information that could be used to predict stock performance should
already be reflected in stock prices. If there is an information that the stock is undervalued,
which offers opportunity to make profit, investors would go en masse to buy the stock
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and bid up the prices to a fair value where only normal rates of return can be achieved.
These normal rates of return are the rates adjusted for the levels of risk involved.
If the prices are either bid up or down to fair levels given all the available information,
the price can increase or decrease only if there is new information and this new
information must be unpredictable. If the information is predictable, then this will be
part of all available information. Thus, only stock prices that change in response to new
unpredictable information will be unpredictable.
If this argument is valid, stock prices should follow a random walk, that is, price
changes should be random and unpredictable. Randomly evolving stock prices are the
consequence of rational investors discovering relevant information on which they decide
to buy or sell stocks before the rest of the market becomes aware of that information. The
notion that price reflects all available information is referred to as the efficient market
hypothesis.
3.2 Versions of the Efficient Market Hypothesis

There are three versions of the efficient market hypotheses, namely, weak, semi-strong
and strong forms of the hypothesis. The main difference among these is in defining “all
available information”.
Weak-form hypothesis states that stock prices reflect all information that can be derived
from examination of market trading data such as the history of past prices and trading
volume. This version of efficient market hypothesis implies that trend analysis will not
provide any benefit. Past stock price data is publicly available and costless to obtain.
If such data conveys any reliable signal about future performance, all investors would
already have learned to exploit these signals, which would lead to these signals to lose
their value as they would be widely known. For example, a buy signal would result in
immediate price increase.
The semi-strong form hypothesis states that all publicly available information regarding
the prospects of the firm must be reflected in the stock price. Such information includes,
in addition to past price data, fundamental data on the firm’s product line, quality
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of management, balance sheet analyses, earnings forecasts and accounting practices. If

investors have access to such information from publicly available sources, this information
should be reflected in stock price.
The strong-form version of efficient markets states that stock price reflects all information
relevant to the firm, even including information available only to company insiders. It is
quite evident that corporate officers have access to pertinent information long before it
becomes available to the public so that corporate insiders can profit through trading on
that information. In order to avoid this, regulations put a limit on trading by corporate
officers, directors and substantial owners, and requiring such trades should be reported.
3.3 Implications of Efficient Market Hypothesis

The main implication of the efficient market hypothesis is that any individual who is
trying to trade based on the information he has will not be able to make abnormal profits
because all information is already reflected in prices. However, it becomes necessary to
know how long it takes for information to be included in the price. If new information
arrives, does price take it into account immediately or does it take a few minutes before
the price adjusts to this information? Typically, it takes about 3 to 5 minutes before the
information is reflected in the price and if a trader enters the market at the moment
information arrives, he can make a profit. Thus, people argue that even in efficient
markets, there is an opportunity to make profits.
However, it should be noted that making money in a short time in the market would
involve two transactions. For example, if the price were expected to increase, one would
buy at the low price and sell at the higher price once the new price is reached. These
transactions would involve brokerage and other fees and hence the profit will be (change
in price less brokerage fee paid for two transactions) small. Therefore, one can make
money only if the price moves substantially in a short time beyond the transaction costs
involved.
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Therefore, the main implication of the efficient market hypothesis is that one cannot make
abnormal profits after adjusting for transaction costs. It will appear that security analysis
is without any merit, based on this knowledge. We will discuss this aspect in the next
section.
3.4 Security Analysis and Efficient Markets

There are two types of analyses used in studying the stock prices, namely, technical
analysis and fundamental analysis.
Technical analysis is essentially the search for recurrent and predictable patterns in stock
prices. Technical analysts believe that information regarding the future prospects of a firm
is not necessary to formulate trading strategy. The key to successful technical analysis is
a sluggish response of stock price to fundamental supply and demand factors. However,
efficient market hypothesis implies that technical analysis is without merit because past
price and volume trend are easily available to all at no cost. Does it mean that one would
not try to devise trading rules based on technical analysis? Technical analysis can provide
for abnormal profits even in efficient markets because traders using the same publicly
available data may interpret the information in a different manner and some of them may
be able to come up with profitable strategies mainly because technical analysis is used for
trading over a short-term period.
Fundamental analysis requires the analyst to study the fundamentals of the company and
apply an appropriate valuation model to arrive at the fair value of shares. Comparison
of fair value with the market price will indicate whether the shares are undervalued
or overvalued. One can buy undervalued and short-sell overvalued shares to make
money. Efficient market hypothesis implies that fundamental analysis will not provide
any abnormal profits because all analysts with same publicly available information will
have the same value and hence the price will always equal the fair value and no shares
will be under or over valued. However, fundamental analysis requires analysts to make
subjective assumptions about the future prospects of the company and hence different
analysts may come up with different fair values for the same shares of a given company
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and even in an efficient market, fundamental analysis can provide gains to some analysts.
One more aspect needs to be taken into account while discussing whether one can make
money in an efficient market. The traders in the market can be classified into two groups
as:
i. Information traders
ii. Liquidity traders
Information traders are those who collect information and analyse the information to
arrive at a trading strategy (if the trader is a technical analyst) or to trade based on
whether the share is over or under valued (if the trader is a fundamental analyst). On
the other hand, liquidity traders are those who want to trade for liquidity purposes. It
would include traders who have excess funds, which they want to invest in shares of some
company, and traders who need funds, which can be raised through the sale of shares.
If a market has few liquidity traders compared to the number of information traders, the
demand and supply of shares will tend to be low assuming all information traders derive
the same conclusion (as hypothesised in the efficient market) and there will be little price
movement causing the price to be equal to the fair value. On the other hand, if the market
has a large number of liquidity traders compared to information traders, there will be
either a price higher than fair value if there is excess demand over supply from liquidity
traders or a price lower than fair value if there is excess supply over demand from liquidity
traders. In such a case, information traders can make money if they enter the market early.
In general, the price in the market will tend to fluctuate around the fair value and will not
be equal to fair value at all time as the efficient market hypothesis would suggest.
Lesson Recording
Efficient Market Hypothesis
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Formative Assessment
1. Difference between primary market and secondary market is that

a. New securities are created in primary market whereas securities already issued
are traded in secondary market
b. In a primary market transaction, issuer of a security does not receive any
money whereas in a secondary market transaction, issuer receives money from
the buyer.
c. Secondary market transactions are aided through investment bankers whereas
primary market transactions are aided through stock brokers
d. Secondary market transactions are all over-the-counter market transactions
while primary market transactions take place in stock exchanges
2. Money market
a. Allows traders to invest in stocks of companies
b. Allows traders to invest in long-term bonds of companies
c. Allows traders to invest in securities with a maturity of more than one year
d. Allows traders to invest in securities with a maturity of less than one year
3. Difference between a money market security and capital market security includes all
of the following except
a. Owners of capital market security receives periodic payments during the life
of the security whereas the owners of the money market security do not receive
any payment during the life of the security except at maturity
b. Money market security is generally pure discount security whereas capital
market security can sell at either discount or at par or at a premium
c. Money market security generally has a maturity of less than one year whereas
capital market security has a maturity of more than one year.
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d. The return on money market security is always lower than the return on capital
market security
4. The major characteristics of a financial market include all of the following except,
a. Mobilise savings
b. Provide liquidity
c. Aid in price discovery
d. Provide positive return on investment
5. The characteristics of a financial security include all of the following except

a. Conception
b. Context
c. Computation
d. Condition
6. Financial markets are regulated

a. To protect the issuers of securities
b. To protect the investors
c. To protect the interests of the government
d. To protect the interests of investment banks
7. According to weak-form efficiency,

a. No trader can make abnormal profits by undertaking technical analysis only
b. No trader can make abnormal profits by undertaking technical analysis or
fundamental analysis
c. No trader can make abnormal profits including corporate insiders
d. There are opportunities for all traders including technical analysts,
fundamental analysts, and corporate insiders to make abnormal profits
8. According to semistrong-form efficiency,
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a. A trader can make abnormal profits by undertaking technical analysis only

d. There are opportunities for all traders including fundamental analysts, and
corporate insiders to make abnormal profits
9. According to strong form efficiency,

b. A trader can make abnormal profits by undertaking technical analysis or
10. Characteristics of an efficient market include all of the following except,

a. No trader can make abnormal profits
b. All securities are always priced at their fair value
c. Price can change only when there is new information, both expected and
unexpected
d. Price can change only when there is new unexpected information
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Solutions or Suggested Answers
1. Difference between primary market and secondary market is that
a. New securities are created in primary market whereas securities already
issued are traded in secondary market
Correct. Answer is correct. New securities are created in primary market
whereas securities already issued are traded in secondary market. Even
additional issue of shares increase the number of shares outstanding and
hence can be considered as new securities. Answer b is wrong because:
In a primary market transaction, issuer of a security receives money
whereas in a secondary market transaction, issuer does not receive any
money. Answer c is wrong because: Secondary market transactions are
aided through stock brokers whereas primary market transactions are
aided through investment bankers. Answer d is wrong because: Secondary
market transactions can be over-the-counter market or stock exchange
transactions while primary market transactions take place in over-the-
counter market.
b. In a primary market transaction, issuer of a security does not receive any

money whereas in a secondary market transaction, issuer receives money
from the buyer.
Incorrect. Answer is wrong because: In a primary market transaction, issuer
of a security receives money whereas in a secondary market transaction,
issuer does not receive any money
c. Secondary market transactions are aided through investment bankers

whereas primary market transactions are aided through stock brokers
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Incorrect. Answer is wrong because: Secondary market transactions are

aided through stock brokers whereas primary market transactions are aided
through investment bankers
d. Secondary market transactions are all over-the-counter market transactions

while primary market transactions take place in stock exchanges
Incorrect. Answer is wrong because: Secondary market transactions can
be over-the-counter market or stock exchange transactions while primary
market transactions take place in over-the-counter market
2. Money market
a. Allows traders to invest in stocks of companies
Incorrect. Answer is wrong because stocks of companies is not a money
market security due to its long-term maturity
b. Allows traders to invest in long-term bonds of companies

Incorrect. Answer is wrong because long-term bonds are not money market
securities due to long maturity
c. Allows traders to invest in securities with a maturity of more than one year
Incorrect. Answer is wrong because these securities have a maturity of more
than one year
d. Allows traders to invest in securities with a maturity of less than one year
Correct. Answer is correct. By definition, money market securities have a
maturity of less than 1 year. All other answers are wrong because maturity
is longer than 1 year
3. Difference between a money market security and capital market security includes all
of the following except
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a. Owners of capital market security receives periodic payments during the

life of the security whereas the owners of the money market security do not
receive any payment during the life of the security except at maturity
Incorrect. Answer is wrong: Owners of capital market security receives
periodic payments during the life of the security whereas the owners of the
money market security do not receive any payment during the life of the
security except at maturity
b. Money market security is generally pure discount security whereas capital

market security can sell at either discount or at par or at a premium
Incorrect. Answer is wrong: Money market security is generally pure
discount security whereas capital market security can sell at either discount
or at par or at a premium
c. Money market security generally has a maturity of less than one year
whereas capital market security has a maturity of more than one year.
Incorrect. Answer is wrong: Money market security generally has a maturity
of less than one year whereas capital market security has a maturity of more
than one year
d. The return on money market security is always lower than the return on
capital market security
Correct. Answer is correct: The return on money market security need not
be lower than the return on capital market security. The return on money
market security depends on the interest rate. In case the capital market
security is a bond, the return on bond can be lower if the term structure
is downward sloping. The stock market return depends on the market
conditions and in bear market, stock can have negative return whereas
money market securities generally provide a positive return.
4. The major characteristics of a financial market include all of the following except,
a. Mobilise savings
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Incorrect. Answer is wrong as mobilising savings is one of the characteristics

of a financial market
b. Provide liquidity
Incorrect. Answer is wrong as providing liquidity is one of the characteristics
of a financial market
c. Aid in price discovery

Incorrect. Answer is wrong as aiding in price discovery is one of the
characteristics of a financial market
d. Provide positive return on investment

Correct. Answer is correct as the return from security depends on the
interest rate and market conditions which is not a characteristic of a
financial market. Mobilise savings, Provide liquidity, and Aid in price
discovery are characteristics of a financial market.
5. The characteristics of a financial security include all of the following except

a. Conception
Incorrect. Answer is wrong as conception is one of the characteristics of a
financial security
b. Context
Incorrect. Answer is wrong as context is one of the characteristics of a
financial security
c. Computation
Incorrect. Answer is wrong as computation is one of the characteristics of a
financial security
d. Condition
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Correct. Answer is correct as condition is not one of the characteristics of a

financial security. Conception, context and computation are characteristics
of a financial security.
6. Financial markets are regulated

a. To protect the issuers of securities
Incorrect. Answer is wrong as the purpose of regulation is not to protect the
issuers of the securities
b. To protect the investors

Correct. Answer is correct as the purpose of regulation is to protect the
investors
c. To protect the interests of the government

interests of the government
d. To protect the interests of investment banks

interests of investment banks.
7. According to weak-form efficiency,

a. No trader can make abnormal profits by undertaking technical analysis only
Correct. Answer is correct as weak-form efficiency deals with effectiveness
of technical analysis only

Incorrect. Answer is wrong because fundamental analysts can make
abnormal profits if the markets are weak-form efficient
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Incorrect. Answer is wrong because corporate insiders can make abnormal

profits if market is weak-form efficient

Incorrect. Answer is wrong because traders doing technical analysis cannot
make abnormal profits
8. According to semistrong-form efficiency,

Incorrect. Answer is wrong as technical analysts cannot make abnormal
profits in a semistrong form efficient market.

Correct. Answer is correct because semi-strong form efficiency indicates
that fundamental analysts and technical analysts cannot make abnormal
profits

Incorrect. Answer is wrong because corporate insiders can make abnormal
profits if market is semistrong-form efficient
d. There are opportunities for all traders including fundamental analysts, and
corporate insiders to make abnormal profits
Incorrect. Answer is wrong because traders doing fundamental analysis
cannot make abnormal profits
9. According to strong form efficiency,

Incorrect. Answer is wrong as technical analyst cannot make abnormal return
in a strong form efficient market
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b. A trader can make abnormal profits by undertaking technical analysis or

Incorrect. Answer is wrong because fundamental analysts and technical
analysts cannot make abnormal profits if the markets are strong form efficient

Correct. Answer is correct because corporate insiders cannot make
abnormal profits if market is strong form efficient

Incorrect. Answer is wrong because corporate insiders cannot make
abnormal profits in a strong form efficient market
10. Characteristics of an efficient market include all of the following except,

a. No trader can make abnormal profits
Incorrect. Answer is wrong as one of the characteristics of an efficient market
is that no trader can make abnormal profits
b. All securities are always priced at their fair value

Incorrect. Answer is wrong as one of the characteristics of an efficient market
is that all securities are always priced at their fair value
c. Price can change only when there is new information, both expected and
unexpected
Correct. Answer is correct because in an efficient market all expected
information is already reflected in price
d. Price can change only when there is new unexpected information

Incorrect. Answer is wrong as one of the characteristic of an efficient market
is that price changes only when new information is unexpected.
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2
Study
Unit
FIN301
Learning Outcomes
• Discuss operations of a bank

• Demonstrate the functioning of a bank from its assets, liabilities and income
components
• Assess the implications of the size and structure of banking system
• Develop arguments providing a rationale for bank regulations
• Appraise the regulatory structures prevailing in Singapore and other economies
• Appraise the functioning of investment banks
• Assess the various roles performed by investment banks
• Appraise the regulatory structure of investment banks
• Appraise the functioning of mutual funds
• Differentiate between different types of mutual funds
• Assess the investment characteristics of mutual funds
• Appraise the operation of insurance companies
• Distinguish between various types of insurance companies and policies
• Analyse the rationale for regulation of insurance companies
• Assess the operation of pension funds
• Appraise the functioning of CPF system in Singapore
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Overview
The role of financial institutions within the system is primarily to intermediate between
those that provide funds and those that need funds, and typically involves transforming
and managing risk and hence it is important to learn about how the different financial
institutions function, the role played by these institutions in intermediation, and how
these institutions are regulated. In this study unit, the operation of banks, investment
banks, mutual funds, insurance companies and pension funds will be discussed.
Read
Chapters 11, 13, 15, 16, 17 and 18 of “Financial Markets and Institutions”, Saunders and
Cornett, Sixth International Edition, (2015).
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Chapter 4: Financial Institutions
4.1 Commercial Banks

Banks are a vital part of the financial system, and the main and most significant type
of financial institutions. Banks facilitate transfer of funds from savers to the ultimate
investors. As Study Unit 1 pointed out, banks play a unique role in the economy. The
banking system is a conduit for monetary policy; banks administer the payments system
and determine how credit is allocated in the economy. Banks carry out time, maturity and
denomination intermediation, and provide liquidity services to savers.
Banks are the largest type of depository institution (DI). Traditionally, commercial banks
made working capital loans to businesses and accepted commercial and individual
current and savings deposits. Today, banks and other DIs are much more diversified and
offer many new types of services. For example, large banks now engage in a variety of non-
traditional banking activities ranging from underwriting securities to selling insurance
and offering complex derivative products to customers.
Bank's main assets and liabilities are pieces of paper. This means that unlike other
industries, such as automobiles, or consumer goods, banks and other financial
intermediaries have a difficult time differentiating their product from one another. This
results in intense competition and low margins, a trend that has been reinforced as past
competitive barriers such as regulations, geographical restrictions on operations, etc. have
been eroded by periods of deregulation and technological growth in information services.
Loans are the most important assets on a bank's balance sheet. Deposits are the primary
source of funds. Over time the composition of the loan portfolio has changed, as the
mortgage finance has evolved into an important source of earnings. On the liabilities side,
in many large banks deposits are being supplanted as a source of funds by borrowing in
money markets.
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4.1.1 Major Assets of a Bank

Liquid assets - Cash and balances due from other DIs
These consist of vault cash, currency in the process of collection (CIPC), correspondent
balances and reserves at the central bank, e.g., the MAS in Singapore, and the Fed in
the United States. These cash reserves are also referred to as primary reserves. Banks
maintain cash reserves to meet regulatory requirements (e.g., required reserves) as well
as depositors’ requests for withdrawals from bank accounts.
Investment Securities
Banks designate their investment securities as held for income (to maturity) or available
for sale. Securities held for income are normally carried at book value; those available for
sale are carried at the lower of current market or book value. Securities held for sale and
other short term investments are sometimes called ‘secondary reserves.’
Short term securities include treasury security and government agency securities.
The liquid part consists of holdings of short-term government securities (Singapore
Government Securities of maturity of a year or less). These securities count towards
secondary reserves. This part of the investment portfolio is very safe and liquid. Singapore
Government Securities with a maturity of less than one year are considered short
term securities. Short term investments are safe liquid assets held to assist in liquidity
management. Rates of return are usually significantly lower than on loans.
Long term securities include municipal bonds, mortgage backed securities, corporate
bonds and foreign bonds. Long term securities are held for income and are typically
investment grade. Bonds, notes and other securities held by banks for the returns that they
generate are classified as income generating investment securities.
This investment portfolio is very safe and liquid.
Loans - Loans are the largest and the highest earning asset on bank's balance sheets and
generate the majority of revenue; hence, the quality and pricing of the loan portfolio are
paramount determinants of a bank’s success. Unearned income and the allowance for
loan and lease losses are contra asset accounts that are subtracted from total (gross) loans
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to calculate net loans. Unearned income is income that the bank has received on a loan
but has not yet earned nor recorded on the income statement. The allowance account is
management’s estimate of the total amount of loans that will not be repaid.
For most banks, loans comprise well up to two-thirds of assets. The major types of loans
include commercial and industrial loans, real estate loans and consumer loans.
Consumer loans: Auto loans are a major component of consumer loans. Others include
credit card loans, signature loans and loans collateralised by consumer durables.
The primary risk faced by a bank is credit risk. A bank is unlikely to be able to remain
profitable if there are significant problems in the loan portfolio.
Mortgage lending is increasing at most banks and C&I loans are declining. The former
has occurred because of the demise of S&Ls and growth in the mortgage markets,
particularly securitisation. The latter is occurring because businesses have been able to
procure alternative financing through the commercial paper market at rates below bank
loans and because the public debt markets have grown rapidly.
Commercial and industrial (C&I) loans: C&I loans may be working capital loans, loans
for capital equipment, bridge loans, etc. They may be secured or unsecured. Traditionally,
banks only made well collateralised working capital loans, but now they may finance
start up businesses without tangible collateral. Analysis of C&I loans varies by type of
borrower. Today, loans of more than one year maturity are likely to be floating rate.
Other loans
Other loans include loans to domestic and foreign FIs, and loans to state, federal and
foreign government entities.
The main use of bank funds is lending (with leasing considered an extension of lending).
Banks make a wide variety of loans compared to other lenders. Bank investment portfolios
exist chiefly to provide liquidity and some income, representing less risk than loans.
Other assets comprise primarily non-earning assets. These may account for up to 10% of
total assets. Other assets also include nonearning assets such as the physical structures and
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property owned, collateral seized on defaulted items, intangible assets, such as goodwill
and mortgage servicing rights, deferred and prepaid items, etc.
4.1.2 Major Liabilities of a Bank

Deposits: Deposits are the largest source of funds. As of 2010, deposits comprised
almost 60% of total funding. The main types of deposits include current accounts or
demand deposits, savings deposits and fixed deposits (also known as time deposits or CD
(certificate of deposit)).
Deposits can be classified as transaction accounts and non-transaction accounts. As the

terms suggest, the former are accounts that enable depositors to carry out transactions
by writing cheques on these accounts or making cash withdrawals. Transaction accounts
include demand deposits (or current accounts such as NOW accounts), negotiable order
of withdrawal current accounts that pay interest if the owner maintains the minimum
balance required, accounts or demand deposits that do not pay interest. Transaction
deposits comprise a small proportion of total deposits. Transaction deposits are declining
as a source of funding at banks.
Non-transaction deposits include savings account, MMDAs and CDs. Non-transaction

accounts made up an overwhelming majority of total deposits.
Over time, an increasing proportion of total funding bears interest rates. This has increased
sensitivity of bank profits to changes in interest rates. This development also explains the
increasing emphasis on fee based income.
MMDAs: Money Market Deposit Accounts are accounts with limited current account
privileges that pay rates of interest comparable to money market mutual funds. MMDAs
are not reservable and they are insured. They typically require higher minimum balances
than NOW accounts.
Other savings accounts
These are primarily passbook savings accounts. Cheques cannot be written on savings
accounts although they can be accessed by ATM.
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Retail CDs
These are time deposits with denominations under $100,000 (US).
Wholesale CD
Wholesale CDs are time deposits with denominations of $100,000 or more. These are
negotiable (saleable) instruments. Banks may obtain wholesale CDs by paying other banks
or investment banks a small finder’s fee to locate corporate or institutional investors
willing to deposit money in the bank for a set time.
Deposits obtained in this manner are called brokered deposits. Time deposits held in
dollars outside the US are called Eurodollar deposits.
Most Eurodollar accounts are time deposits of 6 months or less; many carry variable rate of
interest tied to Libor. Eurodollar accounts pay slightly higher rates than similar domestic
deposits because these accounts avoid some regulatory costs. They are not subject to
reserve requirements or deposit insurance (even though they have de facto been insured).
Borrowings and Other Liabilities include notes and bonds outstanding, fed funds
borrowed, and repurchase liabilities account for an increasing proportion of liabilities,
amounting to nearly a fifth of liabilities.
The liabilities of banks tend to have less default risk than the assets and typically have
a shorter maturity than the assets. That is, banks normally provide maturity and credit
risk intermediation services to savers by providing savers with safer, shorter maturity
accounts while purchasing or creating longer term riskier claims. The banks in turn earn
the interest rate spread between the rates charged on the assets and the rates paid on the
liabilities.
Purchased funds
Purchased funds can be more expensive sources of funds than deposits, particularly core
deposits. Core deposits are deposits that are at the bank for reasons other than earning
interest. Earning interest may still be important but convenience, a relationship with the
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bank, customer satisfaction, etc. keep the customer at the bank even if the bank does not
pay the highest rate of interest available on similar accounts at other banks. Purchased
funds include:
• Fed funds borrowings

• Repurchases
• Banker’s Acceptances sold
• Commercial paper issued by the holding company parent (banks cannot issue
commercial paper)
• Medium term subordinated notes and debentures
• Discount window loans
• Brokered deposits
Noninterest bearing liabilities include:
• Accrued interest owed

• Deferred taxes
• Dividends payable
• Minority interest in consolidated subsidiaries, etc.
Equity
Capital requirements specify the minimum amount of capital a bank must maintain (see
MAS and BIS webpages for specific requirements) under the Basle Accord. Information
on the Basle Accord and recent changes can be found at the website of the Bank of
International Settlements (BIS). Equity consists of common stock (par and surplus),
preferred stock and retained earnings. Regulators define other accounts that may serve as
equity for the purposes of calculating minimum capital requirements.
Banks are highly leveraged entities, employing about 90% debt in their capital structure.
Few nonfinancial firms allow their debt ratios to get over 50% (other than in Highly
Levered Transactions). Nonfinancial firms in volatile industries often use little or no debt.
DIs must employ a high amount of leverage to offer stockholders a satisfactory rate of
return since their ROA is generally very low (in the 0.5%-2% range). Their ROA is low
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because they primarily have paper assets and liabilities. Recall from microeconomics
that in industries with non-differentiable products, competition will force economic rents
(NPVs) to zero. The ability of banks to use such high debt ratios arises from a) banks’
ability to closely manage and hedge risk and b) deposit insurance. Banks that do not learn
to manage risk appropriately quickly fail when environmental factors change. Moreover,
most bank creditors do not demand a risk premium in the form of higher deposit rates
at risky banks because the government guarantees their deposits. This is an example of a
market failure and the problem of moral hazard engendered by deposit insurance.
Off Balance Sheet Activities
Off balance sheet (OBS) assets and liabilities are activities that may lead to changes in on
balance sheet assets and liabilities respectively, contingent upon some event occurring.
Examples of OBS activities include:
• Swap agreements
• Written or purchased options contracts
• Credit derivatives
• Forward & futures contracts other than for foreign exchange
• Commitments to buy or sell foreign exchange (spot or forward)
• Loan commitments
• Securities borrowed or lent
• Standby letters of credit
Other Fee Generating Activities
Correspondent banking - larger banks serve as agents for smaller banks, assisting in:
• cheque clearing
• purchasing securities
• foreign exchange
• loan participations (both ways)
• obtaining and placing fed funds
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• trust services
• obtaining brokered deposits (Jumbo CDs, Euro$)
Fee Generating Activities carried out by banks
• Leasing - Banks may be able to use tax breaks from purchasing equipment that
small/medium size businesses cannot.
• Trust operations - Trust functions are offered only by larger banks, but trust
services are made available at most banks through correspondent relationships.
Trust operations are providing fiduciary services for a third party.
• Swap brokers - Many larger banks act as swap brokers / swap partners helping
financial institutions better match the interest sensitivity of their assets and
liabilities. They take a fee for this service.
• Brokerage services
• Underwriting - Underwriting income via bank subsidiaries.
• Banks can advise and manage mutual funds but cannot sponsor the fund.
Off balance sheet (OBS) assets and liabilities are contingent assets and liabilities or
accounts that may end up on the balance sheet depending on what events transpire. They
are disclosed in footnotes to the financial statements.
Loan commitments
Most C&I loans are draw downs of prearranged lines of credit. The line of credit is a
commitment to make a loan, and it is a contingent liability of the bank. Once the loan is
made, it becomes an asset. An upfront fee (or facility fee) is often charged; it may be 1/8
of 1% of the commitment amount. The borrower may also be charged a back-end fee at
the end of the period on the unused portion of the credit line.
Commercial letters of credit
Commercial letters of credit are a commitment by a bank to pay a seller of goods if

the buyer of the goods cannot pay. The creditworthiness of the bank is substituted for
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the creditworthiness of the buyer. They are frequently used in international trade where
sellers would find credit investigation of buyers to be costly.
Letters of credit of this type are used less frequently in trade between developed
economies where information about firms is widely available and trade problems have
historically been low. Using letters of credit adds significantly to the cost of trade for
corporations and in the majority of cases the bank does not have to pay anything.
Standby letters of credit
Sometimes called performance letters of credit or financial letters of credit, these cover
less predictable risks, and are usually for higher amounts than commercial letters of
credit. Examples of financial letters include a bank’s promise to pay if a commercial
paper borrower fails to repay the amount owed, or if a municipal borrower cannot make
scheduled interest and principal payments. Financial letters are often used by commercial
paper issuers to obtain higher credit ratings on the paper. Commercial paper rating
spreads may be 40 basis points or more; thus, if the bank’s fee is less than this amount, the
issuer of marginal quality paper can reduce its borrowing costs by procuring a standby
letter of credit. A loan commitment may be a less costly alternative to the standby letter.
Performance letters may be issued where banks agree to pay if a construction project is
not completed on time, or if goods do not meet certain specifications, etc. Both commercial
and standby letters are forms of insurance, and it should not be surprising that property
and casualty insurers (and also some foreign institutions) issue standby letters. One reason
banks have not issued more standby letters is their own lack of a high credit rating.
This has left an opening for higher rated non-bank FIs and foreign banks to issue more
attractive standby letters.
Loans sold
Loans may be sold in part or as a whole. Sales may be with or without recourse. Most are
without recourse.
Derivative contracts
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Derivatives include futures, forwards, swaps and options positions. Their use is heavily
concentrated among the largest banks. These positions may create contingent risk to the
institution depending upon whether they are used for hedging other bank positions or
speculating. Forward contracts and other OTC contracts also expose the institution to
credit risk, but exchange traded options and futures do not.
Processing services
Many banks provide data processing services for business customers. They may help
manage a firm’s accounts receivables and payables, assist in cash management and in
information technology services for customers.
4.1.3 The Major Income Components of a Bank

Interest income
Interest income is the largest component of income. It comprises interest and fee income
on loans and securities.
Interest expense
Interest expense is composed of interest on deposits, interest on purchased funds and

interest on other borrowings.
Net interest income is interest income less interest expense.
Provision for loan losses (PLL)
The PLL is a deduction from current earnings made by management to offset loans that
management believes will go bad in the upcoming quarter.
Noninterest income
Noninterest income includes income from service charges on deposits, income from
fiduciary activities, gains and losses and fees from trading activities and fees from
commitments and letters of credit, etc. Interest income plus noninterest income equals
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total operating income. This is equivalent to the sales revenue figure for a nonfinancial
firm.
Noninterest expense
This component consists of salaries and benefits, expenses for the premises and equipment
and other expenses.
Income before taxes and extraordinary items
This is operating profit before taxes and extraordinary items.
Extraordinary items
One off events, including changes in accounting rules, major asset liquidations, lawsuit
damages, etc.
4.2 Size, Structure, and Composition of the Banking Industry

As of December 2007, there were 7,282 commercial banks in the United States. This
number has declined 42.86% since 1989. The decline is somewhat misleading because the
number of bank offices including branches grew from 60,000 in 1984 to 83,000 in 2007.
Industry consolidation has been occurring rapidly, largely via unassisted mergers, but
total bank assets and the total number of banking facilities have grown at significant rates.
Banking remains a growth industry.
Economies of Scale and Scope
The last few years have seen many megamergers (mergers of banks with over $1 billion in
total assets). Primary reasons include cost and revenue economies and regulatory changes.
Economies of scale and scope are generated by declines in unit costs required to produce
bank activities as the bank gets larger or adds more services respectively.
Cost economies of scale result from fixed costs spread over larger output as the bank
grows.
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Institutions such as J.P. Morgan and Chase Manhattan estimated that their merger would
result in cost savings of $1.5 billion.
Cost economies of scope result from cost sharing when multiple products are offered.
That is, as more products are added, costs do not rise proportionally with revenues.
The Financial Services Modernisation Act of 1999 (FSMA) allows banks to merge with
insurance firms and investment banks for the first time since 1934. The 1998 merger of
Citicorp and Travellers (a bank and an insurance firm) prompted the change.
The merger of UBS and Paine Webber is another example of a merger that may exploit
cost economies of scope.
Both of these economies derive from fixed costs arising from technology. As more
customers and/or more services are added the cost per unit to provide the service
(such as brokerage, financial planning, underwriting insurance, etc,) drops, improving
profitability.
Revenue economies of scale and scope also provide motives for mergers. Additional
revenues can be generated via mergers by adding additional customers, moving into less
competitive markets and stabilising revenue by serving customers in different regions.
The 2004 J.P. Morgan Chase acquisition of Bank One, added Bank One’s large credit card
operations and retail network in an attempt to broaden Chase’s revenue sources.
X efficiencies are cost savings that occur which are not attributable to economies of scale
and scope. They may include managerial learning processes or other unspecified cost
savings.
Diseconomies of scale may also arise from mergers. It is notoriously difficult to

manage large institutions that have different organisational cultures. Managerial hubris
cannot be overlooked in discussing mergers. Managers tend to overestimate their ability
to generate revenue and cost economies and tend to underestimate the complexities
involved, including loss of employee morale when jobs are cut, technological problems in
integrating different computer systems, problems in corporate culture, etc.
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It remains to be seen whether these cost economies will turn out to be illusory or real.
Academic studies identify large economies of scale up to the $10-$25 billion range in
asset size. It is likely that overcapacity, integration problems and difficulties in merging
corporate cultures will result in lower synergies than anticipated. Recall the conglomerate
boom of the 1960s that led to the divestiture boom of the 1970s and 1980s. Note that
Citigroup decided to partially divest Traveler’s, reversing their prior merger. Only time
will tell.
Academics have been forecasting a sharp decline in the number of banks for years. Indeed,
most developed countries operate with far fewer banks than in the US. US regulations
have long been designed to protect the small community banks (banks with assets under
$1 billion). These banks may eventually disappear as consolidation via mergers and
acquisitions gains speed.
4.2.1 Bank Size and Concentration

The largest banks increasingly dominate the industry and the largest banks control the
vast majority of industry assets. This is now true in all aspects of the financial services
industries. Banks can be classified as:
Money centre banks which include the largest banks, typically located in New York
city. Size alone however does not make a money centre bank. These banks generally rely
on nondeposit sources of funds and are heavily engaged in wholesale banking (with
or without a retail banking presence) and involved in international markets. Wholesale
banking refers to providing loans services to corporations and other institutions as well
as acquiring nondeposit sources of funds. Retail banking is providing consumer oriented
banking services such as loans and deposits. Money centre banks include Bank of New
York, Citigroup, J.P. Morgan Chase, HSBC Bank USA and Bankers Trust (owned by
Deutsche Bank).
Superregional or regional banks that operate primarily in one or more regions of the
country
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Community banks that operate in local markets
There is a heavy concentration of assets among the largest banks. Nevertheless, thousands
of small banks remain throughout the country, although more and more of these small
institutions are being absorbed by mergers. Absorptions are running higher than new
charters so the trend towards increasing concentration will continue.
4.3 Bank Size and Activities

Large banks generally are less liquid, are more heavily concentrated in loans and use
more purchased sources of funds. They have greater access to brokered deposits and non-
deposit liabilities and they tend to hold less equity.
Large banks lend to more sophisticated corporate customers which means that their
profit margins are often lower than for smaller banks that operate in more isolated, less
competitive circumstances. A key ratio for bank management includes the net interest
margin which is equal to the interest rate spread divided by earning assets. The interest
rate spread is the interest earned on assets minus the interest paid on liabilities. Large
banks typically pay higher salaries than smaller banks and have greater investments
in facilities and in the provision of services. On the other hand, large banks generate
substantially more fee income than small banks.
At times, small banks have been more profitable than large banks, but this has not always
been the case. The higher profitability at smaller banks is often due to a lack of local
competition. As large banks gain the ability to enter local markets, it is questionable
whether the smaller banks’ profitability can be maintained.
4.4 Technology in Commercial Banking

Technology is profoundly changing the banking industry, and the major changes are still
ahead. Technology investments can generate operating efficiencies and economies of scale
and scope. Internet and wireless communications constitute new methods of offering both
existing and new financial services to current and potential customers at much lower costs
than currently available.
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4.4.1 Products Available in Wholesale Banking

Cash management services: Technology is allowing banks to offer corporate customers
real time information of cash balances related to the following services:
• Controlled disbursement accounts – Accounts that allow the customer to know

exactly which cheques or payments will be withdrawn that day from the account.
• Real time account reconciliation
• Electronic lockboxes allow corporate customers to reduce the float time; in this
context, float is the time between when the customer pays the cheque and the
corporation collects.
• Funds concentration allows sweeping of funds from various accounts into one
centrally managed account.
• Electronic funds transfer via CHIPS or Fedwire, automated payments via ACHs
and automated message transfers via SWIFT
• Automated cheque deposit services
• Electronically generated letters of credit
• Access to treasury management software
• Electronic invoicing interchange between businesses
• Electronic B2B commerce
• Electronic billing
• Verification of identities in transactions
4.4.2 Products Available in Retail Banking

• ATMs and ATM networks
• Point of sale cards
• Home banking
• Preapproved debits or credits
• Paying bills by phone
• E-mail billing
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• Online banking
• Smart cards
4.5 Regulation of Banks

Financial Institutions (FIs) and banks in particular, are among the most regulated entities
in the global economy. This is due to the vital importance of banks in the economy,
and the profound impact poorly functioning banks can have on the broader economy.
A cursory look at data on the costs of bank failures will show the unparalleled damage
arising from financial crises stemming from banking crisis. Estimates of losses due to the
subprime crisis range up to over $8 trillion. Thus close monitoring and regulation of banks
are important. FIs can help enhance the efficient operation of the economy. Successful
financial intermediaries provide sources of financing that fund productive projects,
ultimately raising the overall level of economic activity. Financial intermediaries also
provide transaction services to the economy that facilitate trade and wealth accumulation.
Conversely, distressed FIs create negative externalities for the entire economy. That is,
the adverse impact of an FI failure is greater than just the loss to shareholders and other
private claimants on the FI's assets. For example, the local market suffers if an FI fails
and other FIs also may be thrown into financial distress by a contagion effect. Therefore,
since some of the costs of the failure of an FI are generally borne by society at large,
the government intervenes in the management of these institutions to protect society's
interests. This intervention takes the form of regulation.
However, the need for regulation to minimise social costs may impose private costs to the
firms that would not exist without regulation. This additional private cost is defined as a
net regulatory burden. Examples include the cost of holding excess capital and/or excess
reserves and the extra costs of providing information. Although they may be socially
beneficial, these costs add to private operating costs. To the extent that these additional
costs help to avoid negative externalities and to ensure the smooth and efficient operation
of the economy, the net regulatory burden is positive.
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4.6 Regulatory Principles Governing Operations of Commercial

Banks
Banks are regulated on several aspects of their operations, and the consequences of these
operations
• Safety and soundness regulation

• Monetary policy regulation
• Credit allocation regulation
• Investor protection regulation
• Entry and chartering regulation
4.6.1 Safety and Soundness Regulation

• This has assumed profound importance in the aftermath of repeated financial crisis.
The Bank for International Settlements (BIS) has been at the forefront of coordinated
international initiatives to address systemic and other risks to banking systems
• assets must be diversified: banks cannot make loans greater than 10% of their equity
capital to any one borrower (number varies across countries)
• banks must maintain adequate equity capital levels to protect against insolvency
risk. Prescribed by the BIS
• provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects
depositors in the event of default and prevents bank runs
• monitoring and surveillance: banks must submit (publicly accessible) quarterly
reports and are subject to on-site examinations
4.6.2 Monetary Policy Regulation

• the Central Bank (the Federal Reserve in the US, the MAS in Singapore) directly
controls the quantity of notes and coins (i.e., outside money) in the economy
• however, the bulk of the money supply is held as bank deposits, called inside money
• regulators require cash reserves to be held at commercial banks
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4.6.3 Credit Allocation Regulation

• regulators encourage (and often require) lending to socially important sectors of
the economy (e.g., housing and farming)
• usury laws cap interest rates that can be charged on loans
4.6.4 Investor Protection Regulation

• protects investors against insider trading, lack of disclosure, malfeasance, and
breach of fiduciary responsibility
4.6.5 Entry and Chartering Regulation

• the entry of commercial banks is regulated
• the permissible activities of commercial banks are defined by regulators
• the barriers to entry and the scope of permissible activities allowed affect the charter
values of banks and the size of the net regulatory burden
The net regulatory burden is the difference between the costs of regulations and the
benefits for the producers of financial services.
4.7 Regulators
In the US
• the Federal Deposit Insurance Corporation (FDIC)

• the Office of the Comptroller of the Currency (OCC)
• the Federal Reserve System (FRS)
• state agencies
In Singapore
• The Monetary Authority of Singapore (MAS)

• Unlike the multiplicity of regulators in the US, the MAS is a unitary and single
regulatory agency in Singapore
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4.8 The Four Facets of Regulatory Structure

• regulation of product expansion
• regulation of geographic expansion
• provision and regulation of deposit insurance
• balance sheet regulation
• off-balance-sheet regulation
4.8.1 Product Segmentation Regulation

A. Commercial banking vs. investment banking
• commercial banking involves deposit taking and lending

• investment banking involves underwriting, issuing, and distributing securities
• the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and
investment banks
• by 1987 commercial banks were allowed to engage in limited investment banking
activity through Section 20 affiliates
• the Financial Services Modernisation Act (FSMA) of 1999 repealed Glass-Steagall
B. Commercial banking vs. insurance underwriting
• the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies
from owning or being affiliated with commercial banks
• the FSMA of 1999 now allows bank holding companies to open insurance
underwriting affiliates and also allows insurance companies to open banks
C. Commercial banks and commerce

• the BHCA of 1956 restricts commercial firms from acquiring banks
• the 1970 Amendment to the BHCA requires banks to divest nonbank related
subsidiaries
• Singapore banks are universal banks, i.e., they can practise commercial and
investment banking
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4.8.2 Geographic Expansion Regulation (This pertains primarily to the US)

• Restrictions on intrastate banking
• most banks used to be unit banks—i.e., banks with single offices
• by 1997 only six states restricted intrastate branching
• the McFadden Act of 1927 (amended in 1933) restricted national banks from
branching across state lines
◦ as a result, the largest banks were set up as multibank holding companies
(MBHCs)
◦ an MBHC is a parent banking organisation that owns a number of individual
bank subsidiaries
• the Douglas Amendment to the BHCA of 1956
◦ let states regulate MBHC expansion
◦ subsidiaries established prior to the passage of the amendment were
considered grandfathered and not subject to the law
• the 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one
bank holding companies (OBHCs) could engage in
◦ an OBHC is a parent banking organisation that owns one bank subsidiary
and nonbank subsidiaries
• the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
◦ allows consolidation of out-of-state bank subsidiaries into a branch network
and allows interstate mergers and acquisitions
• Needless to say, Geographic expansion regulation is not relevant to Singapore
4.8.3 Deposit Guarantee Funds

• The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain
the stability of the US banking system
◦ worked well until 1979
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◦ from October 1979 to October 1982 the Fed targeted bank reserves and let
interest rates rise dramatically
◦ led to disintermediation—i.e., the withdrawal of deposits from depository
institutions and their reinvestment elsewhere
◦ problems were exacerbated by a policy of regulatory forbearance—i.e., a
policy of not closing economically insolvent depository institutions, but
allowing their continued operation
• The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance
Fund (BIF)
• The demise of the Federal Savings and Loan Insurance Corporation (FSLIC)
◦ the FSLIC insured savings institutions from 1934 to 1989
◦ savings institutions failures in the 1980s led to an insolvent FSLIC by 1989
• The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of
1989
◦ dissolved the FSLIC and transferred its management to the FDIC
◦ created the Savings Association Insurance Fund (SAIF)
• The FDIC introduced risk-based deposit insurance premiums in January of 1993
◦ by 1996 the safest institutions insured by the BIF paid no deposit insurance
premiums
◦ by 1997 the safest institutions insured by the SAIF paid no deposit insurance
premiums
◦ by the early 2000s over 90% of depository institutions were in the “safe”
category that paid no deposit insurance premium
• In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund
(DIF)
• In January 2007 the FDIC began a more aggressive insurance system where all
institutions pay into the fund
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4.8.4 Balance Sheet Regulation

• Liquidity regulation
◦ banks must hold minimum levels of reserves against net transaction accounts
◦ ensures that banks can meet required payments on liability claims such as
deposit withdrawals
4.8.5 Capital Adequacy Regulation (See the next section on BIS capital
adequacy guidelines)
• Since 1987 commercial banks have faced two different capital requirements
◦ Tier I capital risk-based ratio
◦ Total capital (Tier I + Tier II) risk-based ratio
• Tier I capital is composed of the book value of common equity plus an amount
of perpetual preferred stock plus minority equity interests held by the bank in
subsidiaries minus goodwill
• Tier II capital includes secondary capital resources such as loan loss reserves and
convertible and subordinated debt
• risk-adjusted assets include both on- and off-balance-sheet assets whose values are
adjusted for approximate credit risk
• the total risk-based capital ratio is equal to the sum of Tier I and Tier II capital
divided by risk-adjusted assets
• the Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets
• since 1991 banks have also been assessed based on their capital-to-assets (i.e.,
leverage) ratio
◦ capital-to-assets ratio = core capital ÷ total assets
◦ does not account for market values, riskiness of assets, or off-balance-sheet
activities
• since December 1992 regulators must take Prompt Corrective Action (PCA) if and
when a bank falls outside of the “well capitalised” zone
• risk-based capital ratios were phased in by Bank for International Settlement (BIS)
countries (the US included) by 1993 under the Basel Accord
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4.8.6 Capital Adequacy Framework: Basel II

The Basel II framework was adopted in Singapore on January 1, 2008. Basel II framework
consists of three pillars:
Pillar 1 prescribes rules for the calculation by banks of the minimum capital that they are
required to hold for credit, market and operational risks.
Pillar 2 describes the supervisory framework, which encourages banks to develop and use
better risk-management techniques.
Pillar 3 prescribes the minimum disclosure requirements.
The minimum Tier 1 and total capital-adequacy ratios for banks in Singapore are 6% and
10%, respectively, higher than the Basel standards of 4% and 8%.
In June 2011, the MAS announced that banks will be required to hold a minimum common
equity Tier 1 capital-adequacy ratio (CAR) of 6.5% (common equity only), Tier 1 CAR of
8% (common equity plus retained earnings) and total CAR of 10% (Tier 1 capital plus other
permissible types of capital such as undisclosed reserves) from January 2015. The increase
will be phased in between January 2013 and January 2015. These are higher than the Basel
III global capital standards of 4.5%, 6% and 8%, respectively.
The MAS also announced that it will require Singapore-incorporated banks to meet the
Basel III minimum CAR requirements of 4.5% for the minimum common equity Tier 1 and
6% for Tier 1 by January 2013, two years ahead of the Basel 2015 deadline.
4.8.7 Off-Balance-Sheet Regulation

• Banks earn fee income with off-balance-sheet (OBS) activities
• By engaging in OBS activities, banks can avoid regulatory costs such as reserve
requirements, deposit insurance premiums, and capital adequacy requirements
• Banks must report notional values of OBS activity on Schedule L (US)
• OBS activity is incorporated into the total risk-based capital ratio and the Tier I
capital ratio, but not the leverage ratio
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4.8.8 Foreign vs. Domestic Regulation

• Regulation of US banks in foreign countries
◦ the Overseas Direct Investment Control Act of 1964 restricted US banks’
ability to lend to US corporations to make foreign investment
◦ the North American Free Trade Agreement (NAFTA) of 1994 enabled US
banks to expand to Mexico and Canada
◦ a 1997 agreement between 100 countries (under the World Trade
Organization (WTO)) began dismantling barriers inhibiting foreign direct
investment into emerging countries
4.8.9 Regulation of Foreign Banks in the US

• the International Banking Act (IBA) of 1978 declared foreign banks are to be
regulated the same as national domestic banks
◦ foreign banks are subject to Federal Reserve examinations
• the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional
powers to the Federal Reserve
◦ Fed must approve new subsidiary, branch, agency, or representative offices
of foreign banks in the US
◦ Fed has the authority to close foreign banks operating in the US
◦ only foreign banks with access to the FDIC can accept consumer deposits
◦ state-licensed foreign branches are regulated as national branches
4.8.10 Monetary Policy Regulation

• Outside money is that part of the money supply directly produced and controlled
by the Fed, for example, coins and currency. Inside money refers to bank deposits
not directly controlled by the Fed.
• The Fed can influence this amount of money by reserve requirement and discount
rate policies.
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• In cases where the level of required reserves exceeds the level considered optimal by
the FI, the inability to use the excess reserves to generate revenue may be considered
a tax or cost of providing intermediation.
4.8.11 Credit Allocation Regulation

• The qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their
assets in residential mortgage-related assets to retain the thrift charter.
• Some states (in the US) have enacted usury laws that place maximum restrictions on
the interest rates that can be charged on mortgages and/or consumer loans. These
types of restrictions often create additional operating costs to the FI and almost
certainly reduce the amount of profit that could be realised without such regulation.
Legislation passed specifically to protect investors who use investment banks directly or
indirectly to purchase securities
• In the US, the Securities Acts of 1933 and 1934 and the Investment Company Act
of 1940 were passed by Congress to protect investors against possible abuses such
as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary
responsibilities.
Regulations regarding barriers to entry and the scope of permitted activities
• The profitability of existing firms will be increased as the direct and indirect costs
of establishing competition increase.
• Direct costs include the actual physical and financial costs of establishing a business.
• In the case of FIs, the financial costs include raising the necessary minimum capital
to receive a charter.
• Indirect costs include permission from regulatory authorities to receive a charter.
Again in the case of FIs, this cost involves acceptable leadership to the regulators.
As these barriers to entry are stronger, the charter value for existing firms will be
higher.
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4.9 Regulation in Singapore

The regulating authority is the Monetary Authority of Singapore (MAS). MAS is the
central bank of Singapore with a mission to promote sustained non-inflationary economic
growth, and a sound and progressive financial centre.
MAS' Functions
• To act as the central bank of Singapore, including the conduct of monetary policy,
the issuance of currency, the oversight of payment systems and serving as banker
to and financial agent of the Government
• To conduct integrated supervision of financial services and financial stability
surveillance
• To manage the official foreign reserves of Singapore
• To develop Singapore as an international financial centre
History of MAS
Prior to 1970, the various monetary functions associated with a central bank were
performed by several government departments and agencies. As Singapore progressed,
the demands of an increasingly complex banking and monetary environment necessitated
streamlining the functions to facilitate the development of a more dynamic and coherent
policy on monetary matters. Therefore in 1970, Parliament passed the Monetary Authority
of Singapore Act leading to the formation of MAS on 1 January 1971. The MAS Act gives
MAS the authority to regulate all elements of monetary, banking and financial aspects of
Singapore.
The MAS has been given powers to act as a banker to and financial agent of the
Government. It has also been entrusted to promote monetary stability, and credit and
exchange policies conducive to the growth of the economy.
In April 1977, the Government decided to bring the regulation of the insurance industry
under the wing of the MAS. The regulatory functions under the Securities Industry Act
(1973) were also transferred to MAS in September 1984.
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The MAS now administers the various statutes pertaining to money, banking, insurance,
securities and the financial sector in general. Following its merger with the Board of
Commissioners of Currency on October 1, 2002, the MAS has also assumed the function
of currency issuance.
4.9.1 Supervisory Objectives and Principles

As the integrated supervisor of financial services in Singapore, MAS seeks to promote a
sound and progressive financial services sector. Through its supervisory activities, it aims
to achieve the following six supervisory objectives or desired outcomes:
• A stable financial system

• Safe and sound financial intermediaries
• Safe and efficient financial infrastructure
• Fair, efficient and transparent organised markets
• Transparent and fair-dealing intermediaries
• Well-informed and empowered consumers
Financial stability is the overarching objective of financial supervision. Without it,

participants will not transact in financial markets and use the services of financial
institutions with confidence. To achieve a stable financial system requires the fulfilment
of the other five objectives.
To achieve the above supervisory objectives, MAS performs various functions directly,
such as regulation, authorisation, supervision, surveillance and enforcement. It also
facilitates initiatives relating to corporate governance, market discipline, and consumer
education and consumer compensation.
MAS is guided by 12 key principles when carrying out its supervisory work.
These principles collectively characterise MAS' supervisory approach as risk-focused,
stakeholder-reliant, disclosure-based and business-friendly. These principles seek to:
• Emphasise risk-focused supervision rather than one-size-fits-all regulation.
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• Assess the adequacy of an institution's risk management in the context of its risk
and business profiles.
• Allocate supervisory resources according to impact and risks.
• Ensure institutions are supervised on an integrated (across industry) and
consolidated (across geography) basis.
• Maintain high standards in financial supervision, including observing international
standards and best practices.
• Reduce the risk of failure rather than prevent the failure of any institution.
• Place principal responsibility for risk oversight on the institution’s board and
management.
• Work with relevant stakeholders, professionals, industry associations and other
agencies.
• Rely on timely, accurate and adequate disclosure by institutions rather than merit-
based regulation of products to protect consumers.
• Empower consumers to assess and assume for themselves the financial risks of their
financial decisions.
• Give due regard to competitiveness, business efficiency and innovation.
• Adopt a consultative approach to regulate the industry.
4.10 Regulation in the United States

Regulators
Federal Deposit Insurance Corporation
The FDIC, created in 1933, manages the deposit insurance funds for the thrift and banking
industries. The FDIC examines banks and disposes of failed bank and savings association
assets.
Office of the Comptroller of the Currency
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The OCC has been around since the Civil War. The OCC grants national charters, although
banks may be state chartered instead. The OCC examines national banks and approves or
disapproves their merger applications.
Prior to 1863 the US had only state chartered banks. In an attempt to help finance the
Civil War, the National Banking Acts of 1863 and 1864 created nationally chartered banks
that the federal government could more tightly regulate. The laws required nationally
chartered banks to hold US government bonds to collateralise their bank notes. This
allowed the government to finance the rest of the war. The acts did not outlaw state
banking and as a result we have a dual banking system today.
About twenty-three percent of federally insured banks are nationally chartered banks; the
remainder is state chartered. Nationally chartered banks must be members of the Fed and
must be FDIC insured. State chartered banks have a choice on both. State chartered banks
may have fewer regulations imposed upon them and state chartered banks cannot use the
word ‘national’ in their name.
The Federal Reserve System
About 35% of federally insured banks are members of the Federal Reserve and 65% are
not. Fed membership allows banks direct access to the Fedwire system. The Fed regulates
bank holding company activities.
State Authorities
State chartered banks are regulated by state banking authorities. Federally insured state
chartered banks pass into receivership of the FDIC if they fail.
4.11 Investment Banks

Investment banks (IBs) perform a variety of functions in capital markets and money
markets. Traditionally, underwriting has been their most important function, but over the
past two decades there has been a great deal of innovation in the services provided by
investment banks.
In capital markets, investment banks:
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• Assist corporations and governments raise capital through debt and equity security
issues in the primary market through underwriting the issue of new securities.
• Advise on mergers and acquisitions (M&As) and corporate restructuring.
• Help to make markets (as dealer) or arrange buying and selling (broker) of securities
in secondary markets.
4.11.1 Functions performed by Investment Banks

New issues, first placed in the primary market, are called primary issues. The first sale of
securities to the public is called an Initial Public Offering (IPO).
A Seasoned Offering refers to additional issue of securities that are already trading in the
market.
There are three steps of bringing a new issue to market:
1. Origination - design of a security contract that is acceptable to the market;

2. Preparation of SGX (in Singapore) or SEC (in the US) registration statements and
a summary prospectus. Obtain a credit rating on the issue (in the case of bonds),
obtaining bond counsel, a transfer agency and a trustee.
3. The Underwriting process - the Investment Bank buys the securities at a given
price to resell them to the public at a higher price.
4. Sales and distribution - selling quickly reduces inventory risk. The lead bank
may form a syndicate to reduce inventory risk.
The difference between the price at which the issue is sold and that promised to the issuer
is the underwriting spread. This is the profit earned by the IB.
Investment Banks enter into one of two types of contracts with their clients:
4.11.1.1 Placement Methods

In a Firm commitment the underwriter (investment bank) buys the issue from the issuer
at a mutually agreed upon price, the bid price, and then attempts to sell the issue to the
final buyers (investors) at a slightly higher price, the offer price.
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In the event the entire issue is not sold, the investment bank bears the risk. It will have
to buy the unsold stock. The issue price cannot be changed once it is announced. Bankers
underprice the issue to offset the underwriting risk. Prior to the issue, the bank conducts
a 'road show' to assess potential demand for the new issue.
In a best efforts contract, the investment bank agrees to market and distribute the issue
using its 'best effort' to place the issue. If the entire issue is not sold, the banker does not
bear the risk of having to buy the issue outright. Unlike a 'firm commitment' contract, with
a 'best efforts' contract, the risk is shared between the investment bank and the issuer.
Securities that are privately placed are sold to a few large institutional investors. These
issues are exempt from registration requirements. Privately placed securities are traded
among institutional investors and high net worth investors.
4.11.1.2 Market Making

Market making entails creation of a secondary market for existing securities or financial
contracts. This involves brokerage and dealer functions. Brokers are compensated with
commissions, dealers earn profits from the bid-ask spread. Dealers incur the risk of price
changes in their inventory of securities. They also bear financing costs associated with
holding that inventory.
If a large number of investors wish to sell the stock, the specialist is responsible for buying
the stock in order to provide liquidity. Many stock exchanges implement 'circuit breakers'
in the event of large movements in stock prices. This offers the market a chance to recover,
for 'sentiments' to cool down, and specialists to muster resources if they are running short
on liquidity.
The size of the bid-ask spread is determined by:
• The security’s price volatility

• Inventory financing costs
• Trading and competition between non-colluding dealers
• Regulations
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To the extent that reduced spreads encourage more trading volume, specialists and other
brokers could see an increase in commission revenue. Increased competition from ECNs
and other markets have led to an erosion of specialist profits however.
4.11.1.3 Trading
Trading activities include:
• Position trading entails holding a position for weeks or even months.

• Pure arbitrage entails taking advantage of a mispricing between two markets by
simultaneously buying and selling the same commodity. A common example of
arbitrate is between the spot and futures market.
• In Risk arbitrage traders take advantage of a real or perceived mispricing based
on some information the trader possesses without perfectly covering or eliminating
all the risk.
• Program trading is the simultaneous buying and selling of a portfolio of at least
15 different stocks valued at more than $1 million. Trading is initiated through a
computer program. Some forms of program trading are either pure or risk arbitrage,
such as stock index futures arbitrage trades.
• Portfolio insurance is a form of program trading.
Stock brokerage entails processing of buy and sell orders from the public.
Full service brokers offer research and advice about which stocks to buy; discount
brokers process public orders for a reduced fee.
Electronic brokerage offers investors direct access to the trading floor, bypassing normal
brokers and offering even lower fees than discount brokers, e.g., E-Trade and Ameritrade
in the US; all the major banks and brokerage houses in Singapore offer electronic brokerage
services. Most large firms now offer clients a choice of full service brokerage or reduced
cost electronic trading.
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4.11.1.4 Cash Management

Securities firms have long offered accounts called Cash Management Accounts (CMAs)
that were similar to bank current accounts. As of 1999, securities firms were allowed
to offer federally insured deposits. These accounts have normally been current accounts
written on mutual fund investments. Many of these accounts now offer ATM and debit
card services. CMAs make it easier and cheaper for brokers to process payments for
security buy and sell orders. In the US, since the FSMA was passed in 1999, securities firms
can also offer loans, credit cards and other banking type services to customers and banks
can offer traditional brokerage services.
4.11.1.5 Mergers and Acquisitions (M&A)

Investment bankers help arrange mergers that produce economic synergy and increase
total value. IBs may help find merger partners, underwrite new securities to be issued as
a result of a restructuring or acquisition, assess the value of a potential target, recommend
takeover terms, or assist in fighting off a hostile takeover. M&A have been a profitable
segment of IBs business. During the growth phase of a business cycle, IBs expand their
M&A departments.
4.11.1.6 Other Service Functions

In addition to the above functions, investment bankers and securities firms also provide
security custodian services, clearance and settlement services, escrow services, research
and advice on divestitures and asset sales. Fees for these services are often bundled
together and allocated for different activities. Some of these ‘soft dollar’ allocations have
come under scrutiny as alleged conflicts of interest have arisen between the underwriting
and security selling functions of investment bankers.
4.11.2 History of Investment Banking

The earliest Investment Banks trace their origins to European investment houses which
branched to the US Prior to the establishment of the Federal Reserve, commercial
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banks were chartered for note issue and business lending. Their structure differed from
commercial banks, as they were organised as partnerships. Investment Banking grew with
security issuance and trading during the Civil War years. Subsequently, as the United
States industrialised, the railroad and steel industries sought to raise funds through
issuance of securities. Commercial banks, which had hitherto been denied permission to
underwrite securities, lobbied for investment banking privileges. By the early 1930s, they
were allowed to offer full investment banking services.
The stock market crisis and banking crisis in 1929 triggered comprehensive regulation
overseeing all types of banking. The Glass Steagall Act of 1933 separated commercial
banking from investment banking. Commercial banks were restricted to under-writing
low risk securities.
In Singapore, commercial banks operate as universal banks, i.e., banks that are allowed to
engage in commercial and investment banking activities, as well as in brokerage functions,
securities underwriting and insurance. Such banks were the norm. The Glass-Steagall Act
sought to prevent a recurrence of the circumstances that led to the market crash of 1929.
The comprehensive regulations passed sought to prevent conflicts of interest, and restore
confidence and stability in the financial system.
Accordingly, commercial banks were discouraged from investing in risky corporate

securities and speculation in financial markets. Investment banks were not allowed to
accept deposits from the public.
The Financial Services Modernization Act of 1999, known as the Gramm-Leach-Bliley

Act, repealed the Glass-Steagall Act, permitting a financial holding company to offer
commercial banking, investment banking and insurance underwriting under one roof.
The intent was to put US banks at par with other global banks that were deemed to have
an advantage operating as universal banks. The Act of 1999 triggered a number of mergers
and acquisitions in the financial sector. Prominent among these was the acquisition of
Salmon Smith and Barney, an investment bank, by Citibank, and then the merger of
Citicorp and Travelers Insurance Group into Citigroup, noted earlier.
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In most countries, including Singapore, IBs are allowed to participate in both investment
and commercial banking. They are called Universal banks and engage in deposit taking,
making loans, brokerage, securities underwriting, and insurance.
4.11.3 Structure of the Investment Banking Sector

Investment Banks provide many creative and often customised over the counter
derivative products. In addition, they may offer brokerage and market making services.
The investment banking and securities industries are complementary and many firms
provide a broad range of services. Some specialised entities with advantages in certain
market niches remain less diversified however. The industry has undergone tremendous
consolidation in the last decade due to increasing scale and scope economies and the need
for greater capital. Working for many of these firms is often considered the penultimate
finance career, with prestige and remuneration to match.
Many investment banking houses are part of financial conglomerates that have evolved
for a variety of reasons: a desire for low-cost funding, a need to assist customers with
credit as products of the firm are sold, profit opportunities in the financial services area,
and a desire to serve their present customers with a full range of financial services,
while achieving economies of scope. Expansion into a variety of financial services may
be undertaken internally or externally, or through merger with an existing firm. The
acquisition strategy has been the favourite strategy of the financial conglomerate. In
an attempt to build shareholder value, various subsidiaries and divisions are bought,
sold, or spun off very quickly. The merger of Citicorp, Travelers Insurance, and Salomon
Brothers into Citigroup mentioned earlier, provided the momentum for Congress to pass
the Financial Services Modernization Act of 1999. This law provided a legal means for
combining investment banking, commercial banking, and insurance underwriting.
Investment banks often create formal or informal syndicates to assist in sharing risk and
expertise. Some bankers are stronger in distribution, such as Merrill Lynch, some are
stronger in corporate negotiations, such as Morgan Stanley, and some are stronger in
certain industries or in certain aspects of restructurings such as Goldman Sachs. Corporate
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finance activities such as spin-offs, divestitures, mergers and acquisitions, tender offers,
and other financial restructurings are often undertaken with the advice and assistance of
investment bankers. Securities firms provide brokerage, research and advising services
and trade securities for their own account. Full line firms provide both investment banking
and brokerage services. Specialised firms may concentrate on firms in a given region,
focus on a trading method, such as over the Internet, or specialise in a particular type of
financing such as providing capital for start-ups and small firms (venture capital).
In the US, the investment banking industry can be broken down into three major
subdivisions:
Diversified national full line firms serve both retail and corporate customers such
as Morgan Stanley. These firms’ income comes primarily from brokerage, lending, and
underwriting, although trading activities are a growing component of income at all
investment banks.
National full line firms specialise in corporate finance such as Goldman Sachs. Their
income is primarily from underwriting, placement, mergers and acquisitions and other
consulting services.
Specialised firms such as:
• regional investment bankers (D.A. Davidson), (sometimes labelled ‘boutiques’)

• discount brokers (Schwab)
• Internet brokers (E-Trade)
• venture capital firms (New Enterprise)
• subsidiaries of commercial banks (J.P. Morgan Chase)
4.11.4 Investment (or Merchant) Banks in Singapore

Merchant banks are approved under the Monetary Authority of Singapore Act and their
operations are governed by the Merchant Bank Directives. Their ACU operations are also
subject to the Banking Act. Besides the three categories of commercial banks, financial
institutions may also operate as merchant banks.
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The typical activities of merchant banks include corporate finance, underwriting of

share and bond issues, mergers and acquisitions, portfolio investment management,
management consultancy and other fee-based activities. Most merchant banks have, with
MAS' approval, established ACUs, through which they compete with commercial banks
in the Asian Dollar Market. In their DBU, merchant banks may not accept deposits or
borrow from the public. However, they may accept deposits or borrow from banks, finance
companies, shareholders and companies controlled by their shareholders.
Singapore had 47 licensed merchant banks as of July 2011. These banks, which are
governed by both the Companies Act and the Banking Act, can conduct a variety
of activities: corporate finance, equipment finance, financial-advisory services, gold
and foreign-exchange trading, investment management, portfolio management, and
underwriting. They investigate and advise on mergers and acquisitions, and participate
in the Asia dollar market.
Merchant banks can establish branches only after obtaining permission for the MAS. They
need permission to issue promissory notes, commercial paper or certificates of deposit; or
raise funds from the public. Merchant banks are prohibited from engaging in wholesale
or retail trading (including import and export trade), either for their own account or on
a commission basis. A risk-based capital framework came into effect for securities and
futures intermediaries in October 2002. The framework applies to capital markets services
licence holders.
Of the top ten investment banks operating in Singapore, six were foreign and only four
were domestic. In the period from January 1 to July 22, 2011, DBS Bank was the leading
investment bank in terms of funds raised, with S$2,823.67m, or 32.68% of the market.
It was followed by Goldman Sachs (US) with S$2,423.67m (28.05%) and Deutsche Bank
(Germany) with S$2,325.05m (26.91%).
As of July 2011, there were 28 brokerage firms authorised to trade on the Singapore
Exchange (SGX). Prominent foreign brokers include Deutsche Bank (Germany), Merrill
Lynch (US) and Credit Suisse (Switzerland). In April 2008, Mitsubishi UFJ invested US
$118m to increase its equity holding in local brokerage Kim Eng Securities from 3.6% to
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14.6%. It subsequently increased its shareholding further and had an equity interest of
29.16% as of June 2011. In June 2011, Mitsubishi UFJ announced that it was selling its
interest in Kim Eng to Malayan Banking for Rmb34bn.
Under SGX rules, member firms must have base capital (paid-up ordinary share capital,
preference shares, share premiums, a reserve fund, and profit and loss) of at least S$1m
(for a trading member) or S$5m (for a clearing member). Also, the firm’s licence to trade in
stocks will lapse if its aggregate indebtedness exceeds 1,200% of its aggregate resources.
4.11.5 Regulation of Investment Banks (IBs)

The Securities and Exchange Commission (SEC) is the primary regulator of the securities
industry. The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed
federal (over state) authority over issues pertaining to the securities industry. However,
state attorneys general intervene through securities-related investigations that have led to
many highly publicised criminal cases, listed in the next section.
The omnibus Sarbanes-Oxley Act (SOX) of 2002 created an independent auditing

oversight board under the SEC. SOX increased penalties for corporate wrongdoers,
required companies to provide faster and more extensive financial disclosure, and created
avenues of recourse for aggrieved shareholders.
The SEC sets rules governing underwriting and trading activity. SEC Rule 144A defines
boundaries between public offerings and private placements. SEC Rule 415 allows shelf
registration allowing firms that plan to offer multiple issues of stock over a two-year
period to submit one registration statement summarising the firm’s financing plans for
the period.
Two self-regulatory organisations oversee the day-to-day regulation of trading practices.

They are the New York Stock Exchange (NYSE) and the National Association of Securities
Dealers (NASD).
In 2003 following the passage of the U.S.A. Patriot Act, firms were required to verify
identities of customers, and maintain records of identities of customers. According to the
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Act, it is incumbent upon the firms to verify that their customers are not on suspected
terrorist lists.
Investors are protected by the Securities Investor Protection Corporation (SIPC). The SIPC
protects investors against losses of up to $500,000 due to securities firm failures (but
not against poor investment decisions). The SIPC was created following passage of the
Securities Investor Protection Act in 1970.
In Singapore, Investment Banks are regulated by the Monetary Authority of Singapore

(MAS).
The Securities Investor Protection Corporation (SIPC) insures losses of funds deposited
with securities firms up to $500,000 per investor in the event of the failure of a securities
firm. Losses to security values due to adverse market moves are not insured.
The daily activities of the securities industry are primarily regulated via the New York
Stock Exchange and the National Association of Securities Dealers (NASD). Thus, to a
large extent these firms are self-regulated according to rules promulgated by the SEC.
The Federal Reserve regulates margin requirements on stocks and occasionally suggests
rules changes involving securities trading and underwriting. Recently, the Fed suggested
shortening securities settlement from the current three days to one day because securities
are often used as collateral for bank loans.
Since the passage of the National Securities Markets Improvement Act of 1996 removed
state oversight of securities firms, the SEC has the primary jurisdiction over securities
firms and sets standards for their activities. The SEC regulates underwriting and trading
activities and promulgates a series of rules such as Rule 144A regulating private
placements, Rule 415 allowing shelf registrations, etc. Under Rule 144A, security issuers
may avoid the registration process (and the considerable expense) if they are sold to a
few qualified buyers. The buyers are typically institutional investors but certain high net
worth individuals can qualify. These securities may now be re-traded among the qualified
investors but may not be sold to the public.
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Very few equities are privately issued; the private market is mostly for debt. Privately
placed debt issues will have lower flotation costs but often carry higher interest rates.
In the early 2000s, certain states began to take a much more active role in regulations of
the markets. Former New York State General Attorney Spitzer led in this process. These
prosecutions led to SEC rules changes to help ensure fewer conflicts of interests between
analysts and investment bankers and better methods of allocating IPO shares.
Investment bankers paid large fines as a result (fines totalled $1.4 billion). In particular,
analysts have been barred from attending/participating in the ‘road shows’ and may not
receive compensation based on the amount of underwriting business the firm generates.
Within days of the settlement however, Bear Stearns allegedly violated the new rules.
More recently, Morgan Stanley allegedly withheld emails pertinent to hundreds of

arbitration cases, falsely claiming the emails were lost in the September 11, 2001 terrorist
attacks when they were not.
Interestingly, Bear Stearns, as well as other investment banks, would have had a very
explicit code of ethics requiring employees to treat customers fairly and to report all ethical
violations. The corporate culture on Wall Street, including compensation schemes, needs
an overhaul. Moreover, these violations matter. They impede growth by raising the cost of
funds to everyone. How much value was destroyed by unethical behaviour of managers
at Enron, WorldCom, HealthSouth, Tyco, Parmalat, etc.? How much spill over to other
firms’ stock prices occurred as a result of the loss of confidence in management? What
did this do to our cost of funds, or reliance on foreign funds if you prefer. What has/will
this cost us in the future in terms of costly contracting? Already a class action lawsuit
against bankers that underwrote WorldCom debt has resulted in payments of $6 billion
by bankers (with the largest payment of $2.85 billion by Citigroup). Citigroup also paid
$2 billion to settle a class action suit over Enron and $75 million to settle a similar suit over
its involvement with Global Crossing.
Citigroup has now instituted mandatory ethics training for all employees. The long jail
sentences that Ebbers (WorldCom CEO), Rigas (Adelphia CEO), Dennis Kozlowski and
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others received should also help deter some of the more egregious fraud schemes. At
some point, increased sentences may be needed to rein in unethical investment banking
practices as well.
The markets themselves have not been immune to scandal. In 1996, the SEC charged
the NASD (the regulatory body of the NASDAQ stock market) with ignoring evidence
of price fixing by NASDAQ market makers or dealers. The dealers were allegedly
colluding to keep bid-ask spreads artificially high by refusing to quote odd eighths and
blackballing dealers who did not comply (at that time, many stock prices traded in
minimum increments of one eighth). The NASD agreed to spend $100 million to improve
rules enforcement. Subsequently, 30 brokerage firms agreed to pay $900 million to settle
a civil suit alleging they engaged in price fixing of NASDAQ securities.
In 2003 the NYSE fined a trader of Fleet Specialist Inc $25,000 for front running. Front
running occurs when a specialist executes orders for their own account ahead of public
orders. The trader sold GM stock from the specialist’s own account on rumours of
accounting problems at GM ahead of a public sell order.
In July 2002, Congress passed the Sarbanes-Oxley Act seeking to improve corporate
governance and accounting oversight. This bill created an independent auditing oversight
board run by the SEC, increased penalties for corporate malfeasance, and gave disgruntled
shareholders more options to pursue lawsuits. The law restricts accounting firms’ ability
to provide non-audit services to audit clients and no longer allow the AICPA to set
accounting and auditing standards. These will be set by the Public Company Accounting
Oversight Board. The act requires that the CEO and CFO prepare and sign a statement
certifying the reasonableness of the firm’s financial statements. The NYSE and the NASD
have also changed their listing requirements with respect to corporate governance.
Anti-money laundering activities
The USA Patriot Act added three new requirements to securities firms as of October 2003.
The new rules include:
1. Firms must verify the identity of any person seeking to open an account.
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2. Firms must keep records of the information used to verify the client’s identity.
3. Firm must determine whether the client appears on any lists of known or
suspected terrorists or terrorist organisations.
4.11.6 Global Issues

Investment banking activities are highly globalised. For instance, the Swiss bank UBS is
the number one underwriter of global IPOs. Foreign transactions in US stocks increased
from $211.2 billion in 1991 to $7,579.9 billion in 2007. This represents a compound average
annual growth rate of 25%. US transactions in foreign stocks increased from $152.6 billion
in 1991 to $5,028.3 billion; an annual compound growth rate of over 24%. However, there
has been a marked slowdown since the onset of the subprime crisis and the continuing
crisis in the Eurozone.
International offerings have also grown rapidly, but recent scandals, the US stock market
weakness, disclosure requirements and the decline in the value of the dollar have probably
deterred foreign investors and foreign issuers from participating in the US markets. US
firms are seeking a greater presence in fast growing markets such as China and India.
4.12 Mutual Funds

Mutual funds are financial intermediaries that pool the resources (funds) of many small
investors by selling them shares and using the proceeds to buy securities, such as stocks,
bonds, money market instruments, etc.
Mutual funds are operated by professional fund managers, who invest the fund's capital
and attempt to produce capital gains and income for the fund's investors. Through
the asset transformation process of issuing shares in small denominations and buying
large blocks of securities, mutual funds can take advantage of volume discounts on
brokerage commissions and purchase diversified portfolios of securities. MF allows the
small investor to obtain the benefits of lower transaction costs in purchasing securities and
to take advantage of risk reduction through diversification of their portfolio. The portfolio
is structured and maintained to match the investment objectives stated in its prospectus.
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Each shareholder participates proportionally in the gain or loss of the fund. Mutual fund
units, or shares, are issued and can typically be purchased or redeemed as needed at the
fund's current net asset value (NAV) per share, which is sometimes expressed as NAVPS.
Investment funds provide cost reduction and diversification benefits for the investing
public. As tax and economic conditions have changed, fund managers have introduced
a variety of funds to serve the investing public. We discuss the basic attributes of both
open-end and closed-end funds and trace their recent developments. We will also review
specialty funds, such as unit investment trust, exchange-traded funds, hedge funds and
real estate investment trusts.
Investment companies, dominated by mutual funds, have also been the primary means
for individuals’ defined contribution pension plans in the last few years. There has been
rapid growth in capital market intermediation for individual investors through pension
funds and investment funds relative to direct financial investment in the past, and the
revival of varied direct financial investment issues in the bull financial markets of the
1980s and 1990's. In Singapore, the CPF Investment Scheme (CPFIS) enables funds in the
national pension fund to be invested in mutual funds.
Investment funds have been responsive to the investment needs of the individual investor
as the business cycle, inflation, tax law, and regulation have changed. Technology and
competition have made exchange-traded funds popular in the last few years.
Investors desire to place some of their funds in less liquid, higher earning accounts to
fund long term goals. Long term mutual funds provide investors a low cost means to
gain exposure to high return markets while eliminating most diversifiable risk. The strong
stock market of the 1990s brought record increases in both the level of mutual fund
assets and the number of funds. The poorer stock market performance of the early 2000s,
however, slowed and even reversed the trend of mutual fund growth. From the end of
2001 to June 2002, industry assets declined about $340 billion due to fund withdrawals
and declining equity values. Growth returned to the industry in 2003 and 2004 with better
stock market returns. In 2005 and 2006 net new cash flows in equity funds were $135.6
and $159.4 billion respectively before dropping off to $92.4 billion in 2007.
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4.12.1 Structure of Mutual Funds

Open end mutual funds sell shares to the public and redeem them from the public. Thus,
liquidity is never a concern to fund shareholders. The mutual fund pools the cash received
and invests in securities in line with the fund’s stated objective. Because the funds invest in
large amounts, they are able to negotiate very low transaction costs. Thus, small investors
(and even many institutional investors) are able to obtain diversified portfolios on more
favourable terms than they could achieve on their own. Mutual funds provide other
services to investors as well including:
• Free exchange of investment between a mutual fund company’s funds

• Automatic periodic investment and reinvestment of fund distributions
• Cheque writing privileges on certain funds type (MMMF and bond funds)
• Automatic withdrawals
• Record keeping for tax purposes
Closed end investment companies have a fixed number of shares outstanding and do not
issue new shares or redeem shares from investors. These shares are traded like stocks and
may be exchange listed. Closed end funds are either created as a closed end company,
as most unit investment trusts are, or they are former mutual funds that have decided to
close to new investors, such as Fidelity’s Magellan Fund. Unit trusts, such as the popular
real estate investment trusts (REITs), may be levered and can have extreme rates of return.
Unlike mutual fund shares, closed end fund shares may trade at a premium or a discount
to the NAV of the fund. Empirical evidence has presented no convincing reason why fund
discounts and premiums exist.
4.12.2 Different Types of Mutual Funds

Major types of funds include:
• Long term funds

◦ Equity funds: Primarily hold common and preferred stock
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◦ Bond funds: Primarily hold fixed income securities with maturities of over
1 year
◦ Hybrid funds: Blends of equity and bond funds
◦ Tax exempt funds: Funds that specialise in investing in tax exempt securities
◦ Index funds: Funds that attempt to mimic the performance of a given index;
because they do not actively engage in timing and stock selection they
generally have lower expense ratios than other funds. These have now grown
to 25% of long term funds.
◦ Exchange traded funds (ETF): A variant of index funds that are traded
on an exchange. In 2007, there were about $608 billion invested in ETFs.
The advantage of an ETF is that it can be traded throughout the day at
continuously updated prices. ETFs can be purchased on margin and sold
short, unlike index funds. There are no capital gains distributions to add to
tax liability in a given year either. These features allow for better hedging and
arbitrage strategies. Examples include SPDRs on the AMEX and Vanguard’s
Large-Cap VIPERS funds.
• Short term funds
◦ Money market mutual funds: Funds that invest in securities with 1 year
maturity or less
◦ Tax exempt money market mutual funds
The major holders of both types of funds are individual investors. Investors in MMMFs
give up deposit insurance, but usually gain higher rates of return. This is probably a safe
bet to gain a slightly higher rate of return as only one MMMF has ever failed and it failed
because of positions in derivatives. In 2002 and 2003, bank deposit rates of return were
actually greater than MMMF returns and money flows to MMMFs were reduced as more
people chose bank deposits.
Individual participation in mutual funds is becoming more widespread as financial

education increases and interest in the stock market continues. The primary reason most
people hold mutual funds is to provide supplemental retirement income. The bull markets
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of the 1990s, the low transactions costs of purchasing shares, the diversification achieved,
and the other services provided by funds are major reasons behind their rapid growth.
Fund growth slowed with the poorer stock markets of the early part of the century, but
growth in market value of long term funds from 2002 to 2004 was 22% per year. Money
market fund growth was -8% per year over the same time period. Long term funds grew
to 75.4% in 2006 as the stock market performed well before falling back in 2007 as the
mortgage market effects spilled over into stocks and other long term investments.
4.12.3 Size, Structure and Composition of the Mutual Fund Industry

Historical Trends (Data for the US): Although mutual funds have been around since the
1920s, as recently as 1970 there were only 360 funds with $50 billion in total industry assets.
In 2007, there were 8,017 mutual funds with total net assets of $12,039.4 billion. There
has also been a huge increase in the number of accounts since 1990. Part of the growth in
mutual funds has been driven by the growth in retirement funds under management by
the mutual fund industry. Retirement funds grew for $4.0 trillion in assets in 1990 to over
$15 trillion in 2007. Mutual funds manage about 25% of this total. Much of the growth
in this market has come from so called institutional funds, which are funds that manage
retirement plans for a company’s employees. About 80% of all retirement plan investments
are in institutional funds. From the 1970s onward, mutual funds enjoyed rapid growth.
Money market mutual funds (MMMFs) grew in the 1970s due to Regulation Q. Regulation
Q limited the rate of interest banks could pay on their deposits and rising open market
rates induced investors to seek higher returns in money market mutual funds. Tax exempt
funds grew rapidly in the 1980s as taxes owed climbed, and bond and equity funds grew
tremendously rapidly with the bull markets of the 1980s and 90s. Mutual funds are now
the second largest financial intermediary, and if their rate of growth continues, they will
soon overtake banks as the country’s largest intermediary. As a result of the rapid growth,
commercial banks, insurers and other institutions have also begun operating investment
management funds. There are generally low entry barriers into the fund industry. The
twenty five largest funds however manage 71% of industry assets indicating that there
are large economies of scale in fund expenses that promote large size.
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4.12.4 Mutual Fund Returns and Costs

Mutual funds are required to publish the specific objectives of the fund in the prospectus
(a formal summary of a proposed investment). No investor should invest in a fund
without carefully reading the prospectus. The prospectus will contain historical return
information, usually for 1 year, 3 year and 5 year periods and perhaps longer. The
prospectus must also show historical fees and the effect of those fees on a given investment
over time. A prospectus, while containing necessary information for the investor, is
basically a marketing tool. For instance, one rarely finds much about risk in a prospectus
and the funds will often tout the period that makes the returns appear the best.
4.12.4.1 Aggressive Growth

Common stock fund, stressing picking stocks with unrecognised growth, usually small
firms or sector funds, high turnover, higher beta or σ stocks, little or no dividend income.
These funds have substantial potential for capital loss. Sector funds, small and mid cap
growth funds may fit into this category. There are also some bear market funds that invest
counter cyclically.
Long time horizon, willing and able to take substantial risk in hope of high returns, high
ability to remain in the markets regardless of economic conditions.
4.12.4.2 Growth
Common stock fund, stressing picking some stocks with unrecognised growth, and some
stocks that pay moderate to substantial dividends, moderate to high turnover, higher beta
stocks, only moderate dividend income. These funds also have substantial potential for
capital loss. Large cap growth funds are an example in this category.
Long time horizon, willing and able to take substantial risk in hope of high returns, high
ability to remain in the markets regardless of economic conditions.
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4.12.4.3 Growth & Income

Basically a common stock fund, probably with some bonds, stressing picking some stocks
with unrecognised growth, and some stable stocks that pay substantial dividends as
well as coupon bearing bonds, moderate turnover, fund beta at or near the 'market',
generally higher dividend income. There is a substantial potential for capital loss in
adverse economic conditions. All size blend and value funds may fit into this category.
Those with a moderate to long time horizon, willing and able to take risk in hope of higher
returns, moderate ability to remain in the markets regardless of economic conditions.
4.12.4.4 Index Fund

Duplicate performance of some index such as the S&P500. Like all stock funds, there is
substantial chance of capital loss during adverse economic conditions. These funds have
very low turnover and low expenses. There are index funds that mimic performance of
the entire market while some funds are designed to give returns similar to an industry or
market sector, including different size sectors such as small caps, mid caps, etc. There are
also various international index funds available now.
Investors with a moderate to long time horizon that are willing and able to take risks
in return for yields comparable to the 'market'. Investors are often those who believe in
efficient markets with staying power to ride out tough economic times.
4.12.4.5 Balanced Fund

Approximately equal proportions of stocks and bonds although this varies with market
conditions; they are usually very well diversified. The stocks are usually "blue-chip"
type with established dividend records. Bonds are usually high grade with substantial
coupons; the fund focus is typically (but not always) on current income. Some may
have substantial international investments for diversification purposes. The fund’s beta is
usually below the 'market', with generally high dividend and interest income. Investors
face moderate potential for capital loss in adverse economic conditions. A special type of
balanced funds, called Target Date funds, has now been developed that is designed for
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investors who will retire within the given target date. As investors age, they normally want
to reduce the risk of their investments. These funds do this automatically as the target date
approaches. There are currently Near Term funds with a 2014 target date, Intermediate
Term funds with a range of target dates of 2015-2029 and Long Term with target dates of
2030 and longer.
Those with a moderate time horizon, willing and able to take moderate risk in return
for higher current income, and have some ability to remain in the markets regardless of
economic conditions.
4.12.4.6 Income Fund

Primarily higher current yield, fixed income securities, mostly bonds. Bonds are usually
high grade with substantial coupons; the objective is usually to generate maximum
current income. The fund beta is normally substantially below the 'market', and the fund
normally generates high interest income. There is some potential for capital loss in adverse
economic conditions. Inflation risk can be severe and taxes can significantly erode returns.
Those with a moderate time horizon, willing and able to take moderate risk in return
for higher current income; investors are often those who need the investment income for
living expenses.
4.12.4.7 Money Market Fund

Lower yielding fixed income securities. Most fund investments will have a maturity less
than or equal to 1 year. The fund objective is to provide a rate of return superior to bank
investments while minimising chance of capital loss. There is little risk of capital loss.
Investors with a short to moderate time horizon, who are unwilling or unable to take
much risk in return for moderate to low yields. Investors are often those who need the
investment income for living expenses and cannot afford to risk capital losses, or the funds
may be used as a ‘parking space’ for a short time. There are potentially large opportunity
losses on these investments if held for a long time period.
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These statements are generalities and many variations exist within a fund category. For
instance, it is entirely possible to find a growth fund with greater risk than an aggressive
growth fund. See Morningstar for more specific fund objective definitions. Growth funds
have been among the most popular in recent years.
4.12.5 Investor Returns from Mutual Fund Ownership

Returns come from three sources:
1. Appreciation in the value of shares

2. Dividend Distributions
3. Capital gains Distributions
4.12.5.1 Appreciation in the Value of Shares

Appreciation in the value of the mutual fund’s shares due to unrecognised gains in the
fund’s underlying assets. These are usually marked to market daily. The value of a mutual
fund share is its net asset value (NAV). The NAV is equal to the total value of the fund’s
holdings less any liabilities divided by the number of mutual fund shares outstanding.
Mutual funds are open ended, meaning that investors buy shares directly from the fund
and the fund redeems their shares upon demand.
NOTE: It is important to understand that NAV is set as of 4:00 PM EST each business day.
Most mutual funds are limited in the amount of debt (liabilities) they can use. Many unit
trusts are not however. Leveraged funds have generally riskier rates of return and have
bankruptcy risk. A mutual fund should not technically go bankrupt (absent substantial
derivatives positions) because they owe only the market value of their holdings.
A disadvantage of the open end nature of mutual funds is the need to hold a cash reserve
to handle redemptions from fund shareholders. Without cash reserves, a mutual fund can
be forced to sell fund holdings to redeem shares. A dramatic case of this occurred in the
crash of October 1987. At the time, funds held low cash reserves and were forced to sell
to meet the very large number of redemption orders.
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In a more general sense, newer evidence on funds’ ability to profitably engage in stock
selection indicates that fund managers may have some real stock selection ability once we
separate out liquidity trades from information trades of fund managers. This implies a
higher cost to the open end structure than we previously thought.
4.12.5.2 Dividend Distributions

Distributions by the fund are of dividend and interest income earned on the fund’s
underlying holdings. Funds are normally required to distribute at least 90% of dividend
and interest income earned.
4.12.5.3 Capital Gains Distributions

Recognised capital gain increases due to the fund’s selling of shares result in capital gains
distributions. Funds are normally required to distribute at least 90% of realised capital
gains. Distributions are normally paid quarterly or annually. Investors will not normally
wish to buy into a fund right before a distribution date. Doing so will create taxable income
from the distributions in the current tax year. The taxable income will be offset by a capital
loss on the mutual fund shares, but the loss will be unrecognised until the individual sells
the mutual fund shares.
Investors should choose a fund with a turnover rate that meets their goals, particularly
if the fund is not held in a tax sheltered vehicle. High turnover funds generate more tax
liabilities each year. Taking 0.5 × (1 / annual turnover ratio) will give the average holding
period of securities within the fund. Turnover ratios are reported by Morningstar and in
the fund prospectus.
4.12.6 Mutual Fund Costs

Costs to a mutual fund investor (not all funds charge each type of fee).
• Load charge: The load is usually a front end load, meaning that this fee is paid
upfront when the investor buys shares in the fund. It is conceptually equivalent to
a broker’s commission. The maximum size load allowed is 8.5%, although very few
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funds (mostly sector or international funds) charge loads over 5% today because
of the competitiveness of the mutual fund industry. In fact, the majority of funds
now charge no load at all and the amount of dollars invested in load funds is less
than invested in so called ‘no load’ funds. No load funds are directly marketed;
consequently, the investor must go looking for them. Brokers sell load funds.
Statistical performance of load funds is no better than the performance of no load
funds; thus, investors who use load funds are paying for the advice of a broker as
to what type of fund is appropriate for them, but there is no other return for paying
the load charge. Some funds charge back end loads instead of or in addition to front
end loads. In a back end load, the investor pays the load when the shares are sold.
This is better than a front end load because in a front end load you earn nothing on
the amount that goes to the broker whereas that money could be invested for the
holding period on a back end load.
• If a fund has multiple class shares (and over half now do), the different classes
usually represent different methods of assessing the load charge. Some funds
charge holding period contingent back end loads such that the load is reduced if
the investor leaves his money with the fund for longer periods. Usually after five
years, the load is zero.
For example:
Class Ashares pay a front end load, and usually incur a small 12b-1 fee (see below).
Class B shares have no front load, but incur a back end load and a larger 12b-1 fee;
after a set period of time such as 6-8 years, the Class B shares convert to Class A
and thus incur the smaller 12b-1 fee.
Class Cshares have no front load, and a back end load is incurred only if shares are
sold within a set number of years. These shares do not normally convert to Class A
and carry the full 12b-1 fee for the entire time they are held.
This means investors face tradeoffs in determining which class of fund share to purchase.
The best choice will depend on the terms of the fund, the expected time the investor will
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stay in the fund and in some cases the amount of money invested. Normally, Class A
shares entail the highest cost because less money is invested with the front load deduction.
The real cost of a front end load is actually worse than the stated load. If you have $1,000 to
invest and you place your money in a fund with a 5% front end load, you get an investment
worth $950. So you pay a commission of $50 which gives a commission rate of $50 / $950
or 5.26%. For longer expected holding periods, the investor may be better off with Class B
shares rather than Class C shares because of the reduced 12b-1 fee after the conversion.
The demand for no load funds has been increasing and discount (and other) brokers
offer investors services where the investor can buy and sell mutual funds shares offered
by different mutual funds sponsors without incurring any load charges. Brokers are
compensated by a portion of the 12b-1 fees.
In the US, the American Association of Individual Investors (AAII) publishes a low cost
book annually titled, “The Individual Investor’s Guide to Low Load Mutual Funds.” Low
load is 4% or less. A searchable database is also available. The best source of mutual fund
data is probably Morningstar, which provides its Principia product at a reasonable cost.
Operating Expenses: Fund managers’ expenses and profits are generated by the operating
expenses that are assessed to the fund. A "well managed" fund probably should have an
expense ratio of less than 2%.
4.12.7 Mutual Fund Regulation

In the US, the SEC is the primary regulator of mutual funds. The major acts regulating
mutual funds include the banking and securities acts of 1933 and 1934 and the Investment
Company Act of 1940. These laws required mutual funds to meet disclosure requirements
similar to public issues of debt and equity, and introduced many anti-fraud procedures
and limits on fees. Newer laws such as the Insider Trading and Securities Fraud
Enforcement Act of 1988 required funds to develop mechanisms to avoid insider trading
abuses and the Market Reform Act of 1990 allowed the SEC to introduce circuit breakers.
More recently, the National Securities Markets Improvements Act (NSMIA) of 1996
exempts mutual fund sellers from most state oversight.
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4.12.8 Ethical Problems in the Mutual Fund Industry

Four main categories of trading abuses have been identified:
1. Market timing: Allowing selected traders, typically fund managers, to buy

mutual fund shares and then sell them in a short time period, usually the next
day to exploit prices changes in holdings in overseas markets.
2. Late trading: This is the big news item. It consists of allowing certain investors to
be able to buy or sell mutual fund shares after close of trading at 4:00 PM EST. The
NAV is set for the day at that time. As new information comes out, investors can
profitably set up trades based on the new info that is not yet incorporated into
the fund NAV. Late trading and market timing allow certain classes of investor
to unfairly profit at the expense of longer term investors.
3. Diluted brokerage arrangements: A form of ‘directed order flow.’ In this practice,
mutual fund managers use certain brokers when they decide to buy and sell
shares held in the mutual fund. In exchange for this, the brokers agree to advise
their own clients to purchase that mutual fund, regardless of whether that was
the best fund for that particular client. This is a form of soft dollar kickback.
4. Some brokers have allegedly duped investors into purchasing shares with 12b-1
plans, a form of load charge, by telling the investors the fund had no load. Some
funds and fund families also provide discounts to qualified customers. In some
cases, the brokers did not realise (or just did not tell) the customers they qualified
for a discount and overcharged the customers.
New rules resulting from the abuses:
In general, the rules are designed to increase disclosure about potential conflicts of interest,
close legal loopholes abused by managers and increase oversight and independence of the
board. The minimum percentage of independent board members was increased from 50%
to 75%. Recall that under Sarbanes-Oxley at least one board member must have accounting
expertise and knowledge of GAAP. The SEC also now requires senior executives of funds
to report all trading in funds, not just trading in individual stocks. Client trades and
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holdings must also be held confidential (they had been revealed to other fund managers).
1. Rules on market timing: Firms must promulgate and disclose methods to

limit frequent trading. Firms must disclose whether they are using ‘fair value
pricing’ (FVP). FVP is a method to update securities prices where the last price
quote is ‘stale’ or out of date by several hours or more. This is important for funds
holding stocks that trade in overseas markets.
2. To limit improper directed order flow, brokers are required to disclose to
customers any tie in arrangements with specific funds. These are de facto
conflicts of interest and should be disclosed.
3. As of October 2004, all funds must have a chief compliance officer (CCO) that
answers to the board. The CCO’s duties include policing personal trading by
fund managers, monitoring allocations of trades and commission, ensuring
accurate information disclosure and reporting wrongdoing to the board.
4. Shareholder reports must disclose all fees shareholders paid as well as
management’s discussion of fund performance over the period. Investors now
get a report showing how much they paid, how much the broker (if any) was
paid, and how the fund compares with industry averages for fees, loads and
brokerage commissions.
5. PROPOSED by SEC, but not approved: “Hard closing” on buy/sell order
processing as of 4:00 PM EST daily. The industry is fighting this one because they
claim brokers would have to have the orders by as early as 10:00 am in the day.
(This is a problem that could easily be solved by technology however.)
Morningstar is maintaining a fund watch list for funds under investigation with
prescriptions for investors, such as “Proceed with caution,” “Don’t send new money,” and
“Consider selling.” This information is available at www.morningstar.com.
The scandals don’t seem to have had a lasting deleterious effect on the industry. Surveys
by the Investment Company Institute (ICI) indicate that 75% of people have a favourable
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perception of the industry, although this perception is driven heavily by current mutual
fund performance.
4.13 Insurance Companies

The primary function of insurance companies is to compensate policyholders if a
prespecified event occurs, in exchange for premiums paid. Insurance facilitates transfer
of the burden of a “pure risk” to an entity that pools risk and pays compensation if loss
occurs (the insurance company). 'Pure risk' situations have two possible outcomes, loss or
no loss. With “pooling”, losses suffered by a small number of insured are spread over the
entire group—an insured substitutes the small average loss for the uncertainty that they
might suffer a large loss.
Insurance improves the climate for savings and investment, thereby facilitating economic
growth. In the presence of insurance, market participants are able to make efficient
investment decisions and save for retirement years. Insurance enables risk averse agents
to make decisions that entail a greater degree of risk than they otherwise may take on.
It allows consumers to make decisions based on future income flows, e.g., mortgages,
automobile finance.
Insurance underwriters assess and price risk. Insurance brokers sell insurance contracts
for coverage or for a policy. Insurance is broadly classified into two groups. Life insurance
provides protection against untimely death, illness, and retirement. Property-casualty
insurance protects against personal injury and liability. Insurance provides financial
compensation for losses but does not prevent losses from occurring. Insurance can
thus broadly be classified into two groups.Life insurance provides protection against
untimely death, illness, and retirement, while property-casualty insurance protects
against personal injury and liability.
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4.13.1 Life Insurance Companies

Insurance companies underwrite the risk that a prespecified event will occur in return for
insurance premiums. The underwriting decisions determine which risks are accepted and
which are not, and also how much to charge (in the form of premiums) for accepted risk.
The core business of life insurers is to remove income uncertainty due to death or
retirement from individuals. Insurers must decide which risks are worth accepting (or
underwriting) and which should be rejected. Some insurers act as agents (or insurance
sellers) while others act as underwriters and sellers. A growing number of policies are
now sold through commercial bank offices.
Life insurance companies can be either stock or mutually owned (where the policyholders
are the owners). They pool the risks of individuals to diversify away some of the customer-
specific risk. Thus, they are able to offer insurance services at a cost lower than any
individual could achieve, saving funds on their own. Life insurance also allows the
transfer of income related uncertainties from the individual to the group.
Life insurance companies engage in a number of activities. These include:
• Selling annuities, which are savings contracts that involve the liquidation of those
funds saved over a period of time
• Manage pension plans (e.g., tax-deferred savings plans)
• Provide accident and health insurance
The science of actuaries provides assessment on the likelihood of events with undesirable
outcomes. The objective is to design risk management systems and insurance premiums
that minimise the financial impact of adverse outcomes. Actuaries reduce the risks of
underwriting insurance:
• In the case of life insurance, actuaries analyse mortality, produce life tables, and
apply the time-value-of-money to produce life insurance annuities and endowment
policies
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• With health insurance, actuaries analyse the rates of disability, morbidity, mortality,
fertility, etc.
4.13.1.1 Types of Life Insurance Companies

Ordinary life insurance is marketed to individuals—policyholders make periodic
premium payments in exchange for coverage.
Term life: beneficiary receives payout at time of death. If insured lives beyond the term of
the contract, no benefits are paid.
Whole life: policy protects over entire lifetime; the beneficiary receives face value of
contract upon death.
Endowment life: beneficiary receives payment at time of death. If insured lives beyond
the term of the contract, he/she receives face values at the end of the contract period.
Variable life: premiums are invested in market securities. The value of policy depends on
the value of the securities.
Universal life: allows the insured to change both the premiums and the maturity of the
contract. Variable universal life combines features of variable and universal life insurance.
Group life insurance covers a large number of persons under a single policy. There are
two types of group life insurance policies:
• contributory—both the employer and the employee cover a share of the premiums
• noncontributory—the costs are borne entirely by the employer
Credit life insurance protects lenders against borrower death.
4.13.2 Property-Casualty Insurance Companies

Property insurance provides protection against risks to property. This includes risk of
fire, theft, natural disaster. Specialised types of property insurance, including earthquake
insurance, weather insurance, flood insurance, etc. have grown in recent years, especially
in the aftermath of major disasters such as hurricanes, earthquakes and floods.
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The term casualty insurance, like property insurance, is used to encompass a broad category
of various subtypes of insurance including crime insurance, theft, embezzlement, or
political risk insurance, where a change in government or political upheaval can affect
business conditions.
4.13.3 Insurance Pricing

Insurance companies have to price underwriting risks. If the price is set too high, it will
not be competitive; if premiums are too low, they will be insufficient to cover losses.
Actuaries perform a crucial role in insurance companies. They use mortality tables and
other information to price insurance contracts. Mortality tables have been developed to
statistically estimate the percentage of a given population with certain demographics (age,
sex, smoker/nonsmoker, health history) that will die in a given year. By offering insurance
to large numbers of individuals, insurers are able to set reasonable insurance rates and
make a profit commensurate with the risk the underwriter bears.
4.13.4 Challenges with Insurance

As is the case in banking, problems stemming from information asymmetries affect
insurance companies as well. Adverse selection is a problem with life insurance policies,
as is moral hazard with property and casualty policies. Adverse selection arises when
individuals who are more likely to need life insurance quickly (e.g., an individual with
a terminal disease) seek out higher levels of coverage. Moral hazard occurs when an
individual who is insured against a risk is more likely to engage in risky activities because
of the insurance.
Insurance companies can attempt to share risks by buying insurance from other insurance
companies. This growing practice is called reinsurance. About 10% of all insurance
contracts worldwide are ‘reinsured.’ P&C insurers engage in reinsurance to a greater
extent than life insurers due to the greater unpredictability of P&C claims. Reinsurance
represented about 1.6% of all premiums written in 2006. Foreign insurance firms write
about 75% of the reinsurance contracts used by US insurers. Catastrophe bonds are a
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unique form of reinsurance. Different bonds may have different structures but the basic
idea is that the bond’s principal and interest are reduced if a given catastrophe occurs.
The reduction in the bond issuer’s payments then can offset the additional losses on the
insurance line. As the text mentions, Munich Re issued a $250 million deep discount
catastrophe bond in 2008 that would pay principal of 100(1-α) at maturity. The α equals
the losses incurred on all reinsurer policies over a 24 hour period should an event such as
a flood or hurricane occur if losses are above a minimum threshold.
4.13.5 Regulation of Insurance Companies

P&C insurers are chartered and regulated at the state level. Some states regulate the
premiums insurers may charge; this has also contributed to the high loss ratios of the
1990s. The NAIC assists state regulators in providing examination forms and data on
ratios at insurers.
American International Group (AIG) Inc., the second largest P&C insurer in the world
by revenues, has been embroiled in several scandals recently. AIG allegedly assisted one
or more firms in implementing fraudulent accounting to smooth the client’s earnings by
engaging in payments that looked like insurance transactions but were not. AIG paid $126
million in penalties and costs, but admitted no wrongdoing. The scandals cost the CEO his
job however. Marsh and McLennan (M&M) (an insurance broker) received $845 million
in kickbacks associated with bid rigging. M&M allegedly directed clients to higher cost
insurance packages in order to earn the high fees.
Not all insurers acted honourably during some of the recent crises. For instance, State
Farm and others tried to classify the Katrina storm surge as flood damage which was
not covered under many homeowners’ policies. The courts disagreed and ruled that State
Farm was liable for actual and punitive damages.
4.13.6 Global Issues in the Insurance Industry

The insurance industry is becoming more global and there have been several large cross
border mergers recently although insurers have probably not participated in globalisation
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to the same extent as banks and other financial service providers. About 55% of total global
life insurance premiums written are generated by three countries: the US, Japan and the
United Kingdom. About 63% of P&C premiums are generated by the US, Japan, Germany
and the United Kingdom.
4.13.7 Insurance Companies in Singapore

Insurers may conduct insurance activities in Singapore as registered insurers, authorised
reinsurers or foreign insurers.
As of July 2011, there were 151 insurance companies operating in Singapore. Of these, 62
were direct insurers, 28 were reinsurers and 61 were captive insurers. Total assets of the
insurance industry amounted to S$149.3bn at end-2010, according to the 2010 insurance
statistics report published by the Monetary Authority of Singapore (MAS - the central
bank). The life insurance segment contributed S$118bn to this total, up 8.6% from 2009.
Registered insurers are approved under Section 8 of the Insurance Act (Cap 142) (“the
Act”) to conduct life and/or general insurance business in Singapore. They can be
registered as direct insurers, reinsurers or captive insurers.
In addition to the registered insurers, reinsurers without an operating presence in

Singapore can conduct reinsurance business in Singapore as authorised reinsurers under
Section 8A of the Act. Such reinsurers may be authorised as general insurers and/or life
reinsurers.
Foreign insurers are approved under the law of another country or territory to carry on
insurance business in that country or territory. These insurers operate in Singapore under
a foreign insurer scheme established under Part IIA of the Act. Currently the Lloyd’s Asia
scheme is the only foreign insurer scheme in Singapore.
Direct Insurers
Direct life insurers are insurers that are registered to write life policies as well as long-
and short-term accident and health policies.
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Direct general insurers are insurers that are registered to write all insurance business
other than insurance business concerned with life policies and/or long-term accident
and health policies. Direct general insurers would include the specialist insurers such as
marine mutuals that specialise in protection & indemnity and other marine insurance
policies as well as insurers specialising in credit and political risk insurance and financial
guarantee insurance. Insurers that are registered to conduct both life and general
insurance businesses are known as composite insurers.
Reinsurers
Reinsurers can be registered in Singapore to carry out life reinsurance and/or general
reinsurance business in Singapore. They are not permitted to write direct business and
are only allowed to assume all or a part of the insurance or reinsurance risk written by
another insurer.
Captive insurers
A captive insurer is registered to insure the risks of its parent and related companies as
defined under Section 6 of the Companies Act (Chapter 50).
Authorised reinsurers
An overseas reinsurer may apply for authorisation in respect of life and/or general
reinsurance business. Once authorised, they are allowed to solicit business and collect
premiums from insurers in Singapore.
Lloyd’s Asia Scheme
The Lloyd’s Asia Scheme is a foreign insurer scheme established under Part IIA of
the Act. This scheme seeks to replicate in Singapore the Lloyd’s of London insurance
marketplace. Lloyd’s members may carry on insurance business in Singapore through
locally-incorporated service companies, which are registered with the Administrator of
the scheme. Lloyd’s of London (Asia) Pte Ltd is the approved Administrator of the scheme.
Local-based insurer Great Eastern is one of the market leaders within Singapore’s
insurance industry. The Great Eastern Group reported a profit of SGD$442.1 million (US
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$ 344.7 million) for the third quarter of this year compared to SGD$368.3 million (US
$287.2 million) during the same period in 2009. Great Eastern results were driven by strong
sales of regular premium protection products, which were 30 percent higher than last
year because of the strong performance achieved through their Singaporean distribution
channels. However, Manulife reported a less positive position in the Singaporean
insurance market, largely due to the collapse of partnership arrangements with a local
distribution channel; this was offset by more positive results in the Asian region generally
where sales totaled US$293 million for the third-quarter of this year.
Singapore’s insurance industry is home to some of the major multi-national insurers such
as AXA, China Life Insurance, Manulife, Prudential, Zurich, Ace and Allianz. It is one
of the most mature insurance sectors in the Asian region, with strong foundations and a
solid economy, which has stabilised since the 2007-2008 global financial crises. The results
in 2010 have provided insurers with strong premium returns. The growing demand for
Singaporean protection products offers particular scope for insurers in the healthcare
sector due to the need for individuals to cover rising medical costs.
4.13.8 Challenges before Insurance Sector in Singapore

Two changes in the marketplace have presented challenges for the insurance sector.
1. Proliferation of 'Bancassurance'. The major local banks have moved aggressively

to increase the amount of insurance they cross-sell to their banking customers.
• Development Bank of Singapore (DBS) has tied up with Aviva (UK) for
this purpose in August 2001; in July 2009 DBS extended its partnership
with Aviva from 2010 to 2015.
• OCBC is partnering Great Eastern, and has substantially increased its
stake in the insurance company from 49% to 81% between 2004 and 2006.
• UOB entered into a banassurance agreement with Prudential for a 12 year
period.
2. The passage of the Financial Adviser Act (FAA) in October 2002 led to the
establishment of many new financial advisory firms that provide distribution
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channels for products of smaller insurance firms. In the past these firms had been
constrained by small sales forces.
The FAA act allowed for the establishment of a new class of firms that distribute
the whole range of financial products. In the face of this growing competition,
many insurance agencies have turned themselves into financial-advisory firms,
since this allows them to distribute additional products to their customer bases.
By July 2011, 67 firms had obtained financial adviser's licences.
4.13.9 Regulation
The Insurance sector in Singapore is licensed and regulated by the MAS's Insurance
Commissioner's Department which provides insurance licences to authorised companies.
Insurers are required to maintain two forms of solvency margins and a surplus of assets
over liabilities applies to both the company concerned and its individual funds.
Deregulation measures announced in 1998 reduced the required minimum paid-up

capital of captive insurers from S$1m to S$400,000. (The minimum paid-up capital for
direct insurers carrying out only one type of business is S$5m; for direct insurers carrying
out more than one type of business, S$10m; and for reinsurers, S$25m.) Captive insurers
also gained blanket approval to cover certain non-in-house risks. A tax exemption was
granted to insurers on income earned from offshore marine-hull and liability business.
A risk-based supervision framework was put into effect in 2002 to replace the previous
structure (which employed audit-based inspection) with one that is more forward looking
and emphasises prevention. In November 2003, the Insurance Act was amended to
provide the legal basis for a risk-based capital framework and a consultation paper on
the proposed framework was issued then. On August 25, 2004, the MAS implemented a
system designed to move the insurance sector to a risk-based capital framework.
The framework reflects the relevant risks faced by insurance companies. The minimum
capital it prescribes, which includes a consistent approach to the valuation of assets
and liabilities, will act as a buffer to absorb losses. The formula to calculate capital
requirements takes into account both the insurance risks undertaken by an insurer and
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the risks arising from the way an insurer invests the premiums it has collected. Under this
framework, the MAS can also adjust capital requirements to reflect other risks that cannot
necessarily be quantified, such as operational risks. Requirements have been aligned as far
as possible across financial institutions to minimise capital arbitrage. Insurance companies
had until January 1, 2005 to comply with the new requirements.
The Financial Industry Disputes Resolution Centre is a one-stop service centre for
insurance-related enquiries and complaints. Insurance companies are bound by the
centre’s findings, but in the case of disputes, consumers are free to pursue other resolution
options, such as filing a lawsuit, if they so choose.
Under the Insurance Companies Act, no person is allowed to obtain effective control
(defined as owning 20% or more of issued shares or voting power) or acquire a
substantial shareholding (defined as 5% or more of issued shares or voting power) of
any locally incorporated insurer without MAS approval. The MAS must also approve
the appointments of the principal officers of all insurers and the directors of locally
incorporated insurers (except for captive insurers).
Industry groups include the General Insurance Association of Singapore, the Life
Insurance Association of Singapore, the Singapore Reinsurers Association and the
Singapore Insurance Brokers Association.
4.13.9.1 Regulation of the Insurance Sector (in the US)

The McCarran-Ferguson Actof 1945 left regulation of life insurers up to individual
states. Chartering is entirely at the state level and different states may allow different
activities. The National Association of Insurance Companies (NAIC) has created a national
examination system used by state regulators to examine insurers. There was a bill before
Congress in 2004 to introduce federal oversight of both life and P&C insurers. The new
Paulson Plan of 2008 also suggests this change. The industry wants to allow markets
to set insurance prices. Currently, states regulate the premiums and probably do not
update rates as frequently as changing conditions warrant. The industry also wants a dual
regulatory system at the state and federal level so that they can choose their regulator.
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In 2004 Consecowas accused of providing special investment privileges to large investors

that were denied to small investors. Conseco allegedly allowed certain important clients
to shift funds between variable annuities while limiting similar attempts to move funds
by smaller investors.
State guaranty funds may exist to prevent policyholder losses in the event that an insurer
fails. They do not have federal backing, and virtually all states do not maintain a fund
reserve. The amounts surviving insurers may be required to pay in a given year to cover
policyholders of a defunct insurer vary from state to state. In some cases the guaranty
funds will not receive enough money to immediately cover the loss, and long delays in
payments are common. It is thus important that investors consider the creditworthiness
of an insurer before placing funds with that company. A.M. Bestis the leading source
of insurance ratings and is an excellent resource for information about the insurance
industry.
4.14 Pension Funds

A pension fund is a contractual saving intermediary established by an employer to
facilitate and organise the investment of employees' retirement funds contributed by the
employer and employees. It is a common asset pool intended to generate stable growth
over the long term, and provide pensions for employees when they reach the end of their
working years and commence retirement. Pension funds control relatively large amounts
of capital and represent the largest institutional investors in many nations.
Pension funds enable investors to transfer wealth through time while avoiding taxation
on their investment earnings during their working years. The primary purpose is to
provide retirement income for individuals. Traditionally, most pension funds have paid
set benefits to retirees based on their wage during their tenure with the company and
years of service. Today, more and more individuals are covered by plans that do not pay a
set amount at retirement; rather, their retirement benefits will normally be an annuitised
payment based on the terminal value of their wealth in the plan. The value of their plan
holdings depends upon the amounts paid in and the earnings on the funds invested.
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4.14.1 Defined Benefit Plans

Traditionally, most plans have been defined benefit plans. In this type of plan, the sponsor
agrees to pay employees a set (defined) benefit upon retirement according to some formula
that usually incorporates the employee’s working wages and/or years of service. There
are three types:
• Flat benefit: This type plan pays a flat amount for every year of employment. For
example, a retiree may receive $2,000 per year of service times the number of years
of service as an annual retirement benefit.
• Career-Average Formula:
◦ Flat percentage: Under this type plan, the retiree receives a flat percentage of
their average salary over their entire work period.
◦ Percentage of average salary adjusted for number of years working: With
this plan the retiree receives a given percentage of their average salary
during their career with the firm times the number of years employed. The
percentage may or may not increase with years of service.
• Final-Pay Formula: Under this formula, the retirees receive a percentage of their
average salary during the last three to five years of working for the firm times the
number of years of service.
Example:
An employee works 20 years for a firm. His average salary over his entire career with the
firm was $65,000. His average salary over the last five years was $75,000.
Annual retirement benefit for various defined benefit plans:
• Flat benefit of $2,000 per year worked: $2,000 × 20 years = $40,000

• Career average, flat percentage of 60% of average salary: $65,000 × 0.60 = $39,000
• Career average, flat percentage amount of 4% of average salary adjusted by years
of service: $65,000 × 0.04 × 20 years = $52,000
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• Final pay: A flat percentage amount of 4% of the last five years of salary adjusted
for years of service: $75,000 × 0.04 × 20 years = $60,000
The final pay formula usually results in the highest benefit. Some plans will take the
average of the five highest years of pay instead of the final pay. This variation generally
provides benefits similar to the final pay formula because pay rarely decreases with
seniority.
Defined benefit plans may be:
• Overfunded or fully funded: The plan has assets greater than (overfunded) or
equal to (fully funded) the present value of expected future payouts.
• Underfunded: The plan has some assets held as a reserve against expected future
payouts but does not have an amount equal to the present value of expected future
liabilities. Social Security (SS) is underfunded.
• Unfunded: The plan has no assets held as a reserve against expected future
retirement benefits.
Pension plans are not required to be fully funded but there are minimum funding
requirements and penalties for excessive underfunding.
Changes in actuarial assumptions can improve the corporate plan sponsor’s current
earnings. For instance, if interest rates rise, pension fund contributions (expenses) may
be reduced because the corporate sponsor can now assume that the fund’s assets will
generate higher earnings growth. Ford Motor Co. reduced pension expenses in 1981 and
GM did the same in 1990 by assuming that the fund would earn higher interest rates.
The plan sponsor bears the interest rate and price risk in a defined benefit plan because
the sponsor is liable for all promised pension fund payments, but the earnings rate on the
assets is not guaranteed.
4.14.2 Defined Contribution Plans

A defined contribution plan shifts the risk of poor investment earnings onto the covered
employees. The employer does not guarantee or define the retirement benefit. If an
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investor’s retirement occurs during a protracted recession, his retirement income could
be substantially reduced, particularly if his portfolio had significant equity exposure.
The SEC’s Savings and Investing Campaign indicates that the majority of Americans are
still not well informed about investment risk and returns and are underinvested in stocks.
A quick rule of thumb is that an individual should invest (100 - their age) percent of their
portfolio in stocks. Less well informed individuals are usually uncomfortable with this
level of risk.
In a defined contribution plan, the plan sponsor (employer) typically pays a fixed amount
into an individual’s retirement plan, usually along with employee contributions. The
employee has some limited choice about where the funds are invested. The choices may
include a GIC and several mutual funds. Fixed income funds often guarantee a minimum
rate of return. Investors may seek higher returns in riskier investments, including equities.
Fundholders receive all investment profits (less management fees).
4.14.3 Insured versus Noninsured Pension Funds

A pension plan governs the operations of the pension fund. Insured pension plans are
normally administered by life insurance firms and these plans constitute about 18.8% of
industry assets (in the US). Insured plans do not have segregated assets backing the plan.
Pension fund contributions are instead commingled with an insurer’s policy premiums
and jointly invested in securities. The amount owed to the pension fund is recorded as a
liability called pension fund reserves. The pension fund’s assets are thus owned by the
insurance company.
Noninsured pension plans are typically administered by a trust department of a financial

institution such as a bank or mutual fund that is appointed by the plan sponsor. The assets
of the noninsured fund are owned by the plan sponsor and are listed as separate assets on
the trustee’s balance sheet. In either case, the plan sponsor sets the guidelines for the plan
such as the benefit formula or matching contributions, etc.
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Noninsured pension funds tend to invest in riskier assets and earn higher rates of return
than insured pension funds. This occurs because the insurance firm is at risk of declining
values of pension fund assets, but the trustee making the investments of a noninsured
plan is not at risk from declining asset values because the assets belong to the sponsor.
Nevertheless, the prudent person rule(see below) constrains managers of both types of
funds to limit the riskiness of pension fund investments.
4.14.4 Pension Funds in Singapore

To ensure that workers could take care of themselves in their old age, the Central Provident
Fund was started on July 1, 1955, as a compulsory, government-run retirement savings
scheme. Workers had to save part of their monthly wages with the Board. The savings
could be withdrawn when they retire.
The Central Provident Fund (CPF), a mandatory, government-run retirement scheme, is

the primary source of retirement funds for Singaporeans. Citizens may borrow against it
for a limited number of purposes, the most popular of which is housing. It is administered
by the Central Provident Fund Board, a statutory board under the Ministry of Manpower.
It has since evolved into a comprehensive social security savings system addressing not
just retirement adequacy, but also healthcare, home-ownership, family protection and
asset enhancement.
In 1968, the government allowed Singaporeans to use their CPF savings to buy flats built
by the Housing and Development Board (HDB).
By the 1970s, Singapore had grown into a modern and prosperous nation. Rapid
industrialisation created a thriving economy and jobs for everyone. As wages and living
standards rose, CPF contributions were increased to cushion rising inflation.
In 1984, Medisave was introduced. CPF members could use their Medisave savings for
hospitalisation expenses for themselves and their immediate family members.
CPF schemes were also extended to family members. For example, members could use
their CPF to insure themselves and provide their dependants with financial protection
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should death or permanent disability occur. As life expectancy increased with better living
standards, Singaporeans needed more savings to meet their old age needs. From 1987,
members were required to set aside a minimum sum in their CPF at age 55 to provide
them with a basic monthly income when they retire.
MediShield, a medical insurance scheme to help members pay for expenses incurred by
long-term and serious illnesses, was introduced in 1990. To ensure that all Singaporeans
have adequate savings for healthcare, Medisave was extended to self-employed persons
in 1992.
To help Singaporeans increase their stake in the nation, every Singaporean was given a
chance to buy Singapore Telecom shares at a discounted rate. Members whose parents or
grandparents who did not hold active CPF accounts could deposit the initial sum on their
behalf, thereby helping this group of inactive account holders take their first step towards
becoming shareholders.
Over the years, an increasingly sophisticated and investment-savvy population wanted

higher returns on their CPF savings. Recognising this, the Government set up the CPF
Investment Scheme in 1997 to allow members to enjoy a wider range of investment
options. However, the Board's message to members was to be prudent when it comes to
investing for their old age. Members are made to appreciate that they are responsible for
their own investments.
In 1998, the Ministry of Manpower announced major changes regarding the CPF and
its investment scheme (CPFIS). The measures eased the criteria for CPF approved unit-
trust (mutual fund) managers and considerably widened the choice of fund managers
and investment products for CPF members. As a result, such previous restrictions as
the 50% cap on foreign-currency investments, the 40% limit on non-trustee stocks and
restrictions on investing in overseas markets were eliminated. In 1999, the CPFIS allowed
for investment linked insurance products to be held in CPF accounts.
Since February 1, 2006, new funds seeking to enter the CPFIS have faced more stringent
entry requirements, including meeting the evaluation benchmark which is based on a
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number of criteria, such as the capabilities of fund managers, the investment philosophy of
the fund, the quality of its research, and its portfolio construction and implementation in
the top 25th percentile of funds in the global peer group rather than the top 50th percentile
as earlier. New funds are also required to have an expense ratio lower than the median in
their risk category. There were 141 unit trusts and 178 investment-linked products under
the CPFIS as of December 2010.
As of end-March 2011 there were 3.35m CPF members, with a total balance of S$192.1bn
in their accounts, according to the most recent data from the CPF board. This compares
with 3.31m members with a total balance of S$172.1bn as of end-March 2010.
4.14.5 Structure of Singapore's CPF

The principle of self-reliance is an essential tenet underpinning the CPF system, which
continues to meet the three key needs of retirement expenditure, healthcare and home
ownership. These constitute the basis of financial security in retirement. As Singapore
moves towards an ageing population, gradual enhancements to the system will be made
to ensure that Singaporeans have ample provisions to last through their golden years.
4.14.5.1 Retirement
Working Singaporeans and their employers make monthly contributions to the CPF. These
contributions go into three accounts:
• Ordinary Account - for housing, pay for insurance, investment and education.
• Special Account - for investment in retirement-related financial products.
• Medisave Account - for hospitalisation and approved medical insurance.
At the age 55, members may withdraw their CPF savings after setting aside the CPF
minimum sum. The CPF Minimum Sum may then be used to purchase life annuity
from a participating insurance company, placed with a participating bank, or left in the
Retirement Account with the CPF Board.
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From 62 years of age (current CPF drawdown age), members may make monthly
withdrawals under the Minimum Sum Scheme which provides a monthly income to help
meet basic needs in retirement for about 20 years or whenever the savings are exhausted.
Members may choose to start these monthly payouts later as a way to make the savings
last longer. If the member chooses to participate in the national annuity scheme - CPF
LIFE, he will receive a monthly income for life from age 62. Members may opt into CPF
LIFE up till age 80.
Members turning age 55 in 2013 or later with at least $40,000 in their Retirement Account
will be automatically included in CPF LIFE. Members from these cohorts who did not
have $40,000 but who at their drawdown age have $60,000 in their Retirement Account
will also be auto-included.
The CPF drawdown age is set to increase to 63 in 2012, 64 in 2015 and 65 in 2018.
4.14.5.2 CPF LIFE

CPF LIFE is an enhancement to the minimum sum scheme. It is a mandatory annuity
scheme that allows CPF members to continue making a monthly withdrawal from their
CPF savings, even after they have completely drawn down their CPF Minimum Sum.
Starting with members who will turn age 55 in 2013, those with at least $40,000 in their
Retirement Accounts (RA) will be automatically included while those with lower balances
may still opt in. Upon joining CPF LIFE, depending on age, gender and the plan selected,
a certain percentage of the RA savings will be transferred to the CPF LIFE account as
premium for the annuity.
To allow more members to benefit from this scheme, between September 2009 and
December 2010, CPF LIFE will available for opt-in for those aged 80 and above.
4.14.5.3 Supplementary Retirement Scheme

The Supplementary Retirement Scheme (SRS) is a voluntary scheme that complements
the CPF. Participants can contribute a varying amount to SRS (subject to a cap) at their
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own discretion. The contributions may then be used to purchase various investment
instruments.
The SRS offers attractive tax benefits. Contributions to SRS are eligible for tax relief,
investment returns are accumulated tax-free (with the exception of Singapore dividends),
and only 50% of the withdrawals from SRS are taxable at retirement.
4.14.5.4 The Dependants' Protection Scheme (DPS)

The Dependants' Protection Scheme (DPS) is an optional term-life Insurance Scheme that
covers members for an insured sum of $44,000 up to age 60. The Scheme is aimed at
providing CPF members and their families’ money to tide them over the first few years,
should insured members become physically/mentally incapacitated or die. The claim will
be paid to the insured member if he becomes physically/mentally incapacitated, or to his
CPF nominee(s) upon his death.
4.14.5.5 The Home Protection Scheme (HPS)

The Home Protection Scheme (HPS) is a mortgage-reducing insurance scheme to help
insured members and their families pay off outstanding housing loans in the event of the
insured members' permanent incapacity or premature death before age 65.
Members who are using CPF to pay their monthly housing loan instalments on their
HDB/HUDC flat under the Public Housing Scheme (PHS) have to be insured under HPS,
provided they are in good health at the time they apply for cover. Members who are not
using CPF to pay their monthly housing loan repayment may choose not to be insured.
How much is covered
When applying for the scheme, the member may indicate the proportion of the loan for
which he wishes to be insured. If he is the sole owner, he should be insured for 100% of the
loan. For co-owners, the total coverage should add up to not less than 100% of the loan.
What it costs
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The premium depends on various factors, including the loan amount, repayment period
and age of the member. It is payable annually and is deducted from the member's Ordinary
Account. If he does not have enough savings in his account, he can top up his Ordinary
Account in cash or apply to use his spouse's CPF savings to pay the premium.
An evaluation of the CPF scheme carried out in the first half of 2002 by the Economic
Review Committee led to several minor changes. These included gradually reducing the
salary ceiling in stages for CPF contributions from S$6,000 in January 2003 to S$4,500
on January 1, 2006; increasing the rate of contribution to the CPF Special Account and
the CPF Medisave Account; and capping withdrawals from the CPF account for buying
property to lower proportions of the property valuation over time: 144% in 2004, dropping
to 138% in 2005, 132% in 2006, 126% in 2007 and 120% in 2008, where it remained as of July
2011. The salary ceiling for CPF contributions is being revised upwards to S$5,000 from
September 1, 2011 onwards.
4.14.6 Criticism of CPF

CPF is not compulsory for low wage and self employed Singapore citizens. The CPF
Board does not provide figures of working Singaporeans who do not actively contribute to
their CPF savings or medisave accounts. This implies a significant number of low income
Singaporeans do not enjoy the benefits of medishield coverage and retirement savings.
Critics contend the CPF offers a low yield and the affluent are less dependent on savings
in the CPF than the low income groups.
While the CPF does indeed contribute to Singapore having one of the highest savings
rates in the world, even in Asia (where savings rates tend to be higher than that of
the Western world), the rigid investment nature of CPF, the inadequacies of various
short term schemes Minimum Sum, Annuities, puny provident fund interest and soaring
medical costs will produce significant problems for a rapidly ageing Singaporean society.
In addition, citizens are not entirely happy with the low returns of their CPF savings.
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High-income and affluent middle class usually depend less on savings component of
the provident savings account. They tend to have access to possibly higher yielding
and diversified portfolio. An opportunity cost is realised if their provident fund savings
are not invested in higher yielding professionally managed instruments or business
opportunities. Currently, there are many restrictions on type of investment products using
CPF funds, e.g., CPF savings forming the largest segment of Singapore government's
debt, they are recycled as low yield Hold-To-Maturity financial assets. This implies a large
segment of citizens' wealth will be subjected to low returns and are not efficiently invested
for optimal returns.
Morever for lower and mid-income Singaporeans, CPF accounts contributions

significantly reduce their disposable incomes after adjustments for inflation. This restrict
their personal consumption choices throughout their employment period. This could lead
to an inability to afford more comprehensive health or accident insurance, for which the
Medisave component of CPF may be inadequate in coverage.
Demographic strain as the population ages
The two major risks the CPF schemes face are the dwindling birth rate and persistent
low yield returns from Hold-To-Maturity financial instruments. The dwindling CPF
contributions due to ageing population will test the future government's ability to meet
CPF savings redemptions if population continues to age without raising existing taxes.
Lesson Recording
Financial Institutions (Commercial Banks)
Financial Institutions (Investment Banks and Mutual Funds)
Financial Institutions (Insurance Companies and Pension Funds)
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1. Small banks tend to have more ________ and fewer ________ compared to large
banks.
a. transaction accounts; time deposits
b. borrowed funds; capital stock
c. time deposits; borrowed funds
d. large time deposits > $100,000; transaction accounts
2. All of the following are sources of common equity capital for banks except
a. capital stock
b. undivided profits
c. capital notes
d. special reserve accounts
3. All but one of the following is a purpose of regulating financial institutions:

a. to provide stability of the money supply
b. to serve certain social objectives
c. to reduce barriers to entry
d. to offset the moral hazard incentives to protect the deposit insurance fund
4. Banks have greater liquidity needs than other types of businesses because banks have
a. a high proportion of short-term assets.
b. a low proportion of capital.
c. a high proportion of short-term liabilities and outstanding lines of credit.
d. large amounts of financial assets.
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5. Hollon Securities is underwriting an issue of Llamas Unlimited, Inc. common stock.

Hollon will pay LU $45.00 a share and offer the stock to the public at $48.00. The direct
cost of underwriting the issue is $1.00 per share. The underwriting spread is
a. $4.00 per share.
b. $3.00 per share.
c. $2.00 per share.
d. not ascertainable from the information above.
6. All of the following are associated with the origination function of investment
banking except
a. design of the security to fit the needs of the market and the issuing firms.
b. filing of the required registration statements.
c. obtain a credit rating on a debt issue.
d. commit to a specific price to the issuing firm and attempt to sell the security
in the market.
7. Pension funds tend to invest in

a. higher-yielding long-term securities
b. money market securities exclusively
c. government securities exclusively
d. none of the listed choices
8. Which one of the following statements best describes the insurance industry?
a. major insurance company liabilities are called reserves.
b. most life insurance companies are stock companies.
c. mutual insurance accounts for about half of all the life insurance in force.
d. all of the listed choices are true.
9. Insurance companies manage all but which financial risk?
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a. default risk
b. interest rate risk
c. pure risk
d. liquidity risk
10. Insurance regulation is concerned with all but one of the following:
a. capital adequacy of insurance companies
b. making sure that the perils covered under insurance do not occur too
frequently
c. protecting and informing consumers
d. keeping insurance available and affordable
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1. Small banks tend to have more ________ and fewer ________ compared to large
banks.
a. transaction accounts; time deposits
Incorrect: Smaller banks depend on time deposits for funds; market
borrowings are a significant funding source for large banks
b. borrowed funds; capital stock

c. time deposits; borrowed funds

Correct: Larger banks have the resources to borrow short term. Smaller
banks depend on time deposits
d. large time deposits > $100,000; transaction accounts

2. All of the following are sources of common equity capital for banks except
a. capital stock
Incorrect: This is a source of common equity capital, see a bank’s balance
sheet for details
b. undivided profits
sheet for details
c. capital notes
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Correct: Capital notes are an unsecured and risky type of debt, not included
in common stock.
d. special reserve accounts

sheet for details
3. All but one of the following is a purpose of regulating financial institutions:

a. to provide stability of the money supply
Incorrect: A basic objective of regulation, carried out through monetary
policy
b. to serve certain social objectives

Incorrect: This is a regulatory objective, e.g. lending to disadvantaged socio-
economic groups
c. to reduce barriers to entry

Correct: This is not a regulatory objective, there is tight control over who
can set up a bank
d. to offset the moral hazard incentives to protect the deposit insurance fund
Incorrect: Certain types of deposit insurance may create moral hazard
problems, but regulation is intended to create stable financial institutions.
4. Banks have greater liquidity needs than other types of businesses because banks have
a. a high proportion of short-term assets.
Incorrect: The proportion of short-term assets is considerably lower than the
proportion of short-term liabilities
b. a low proportion of capital.

Incorrect: While the capital base of banks may be low, other sources of funds
provide liquidity to the bank
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c. a high proportion of short-term liabilities and outstanding lines of credit.

Correct: This is reflected in the bank's balance sheet
d. large amounts of financial assets.

Incorrect: Liquidity is necessary to meet depositors request for a withdrawal,
and to meet working capital needs of corporate entities
5. Hollon Securities is underwriting an issue of Llamas Unlimited, Inc. common stock.

Hollon will pay LU $45.00 a share and offer the stock to the public at $48.00. The direct
cost of underwriting the issue is $1.00 per share. The underwriting spread is
a. $4.00 per share.
Incorrect: The underwriting spread is the difference between the offer price
to the public and the amount paid to the issuer, i.e. $48 - $45 = $3
b. $3.00 per share.

Correct: The underwriting spread is the difference between the offer price
c. $2.00 per share.

d. not ascertainable from the information above.

6. All of the following are associated with the origination function of investment
banking except
a. design of the security to fit the needs of the market and the issuing firms.
Incorrect: This is an integral function of investment banks
b. filing of the required registration statements.
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Incorrect: This is an integral function of investment banks
c. obtain a credit rating on a debt issue.

Incorrect: This is an integral function of investment banks prior to issuance
of bonds
d. commit to a specific price to the issuing firm and attempt to sell the security
in the market.
Correct: This function is carried out late in the process, following a scrutiny
of the firm, the market conditions and issuing a 'red herring' prospectus
7. Pension funds tend to invest in

a. higher-yielding long-term securities
Correct: Pension funds are able to do so, as their cash inflows and outflows
are fairly predictable, and pension plans tend to be long-term contracts,
thus pension funds can invest in risky securities
b. money market securities exclusively

Incorrect: Money market securities offer low yields, so they are not attractive
to PF
c. government securities exclusively

Incorrect: Again, these securities offer low yields, so they are not attractive
to PF
d. none of the listed choices

Incorrect: “higher-yielding long-term securities” is correct
8. Which one of the following statements best describes the insurance industry?
a. major insurance company liabilities are called reserves.
Correct: Yes, by definition
b. most life insurance companies are stock companies.
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Incorrect: Most Life Insurance companies are mutually owned, in recent

years many have converted into stock companies
c. mutual insurance accounts for about half of all the life insurance in force.
Incorrect: Please check data
d. all of the listed choices are true.

Incorrect: Only “major insurance company liabilities are called reserves” is
true
9. Insurance companies manage all but which financial risk?

a. default risk
Incorrect: Insurance companies can manage default risk
b. interest rate risk

Incorrect: Due to the mismatch in the balance sheet, insurance companies
manage interest rate risk
c. pure risk
Correct: Insurance companies cannot manage pure risk
d. liquidity risk
Incorrect: Insurance companies try to strike a balance between risk and return
while managing liquidity risk
10. Insurance regulation is concerned with all but one of the following:
a. capital adequacy of insurance companies
Incorrect: Regulators are concerned with the capital base of companies
b. making sure that the perils covered under insurance do not occur too
frequently
Correct: This is beyond the control of insurance companies
c. protecting and informing consumers
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Incorrect: Insurance companies are concerned with protecting and informing

consumers
d. keeping insurance available and affordable

Incorrect: Regulators try to keep the cost of insurance low, and make it
accessible to the poor
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Study
Unit
FIN301
Learning Outcomes
• Analyse the characteristics of money market and money market instruments

• Describe how money market securities are issued in the primary market
• Examine the secondary market trading procedure for money market instruments
• Analyse the characteristics of bond market and bond market instruments
• Describe how bond market securities are issued in the primary market
• Examine the secondary market trading procedure for bond market instruments
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Overview
Money markets and money market instruments allow individuals and businesses to invest
their funds for a short-term period. Businesses and governments issue money market
securities to fund their short-term needs. In Chapter 5, we will discuss the characteristics
of money markets and associated instruments. The procedure for issue of these securities
as well as how long they are traded in the secondary market will be discussed.
Bond market is the avenue where debt securities issued by governments and businesses
are traded. In Chapter 6, we will discuss the characteristics of bond markets and associated
instruments. The procedure for issue of bond market instruments as well as how they are
traded in the secondary market will be discussed.
Read
Chapter 5 and Chapter 6 of “Financial Markets and Institutions”, Saunders and Cornett, Sixth
International Edition, (2015).
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Chapter 5: Money Market and Money Market

Instruments
The money market serves the needs of those who have excess funds for a short period of
time, usually less than 364 days, and for those who require short-term funds. Those who
are short-term users of fund will issue money market securities to the short-term suppliers
of funds, which will be traded in the money market.
Government and businesses use money markets to raise funds for use in the short-
term. Since the tax revenues come at different periods of time, the government needs to
raise funds for regular day-to-day use, which can be repaid from tax revenues received.
Businesses use the money market to raise funds mainly to finance their working capital
needs.
Businesses, institutional investors and individual investors use money market securities
issued by the government and businesses to park their short-term excess cash in order
to receive a positive return. Since holding cash provides no return at all, it is wise to
invest in some security that provides interest. However, such securities need to possess
the following characteristics:
I. The securities should have a liquid market. This means that there should be an
active market for these securities so that when an entity wants to convert the
security into cash by selling it in the market, there should be traders ready to buy
these securities at the fair value.
II. The default risk for the issuers of securities should not be present. In case
the issuer of the security defaults, the investor would lose all or part of the
investment and since these securities are held in lieu of cash, there should be no
default risk.
III. The fair value of the securities should not change too much between the time the
security is bought and sold. If the value drops a lot, the investor will lose on the
investment and hence would be better off holding the excess cash as cash itself.
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Money market securities fulfil all these requirements.
Firstly, the secondary market in which money market instruments are traded is very active
and very liquid. There is almost continuous trading with active buyers and sellers.
Secondly, the default risk of these securities is low. This is due to: a) Only the highly credit
worthy businesses will be able to issue money market securities as demand for securities
issued by low credit worthy businesses will be very low; b) These securities have a life
of less than a year and it would be possible to predict the probability of default over this
short period of time using appropriate analysis.
Thirdly, the value of these securities does not change much during its life. Since these
are short-term instruments, they are generally debt instruments. The value of debt
instruments is related to changes in interest rates. If interest rate in the economy increases,
the value of the instruments will decrease and if the interest rate in the economy decreases,
the value of the instruments will increase. Since changes in interest rate in the short-term
period are small, the percentage change in the value will be very small on the maturity of
these instruments.
Thus, money market instruments provide an efficient way to invest excess cash held by
businesses for short-term period.
5.1 Money Market Instruments

The following are common money market instruments available:
I. Treasury bills or government issues

II. Repurchase agreements
III. Commercial paper
IV. Negotiable certificates of deposit
V. Banker’s acceptances
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5.1.1 Investors in Money Market Instruments

In general, these instruments are created for investing excess cash by businesses and
financial institutions because of which the size of investment tends to be large. Commonly,
minimum investment in these instruments is $100,000. The individual investors do not
have the ability to directly invest in these securities due to the large size of investment
required. However, financial institutions have created funds through which individuals
can invest in money market securities. Money market funds and short-term funds are
available for individual investors to invest in money market securities.
5.1.2 Pure Discount Securities

Money market securities have a life of less than one year and generally pay the face value
of the security at maturity. For example, consider a 90-day T-bill with a face value of
$100,000. If a financial institution buys the T-bill when it was issued and holds it for 90
days until maturity, the institution will receive $100,000 at maturity. Since the value of the
90-day T-bill is $100,000 at maturity, the financial institution will pay less than $100,000 at
the time of issue. How much less it would pay will depend on the required rate of return on
these T-bills. Since the price of the T-bill will always be less than $100,000 before maturity,
the T-bill is usually called a pure discount security. Most of the money market instruments
are pure discount securities implying that the price of the money market instruments will
always be less than the face value before maturity.
5.1.3 Discount Yield

Since the money market instruments are pure discount securities, they are quoted on the
basis of the discount from the face value and this quote is called the discount yield. Since
money market securities can have different maturities, it is necessary to normalise the
discount yield to a common time period so that comparisons can be made among the
various money market instruments. Generally, discount yield is stated as annual discount
yield even if the maturity is less than a year. In calculating the annual yield, the time
remaining to maturity of the instrument is stated as number of days and it is assumed that
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there are 360 days in a year. Under this convention, discount yield is calculated as follows:
Let face value of the instrument be Pf

Price of the security at time 0 is P0
Maturity of the instrument is in ‘h’ days
Then, amount of discount in $ = Pf – P0

and fraction of discount from face value = (Pf - P0 ) / Pf
Assume face value of $100,000 and the price at time 0 is $98,000.

Then the fraction of discount from face value = (100,000 – 98,000) / 100,000 = 0.02
However, this discount is over a period of ‘h’ days and it can be converted to annual terms
as:
Idy = [(Pf – P0)/Pf][360/h]
If the security has a maturity of 90 days, the discount yield is:
Idy = [(100000 – 98000)/100,000][360/90] = 8%
The discount yield provides the percentage annualised discount from face value.
However, it does not help in determining the return that is obtained from investing in this
security. The return from investment in money market security is known as nominal yield
or Bond Equivalent Yield (BEY).
5.1.4 Bond Equivalent Yield

Consider two money market instruments:
I. A T-bill with 90-day maturity with discount yield of 8%

II. A T-bill with 180-day maturity with discount yield of 8%
Which of these investments would provide higher return?
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A 90-day T-bill with discount yield of 8% means that an amount of P0 will be invested at
time 0 and an amount of $100,000 will be received after 90 days. P0 can be calculated from:
Idy = [(Pf – P0)/Pf][360/h] or
P0 = Pf [1 – (Idy * h / 360)] which is P0 = 100000 [1 – (8% * 90 / 360)] = $98,000

This means that an investment of $98,000 at time 0 will provide a cash flow of $100,000
after 90 days or return over 90 days an investment of $98,000 will be given as:
Return over 90-days = (100,000 – 98,000)/98,000 = 2000/98000 = 2.0408%
This has to be converted to annual terms and since a year has 365 days, the annual return
would be:
Annual return = (2/98) * (365/90) = 8.2766%
A 180-day T-bill with discount yield of 8% means that an amount of P0 will be invested
at time 0 and an amount of $100,000 will be received after 180 days. P0 can be calculated
from:
Idy = [(Pf – P0)/Pf][360/h] or

P0 = Pf [1 – (Idy * h / 360)] which is P0 = 100000 [1 – (8% * 180 / 360)] = $96,000
This means that an investment of $96,000 at time 0 will provide a cash flow of $100,000
after 180 days or return over 180 days an investment of $96,000 will be given as:
Return over 180-days = (100,000 – 96,000)/96,000 = 4000/96000 = 4%
This has to be converted to annual terms and since a year has 365 days, the annual return
would be:
Annual return = (4/96) * (365/180) = 8.4491%
Even though both T-bills are selling at the same discount yield, 180 day T-bill provides
a higher return than the 90-day T-bill. The difference in bond equivalent yield or normal
yield and discount yield arises because:
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I. In discount yield, the denominator is the face value whereas in normal yield, the
price paid is used in denominator.
II. In discount yield, a year of 360 days is used whereas in normal yield, 365 days
in a year is used.
Due to these differences, the normal yield will always be greater than the discount yield.
The relationship between normal yield and discount yield is given by:
Ibey = Idy (Pf/P0) (365/360)
5.1.5 Effective Annual Yield

The normal yield or bond equivalent yield provides annual return based on the maturity
of the instrument. Consider an investor who has excess cash available for 6 months. He
could either invest in 6-month T-bill or can invest in 3-month T-bill and when T-bill
matures after 90 days, the mount received can be invested again for another 90 days.
Just a comparison of bond equivalent yield will not be sufficient to decide which of these
investments provides higher return. In order to compare return, effective annual return is
calculated as shown below:
Effective annual rate = [1 + Ibey/(365/h)] 365/h – 1
In the example, effective annual return for 90-day T-bill is
[1 + 8.2766%/(365/90)] 365/90 – 1 = 8.5383%
and effective annual return on 180-day T-bill is
[1 + 8.4491%/(365/180)] 365/180 – 1 = 8.6301%
In calculating effective annual rate (EAR), we are assuming that the 90-day BEY or 180-day
will remain the same when it will be rolled over every 90 days or 180 days. In reality, the
BEY can change when the time comes for rolling over and hence the actual return can be
different. For example, assume that the 90-day T-bill after 90 days is selling at a discount
yield of 2.5%. If the investor decides to roll over the investment after 90 days, the price per
T-bill will be $97,500 for $100,000 face value.
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Originally, the investor invested $98,000 and at the end of 90 days, he would receive
$100,000 and with $100,000, he can buy (100000/97500) = 1.02564 T-bills and at the end of
180 days he would receive $102,564. Thus an investment of $98,000 at time 0 would result
in cash flow of $102,564 after 180 days. The return would be:
[(102,564 – 98,000)/98,000] * (365/180) = 9.4437%
Thus, investing in 90-day T-bill and rolling over at the end of 90 days provides a higher
return than investing in 180-day T-bill. On the other hand, if interest rate had fallen and
if the 90-day T-bill sells at a discount yield of 1.75% after 90 days, price per T-bill will
be $98,250 for $100,000 face value. With $100,000, the investor can buy (100000/98250) =
1.017812 resulting in cash flow of $101,781. The return after 180 days will be:
[(101,781 – 98,000)/98,000] * (365/180) = 7.832%
which is lower than investing in the 180-day T-bill.
This example shows that it is difficult to compare the money market securities when the
maturity is different.
5.2 Treasury Bills

Treasury bills are short-term obligations issued by the government for three purposes:
I. To cover government’s budget deficits

II. To repay maturing government debt
III. To adjust the monetary policies
However, in Singapore, the government does not issue T-bills for the purpose of covering
budget deficits, as the government believes in surplus or balanced budget. Instead, they
are issued for the purpose of developing the debt market and to provide a basis for
determining the interest rate. Also, the Singapore government does not use T-bills for
adjusting monetary policy but uses the exchange rate to adjust monetary policy.
The Treasury Bills issued by the US government is the largest T-bill market in the world.
Original issue of the US government T-bills is done through an auction procedure. The
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maturities are either 13 weeks or 26 weeks and issued with a face value of $1000. Even
though the face value is $1000, the usual amount of purchase is in a round lot of $5 million.
US treasury has a system to sell new issues of Treasury bills called the Treasury bill auction
system. In this system:
I. The amount of new 13-week and 26-week T-bills that will be sold by the Treasury
is announced every week.
II. The government security dealers, financial and non-financial institutions as well
as individuals are required to submit their bids for these T-bills by Monday 1pm
either through the Internet or telephone or through a paper form.
III. Treasury will then announce the allocation and prices on Tuesday morning.
IV. T-bills will be delivered on Thursday.
Bids would specify the desired quantity and the bid price. The highest bidder in terms of
price will receive the first allocation and the next highest bidder will then be allocated and
so on. This process continues until the whole quantity of T-bills is distributed. A bidder
can submit more than one bid. However, a single bidder cannot receive more than 35% of
the issue.
The bids can be either competitive bid or non-competitive bid. All successful bidders will
be allocated securities at the same price, which is the lowest price of all competitive bids
accepted. Large investors and government security dealers generally present competitive
bids. An example of bids and allocations will illustrate the auction process:
Total amount of 13-week T-bills to be issued: $25 billion
Bids are:
Bid no. Amount Price Allocation Price
1. $12b 99.02% $8.75b 98.59%
2. $8b 98.79% $8b 98.59%
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3. $6b 98.65% $6b 98.59%
4. $3b 98.59% $2.25b 98.59%
5. $1b 98.52% 0 -
In the above example, the highest price is 99.02% and the lowest price is 98.52%. The first
bidder’s requirement is $12 billion. However, a maximum of 35% of the total issue can
only be allocated and thus $8.75 billion will be allocated to the first bidder. The second
highest bidder will get an allocation of $8 billion and third highest bidder will be allocated
$6 billion. The fourth highest bidder required $3 billion but only $2.25 billion is remaining
and will be allocated that. The last bidder consequently will not get any allocation. The
price that everyone pays will be the bid from the last allocation, which is 98.59%. This
means that each bidder will pay to the Treasury – 98.59% of the amount allocated and will
receive the T-bills and number of T-bills will be the amount allocated divided by 1000 as
the face value of the T-bill is $1000. The example assumes that all bids are competitive
bids.
When non-competitive bids are also made, they get preferential allocation in the sense
that first allocation will be for non-competitive bids. The bidders of non-competitive bids
will provide the demand only and not the price. They would be willing to purchase the
T-bills at the price determined by the Treasury. In the example, assume that the bidder 5
made a non-competitive bid for $1 billion. In this case, allocation would be:
1. $12b 99.02% $8.75b 98.59%
2. $8b 98.79% $8b 98.59%
3. $6b 98.65% $6b 98.59%
4. $3b 98.59% $1.25b 98.59%
5. $1b 98.52% $1b 98.59%
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In general, non-competitive bids are limited to $1 million per bidder and are designed to
allow small investors to purchase Treasuries directly in the auction.
5.2.1 Secondary Market for Treasury Bills

The major government security dealers are responsible for creating an active secondary
market. These dealers purchase the securities from the government through competitive
bidding. They are called primary dealers who make the market by buying and selling
T-bills for their own account as well as by trading for their customers, which may
include financial institutions such as banks, insurance companies and pension funds. In
addition, there are a large number of secondary dealers who purchase the securities from
primary dealers and trade in the secondary market. Most of the transactions take place via
telephonic lines. The brokers will keep abreast with the market through quotes provided
in the trading room of primary dealers and these bid and asked quotes are available at
any point in time.
Transactions between primary dealers are undertaken through the Fedwire transactions,
which is a book-entry system, operated by the Federal Reserve. On the other hand,
individuals willing to buy and sell government securities need to contact a broker who
will then contact the primary dealer to complete the transaction.
5.3 Government Securities Issued in Singapore

The Monetary Authority of Singapore (MAS), issues 3-month T-bills on behalf of the
Government of Singapore. These are issued weekly, with auctions announced every
Wednesday. The procedure followed by the MAS is very similar to that in the USA.
However, a few distinctions are noted. The maximum allotment will be 30% of the issue
per applicant if the applicant is a primary dealer and 15% if the applicant is a non-primary
dealer. Total non-competitive bids are subject to a limit of 40% of the issue and if the
application amount is more than 40%, allocation will be pro-rated. Maximum allocation
under non-competitive bids will be 1% of the issue for primary dealers and $1 million per
applicant if it is a non-primary dealer.
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As in the USA, the non-competitive bids will be allocated first and the remaining will
be allocated to competitive bidders based on the yield. Those bids with lowest yield (or
highest price) will be allocated first followed by the second lowest yield, etc. until the
whole issue is allocated. The price paid by all the bidders will be the same and is calculated
based on the highest yield from the bids allocated. The face value of the T-bill is $1000 but
price is quoted per $100. The secondary market trading is done at the Singapore Exchange
according to the regulations of the exchange.
5.4 Repurchase Agreement (Repo)

A repurchase agreement is a contract between two parties in which one party agrees to sell
some securities to the other party with a promise to repurchase the securities at a specified
price on a specified date in the future. The security used in the repurchase agreement is
usually T-bill. Thus, a repurchase agreement is essentially a collateralised loan with T-bills
being offered as the collateral for the loan.
A reverse repurchase agreement (reverse repo) is an agreement in which one party agrees
to buy some securities from the other party promising to sell them back at a specified time
in the future at a specified price. It is to be noted that the repo and the reverse repo take
place in the same transaction. When one party enters into a repo, the other party is actually
entering into a reverse repo. Depending on who initiates the agreement, contract will be
termed either as repo or reverse repo. Repos generally have short-term maturity from 1
to 14 days though repos of 1 to 3 months are not uncommon. The repos with maturities
less than one week generally have denominations of $25 million or more, while those with
maturities of 1 to 3 months have denominations of $10 million.
5.4.1 Why do Firms use Repos?

Consider a company that has excess cash available for a week and wants to earn a return
from this amount. It can enter into a reverse repo with a bank whereby the company will
purchase T-bills from the bank and agree to sell the T-bills at a higher price in the future.
Through this, the bank is effectively converting the T-bills into cash and the bank will use
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this when they have a low balance of cash to meet the cash balance that is required to be
maintained according to regulations.
5.4.2 Creation of Repo Securities

Repos are arranged either directly between the two parties or through brokers. The repo
buyer will acquire the title to the securities. If the repo agreement is between two primary
dealers, the Fedwire transaction will be done. Under this, party A, which is selling the
securities will instruct the Federal Reserve to transfer the securities to the account of party
B. Party B will instruct the Federal Reserve to transfer cash from the party’s account. At the
end of repo, these transactions will be reversed and party A will also transfer additional
cash to pay the interest.
The Federal Reserve will also use repos for adjusting monetary policy. If they want to
reduce money supply in the short-run, they would enter into repo transaction with dealers
while reverse repo will be undertaken if they want to increase money supply in the short-
term.
Primary dealers as well as financial institutions use repos to manage their liquidity. They
can also use repos when they anticipate changes in interest rates.
5.4.3 Yield on Repos

The yield on repo is calculated as:
Irepo = [(Pf – P0)/P0]* (360/h)
where P0 is the price at which T-bills are originally purchased, Pf is the price at which they
are sold and h is the maturity of the repo expressed in number of days.
For example, if party A agrees to buy T-bills at $96 and sell them back at $96.10 after 7
days, the yield on this repo is
[(96.10 – 96.00)/96.00] * (360/7) = 5.357%
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5.5 Commercial Papers

Commercial papers are short-term promissory notes used to raise cash for use during a
short period of time and mainly used for financing working capital requirement. Non-
financial institutions generally issue them. Mainly companies, which have very strong
credit ratings, use commercial papers obtaining financing at comparatively low rates
compared to bank borrowings.
These papers are generally sold in denominations of $100,000, $250,000, $500,000 or $1

million. The maturities vary from 1 to 270 days, and most commercial papers have
maturities between 20 and 45 days. The reason for limiting the maturity to 270 days is
that any security that has a maturity of more than 270 days must go through a registration
process, which can be time consuming and costly.
Commercial papers can be sold directly by issuers to investors such as mutual fund, in
which case it is called direct placement. Companies can also sell them through dealers in
the commercial paper market.
Investors usually hold commercial papers till maturity, as there is no active secondary
market. There is no active market mainly because the size of the paper is large. As
these papers are unsecured, that is, they do not have any collateral attached and these
papers cannot be traded in the secondary market, this market is open only to companies
with strong credit ratings. The credit rating firms, such as Standard and Poor (S&P) and
Moody’s, rate these commercial papers. S&P rates these papers on a scale from A-1,
indicating highest quality issues and D for lowest quality issues while Moody’s rating is
P-1 for highest quality issues and “not rated” for the lowest quality issues.
The companies that do not have a very high rating for their commercial papers can back
the issue with a line of credit from the bank. When a company obtains a line of credit
from the bank for the commercial paper issue, the bank guarantees that the bank will pay
the purchaser of the commercial paper in case the company is not able to make the full
payment. However, the bank may in turn require the company to use the bank for other
business opportunities and transactions.
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5.5.1 Issue Process

Commercial paper can be issued directly to the investor by the issuer. In this case, the
company has to identify appropriate investors and also decide the rate at which the paper
will be priced at a discount from the face value. Once it decides how much of commercial
paper is to be issued, it will announce the rates to potential buyers and the rates can be
adjusted during the offer period based on the demand.
The alternate way to issue commercial paper is to appoint an investment banker. The
investment banker would underwrite the issue. This process is costly for the issuer, as
the issuer needs to pay a fee to the underwriter. However, the underwriter will provide
a firm commitment to sell the whole issue. It is the job of the underwriter to sell the
commercial paper to potential buyers. If the underwriter is not able to sell the whole issue,
the underwriter is committed to buy the unsold portion of the issue.
5.5.2 Yields on Commercial Paper

The yield on commercial paper is quoted on a discount basis like that of T-bills.
Icp (discount yield) = [(Pf – P0)/Pf] * (360/h)
From this, the bond equivalent yield can be calculated as
Icp (bond equivalent yield) = [(Pf – P0)/P0] * (365/h)
Example:
Consider a commercial paper with a maturity of 45 days that has a par value of $250,000
and is priced at $248,450.
Discount yield = [(250,000 – 248,450)/250,000] * (360/45) = 4.96%

The bond equivalent yield = [(250,000 – 248,450)/248450] * (365/45) = 5.06%
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5.6 Negotiable Certificate of Deposit

Many banks offer the facility of fixed deposits for a stated issue period. For example, an
investor can deposit $1000 as a fixed deposit for 3 months and at the end of the period, the
$1000 will be received with an interest. If the interest rate were 8% per annum, $20 interest
would be received for the 3 month period and thus, at the end of the period, the investor
would receive $1020, inclusive of the principal. In case the money is required at the end of
month, the fixed deposit account can be closed. However, this would entail a penalty with
interest forgone. Also, the fixed deposits cannot be transferred to somebody else. Thus,
fixed deposits are non-negotiable in the sense that the deposits cannot be transferred to
somebody else.
Consider the case where these deposits are negotiable or can be transferred to somebody
else. In this case, the deposits become negotiable deposits. When you enter into a contract
with a bank to have a negotiable fixed deposit, you would receive a certificate stating that
a sum of money has been deposited with the bank for a specified period and the bank
would pay a specified rate of interest on the deposit. This certificate can then be sold to
some other investor, as this certificate is negotiable. This certificate is a bearer instrument
and the person who has the instrument at the maturity of the certificate can present the
same to the bank and receive the proceeds.
The denomination of NCDs range from $100,000 to $10 million and the value of $1 million
is the common denomination. These are bought generally by mutual funds. The maturity
varies from two weeks to one year with common maturity being 1 to 4 months.
5.6.1 Trading Process

The banks will post a set of rates daily for the negotiable CDs and will try to sell these
to prospective investors. Sometimes, the bank and the investor can negotiate the rate,
maturity and the size of the certificate of deposit. Once the investor and bank agree upon
the terms, the certificate is given to a custodian bank nominated by the investor. The
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custodian bank would then debit the investor’s account and credit the NCD-issuing bank.
There is also a secondary market for NCD’s. It is made up of brokers and dealers who use
telephone lines to transact. When a deal is struck in the secondary market, the certificate
is sent to the custodian bank nominated by the new buyer and that custodian bank will
settle the accounts of seller and buyer. Settlement usually takes place within a day.
5.6.2 Yield on NCD

Assume that a bank issues a 3-month, $1 million negotiable CD with 3.6% annual interest
rate. At maturity of 90-days, the CD holder will receive:
1,000,000 [1+ (0.036/4)] = $1,009,000
Suppose the secondary market price of the CD is $998,450 immediately after issue. Then
the secondary market yield can be calculated as:
1,009,000/(1 + Ibey/4) = 998,450 or Ibey = [(1,009,000/998,450) – 1] * 4 = 4.23%
The effective annual return would be
[(1+0.0423/(365/90)]365/90 – 1 = 4.3%
5.7 Banker’s Acceptances

Chen is a manufacturer of textiles in China and is engaged in exporting textiles to
Singapore. Goh has a shop, which sells textile goods imported from Chen. This is an
international transaction in which both parties face risk. Chen faces the risk that Goh may
not pay the amount due even after receiving the goods and hence may require Goh to pay
the money upfront. However, Goh is averse to the idea of paying upfront because Chen
may not ship the goods as promised. In such a case, international transaction may not take
place. The situation can be improved if we include banks.
Chen will prepare a draft, which is essentially a promissory note, in which Goh needs to
sign. This draft will state that Goh will pay a specified sum of money to Chen at a specified
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time, subject to receiving the goods in order. Chen will send this draft to Goh. Goh will
then take this draft to his bank in which he has obtained a letter of credit in relation to the
import of goods from Chen. The bank will look at the draft for accuracy and then stamp
on the draft with an “accepted” notice. Goh will then send the approved draft and letter
of credit from the bank to Chen.
This will make life easy for Chen. When he sees that the draft has been accepted by
Goh’s bank, he knows that the bank guarantees payment by Goh. That is the purpose
of acceptance. By stamping “accepted”, Goh’s bank acknowledges that the bank will be
responsible for making payment to Chen. The banker’s acceptance becomes a guarantee
to Chen and he can ship the goods to Goh without worrying about possible default by
Goh.
Once Chen receives the acceptance draft of the banker, he can keep it until the date on
which payment will be made and submit the draft to the bank that accepted and request
for payment. In case Chen requires the money before the date specified in the draft, he
could sell it to investors who are willing to purchase the same. Thus, banker’s acceptances
are negotiable and can be traded many times before they are presented for payment. These
are bearer instruments and the accepting bank makes payment to the person who finally
presents the draft.
The usual maturity for these drafts is between 30 and 270 days. Denomination will depend
on the size of transaction. However, in secondary markets, many drafts with the same
maturity can be bundled together and denominations are usually of about $100,000.
These could be sold on a discount basis in the secondary market. The yield on banker’s
acceptance is quite low because the risk of default is also low. Since the default is possible
only if both importer and the bank default simultaneously, the possibility of joint default
is very low. Moreover, the investor who buys the draft also has claim on the goods on
which this draft is prepared.
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5.8 Comparison of Money Market Instruments

The money market instruments have common characteristics such as short maturity,
large denominations and low default risk. However, there are significant differences. Of
all the securities, the T-bill markets are large and have a very active secondary market
providing high liquidity. Commercial paper has no active secondary market and has
almost no liquidity. Though banker’s acceptances and negotiable CDs have secondary
market trading, the trading activity is relatively low. Repo also has no active secondary
market.
5.9 Money Market Funds

One of the major disadvantages of money market instruments from the perspective of
small investors is the denomination of these instruments. Typically, investment could
involve at least $100,000. Thus, small investors will have no opportunity to invest in low
risk, short-term investments. To provide access to money market instruments, money
market funds have been created.
A money market fund invests only in money market securities. To raise funds for
purchasing the money market instrument, the fund manager issues shares of the fund to
individual investors. The share price is usually a small amount of about $10, at the time of
fund creation. Trading in fund shares will depend on whether the fund is created as open-
ended fund or a closed-ended fund. If the fund is closed-end, the fund shares are traded in
the secondary market in either over-the-counter markets or listed exchanges. The trading
procedure is the same as the trading of shares issued by a corporation. If the fund is listed
as open-end, the shares are issued by the fund directly to the buyer and if the buyer wants
to sell the shares, they need to sell the shares back to the fund itself. The value of shares
is calculated based on the total value of all securities held by the fund and the number of
shares issued. This is known as the net asset value (NAV) and is calculated as:
NAV = (Total market value of securities in the fund / Number of outstanding shares)
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Note that an investor in the money market fund need not have a short-term horizon. Even
long-term investors can invest in money market funds, as the life of the fund could be long.
The only requirement to be classified as a money market fund is that the fund can invest
only in money market securities. In case the fund invests in 13-week T-bills, the fund needs
to invest the proceeds after 13 weeks into other money market instruments. The fund may
distribute the capital gains received during their trading activity to the shareholders or
can arrange to issue additional shares depending on the wishes of the investor.
5.9.1 Short-term Investment Fund

Short-term investment funds are money market funds that invest in securities with
maturity of up to 1 year in order to deliver higher returns. These funds usually invest in
medium to top-rated fixed income paper and money market securities. They may also
include debts of corporations, which have maturities of less than one year.
5.10 International Money Market

Among the international money market, the Euro money market is the most important.
In general, most countries allow banks to accept deposits or make loans only if the
currency denomination is that of the local currency of the country. However, in the early
1950’s, banks in Europe allowed the customer to maintain accounts denominated in US
dollars. These were called Euro-dollars. Over time, other currencies were also allowed
and customers could have Euro-yen, Euro-Australian dollar or Euro-Canadian dollar
accounts. Of all these, the Euro-dollar accounts continue to be the largest. In Singapore,
banks allow operation of accounts denominated in foreign currencies.
The Euro-dollar accounts have become predominant mainly because many commodities
such as oil and precious metals are universally priced in US dollars and many traders,
especially from developing countries use the US dollar for invoicing their customers. The
main advantage of the Euro-dollar market is that it is not subject to regulations that affect
the dollar market within the USA.
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The rate offered in the Euro market is called the London Interbank offer rate (LIBOR).
LIBOR rate tends to be close to the rate offered in the USA.
5.11 Financial Instruments in the Euro Market
5.11.1 Euro Dollar Certificates of Deposit

These are certificates of deposit denominated in US dollar issued by foreign banks. The
maturity of these CDs is usually 1 to 6 weeks but can be up to 1 year. These are negotiable
and are traded in the secondary market.
5.11.2 Euro Commercial Paper

Dealers of commercial paper issue these in Europe without involving a bank. The rate
on the commercial paper is slightly higher than the LIBOR rate. These can be issued in
Euro or in US dollar by companies located anywhere in the world as opposed to the local
commercial paper which is limited to local companies.
5.11.3 Euro Note

These are short-term promissory notes issued by borrowers to support debt claims. This
is similar to line of credit offered by banks whereby a company may negotiate with a bank
to institute a note issuing facility up to a certain limit. For example, Sony may negotiate
a note issuing facility with a bank in Germany for USD 200 million. Whenever it requires
funds, it can issue notes to the investors who are willing to buy these notes. These notes
are negotiable and can be traded in the secondary market. These notes are guaranteed by
the bank which has instituted the note issuing facility.
5.12 Participants in Money Market

The major participants in the money market are the Government treasury, the Central
Bank, commercial banks, money market brokers and dealers, corporations, financial
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institutions such as mutual funds, insurance companies, pension funds and individuals.
Treasury – The Treasury raises funds through issue of Treasury securities, mainly, T-bills.
Central Bank – The Central Bank participates mainly in the T-bill market and Repo market
in order to manage the money supply as part of the monetary policy.
Commercial banks – Banks participate both as buyers and issuers in the money market.
They are the major issuers of negotiable CDs, bankers’ acceptances and repos. They also
buy or sell T-bills as a way to manage their cash needs.
Money market mutual funds – They buy large amounts of money market securities and
sell shares of the fund to small investors.
Brokers and dealers – They are responsible for the smooth functioning of the secondary
markets as well as for the issue of securities such as commercial papers.
Corporations – They raise large amount of funds through issue of commercial paper and
trade other money market securities to invest excess cash.
Individuals – Individual investors generally participate through money market mutual

funds.
Lesson Recording
Money Market and Money Market Instruments
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Chapter 6: Bond Markets and Instruments
While money market securities that have a maturity of less than one year are traded in the
money market, securities that have maturity in excess of one year are traded in the capital
market. These types of securities are called capital market securities.
There are two types of capital market securities: equity securities and debt securities. The
classification of equity and debt securities is based on the cash flows provided to the
buyers of the securities by the issuers. In this chapter, we will discuss the nature of debt
securities. Chapter 6 will comprise a discussion in equity securities.
6.1 What is a Debt Security?

The government and government agencies issue debt securities to raise funds for taking
care of long-term expenses such as infrastructure or other long-term projects issue debt
securities. Corporations also issue debt securities to raise funds for new long-term projects.
The major debt security issued by either the government or businesses is known as a bond.
A bond is essentially a promissory note whereby the issuer agrees to make a set of known
payments for a certain time period. The amount of payments and the period for which the
payments would be made will be part of the contract. Typically, two types of payments
are made to the buyer of the bond by the issuer, known as coupon payments and maturity
value.
6.2 Terminologies used in Bonds

Face value – The amount that the issuer is essentially borrowing from the buyers of the
bond that will be paid back upon maturity of the bond is the face value. This is also known
as the maturity value.
Maturity – The life of a bond is known as maturity. The obligations of the issuer will expire
on the maturity date and no payments will be made after this date.
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Coupon payments – These payments are made periodically to the holder of the bond and
this amount is usually stated as a fraction of the face value of the bond.
Coupon rate – This is the fraction of the face value that will be paid as coupon payment.
Coupon payment period – Coupon payments are made periodically and frequency of
these payments is decided through the contract. Usually, coupon payments are made at
the end of every year (annual coupon payment) from the date of issue or at the end of
every six months from the date of issue (semi-annual coupon payment).
Coupon bond – A coupon bond is a bond that pays coupon payments periodically,
according to the terms of the bond contract.
Zero-coupon bond – A zero-coupon bond is a bond that pays no coupon payment at all
during the life of the bond.
Bond price – This is the price that the buyer will pay to purchase the bond. The price needs
to have to be equal to the face value at all time and can also be higher or lower than face
value.
6.3 Payments Associated with Bonds

There are three payments associated with the bond:
i. The price of the bond that the buyer pays to purchase the bond
ii. Periodic coupon payments received at known periods during the life of the bond
iii. Maturity value received at the maturity of the bond
Example:
Consider a bond issued on January 1, 2011 with a coupon rate of 8% and maturity of 5
years. The coupon payable is semi-annual with a face value of $1000. The bond is selling
for $1000. The payments associated with this bond are:
Jan 1, 2011: –$1000 (price paid
Jun 30, 2011: +$40 (half of 8% coupon rate of $1000)
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Dec 31, 2011: +$40
Jun 30, 2012: +$40
Dec 31, 2012: +$40
Jun 30, 2013: +$40
Dec 31, 2013: +$40
Jun 30, 2014: +$40
Dec 31, 2014: +$40
Jun 30, 2015: +$40
Dec 31, 2015: +$1040 ($40 coupon + $1000 maturity value)
6.4 Risks Associated with Bonds

When a bond is purchased, the buyer of the bond faces a number of risks. These risks are
explained below:
i. Default risk – This is the risk the issuer of the bond may not be able to make
either coupon payments or the maturity value.
ii. Interest rate risk – As will be shown later, the price of the bond is based on the
prevailing interest rate at the time the bond is traded. As interest rate is likely
to change from the time the bond is issued to the time of its maturity, the bond
price is also likely to change over time. Thus, the buyer of the bond is likely to
either gain if the price increases in the market or lose if the price decreases in the
market. This aspect of interest rate risk is known as the price risk.
Interest rate risk also has another component. Since coupon payments are
received at various time periods, varying interest rates will provide uncertain
cash flows, as the coupon payments will have to be reinvested at the prevailing
interest rates. So if the interest rate increases, the reinvestment rate will be higher
providing higher cash flows whereas the reinvestment will provide lower cash
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flows in case the interest rate decreases. This is known as the reinvestment rate
risk aspect of interest rate risk.
iii. Liquidity risk – Liquidity refers to the ease at which a security can be traded in
the market. A security is said to have high liquidity if there are large number of
buyers and sellers actively trading that security in a continuous fashion. In an
active market, a security can be easily bought or sold at its fair value. If there
are only a few traders such that trading does not take place continuously, but
at sporadic intervals, the security is said to have low or poor liquidity. In a low
liquidity market, it will be difficult to either buy or sell the security and when
bought or sold, it may not be at fair value.
6.5 Bond Pricing

Bonds are priced using the discounted cash flow method. As shown, a bond purchaser
will receive cash flows at different future times but will pay the price at the current time.
Since cash flows occur at different times, the appropriate method to value these cash flows
is through discounted cash flows. In this method, future cash flows are discounted to the
current time using an appropriate discount rate and the sum of the discounted future cash
flows will be the current value of these future cash flows.
Thus the price of the bond is calculated as:
P0 = Σ[t = 1 to N] Ct / (1 + K)t + F / (1 + K)N
where
Ct = Coupon payment every period
N = Number of periods that the coupon is received
F = Face value of the bond
K = Appropriate discount rate per period
Example:
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Calculate the price of a 10% coupon bond, which has a maturity of 3 years and face value
of $1000. The appropriate discount rate is 8%. Assume that the coupons are paid at the
end of each year.
Here, N = 3 as a coupon payment is made at the end of each of the three years; Ct = 10%
* 1000 = $100; F = $1000; K = 8%
P0 = Σ[t = 1 to N] 100 / (1 + 8%) t + F / (1 + 8%) 3 = $1051.42
Example:
Calculate the price of a 10% coupon bond, which has a maturity of 3 years and face value
of $1000. The appropriate discount rate is 8%. Assume that the coupons are paid semi-
annually.
Here, N = 6 as six coupon payments are made through the three years;
Ct = (10% * 1000) / 2 = $50; F = $1000; K = 8% / 2 = 4%
P0 = Σ[t = 1 to N] 50 / (1 + 4%) t + 1000 / (1 + 4%) 6 = $1052.42
6.5.1 Yield to Maturity

Since the bond price is calculated using all the cash flows including all coupon payments
and the maturity value and since maturity value will be received only when the bond is
held till maturity, the appropriate discount rate is known as the yield to maturity. Yield to
maturity is the average annual return from buying a bond at the current time and holding
the bond until maturity. Yield to maturity will depend on the prevailing interest rate as
well as the risks associated with the bond.
6.6 Bond Markets

Bond markets are where bonds are issued and traded. Funds from individuals,
corporations and government units with excess funds are transferred to government
agencies and corporations which need funds for long-term projects.
There are two types of bond markets:
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i. Treasury bond and note market

ii. Corporate bond market
6.6.1 Treasury Bond and Note Market

Treasury bonds and notes are issued in the Treasury bond and note market. The
government issues these to finance national debt and other government expenditure.
When a country faces budget deficits not covered by tax receipts, it needs to raise
the amount of deficit through borrowing. In order to finance this national debt, the
government issues bonds and notes.
Treasury bonds and notes are backed by the full faith and credit of the government. Due
to this, the treasury bonds have no default risk. However, the bonds and notes do face
interest rate risk because they pay coupons at periodic intervals and the maturity value
at maturity of the bond. If an investor plans to sell these bonds before maturity, he will
face price risk as interest rates could have changed from the time the bond was bought
to the time the bond is sold. Moreover, reinvestment rate risk will be present, as coupon
payments will have to be reinvested at unknown interest rates.
The new treasuries issued are termed as “on the run” as opposed to those, which are older
than 1 year, known as “off the run” issues. The market for “on the run” issues is very active
so that the liquidity for these issues is high, the liquidity for “off the run” issues is not as
high, causing liquidity risk for these issues.
6.6.2 STRIPS
The treasury began issuing 10 year notes and 30 year bonds in 1985 to financial
institutions under a programme called Special Trading of Registered Interest and Principal
Securities (STRIP). These are treasury securities in which periodic coupon payments can
be separated from each other and from the principal payment. This process will result in
converting a coupon bond into a series of zero-coupon bonds.
Consider an 8%, 3-year bond with face value of $1000. If an investor buys this bond on
January 1, 2011, his cash flow would be:
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Jun 30, 2011: $40
Dec 31, 2011: $40
Jun 30, 2012: $40
Dec 31, 2012: $40
Jun 30, 2013: $40
Dec 31, 2013: $40 + $1040
Now the investor can receive the same cash flow if he invests in a number of zero-
coupon bonds with different maturities. Assume that zero-coupon bonds are available
with consecutive 6-month maturities for the next 3 years, each with a face value of $40.
This means that if one buys these 6 zero-coupon bonds, cash flow will be the face value
at maturity, or:
Jun 30, 2011: $40
Dec 31, 2011: $40
Jun 30, 2012: $40
Dec 31, 2012: $40
Jun 30, 2013: $40
Dec 31, 2013: $40
In addition, if the investor buys a zero-coupon bond with a face value of $1000 and
maturity of 3 years, he will also receive $1000 on December 31, 2013. This example shows
that a 3-year coupon bond that pays semi-annual coupons can be replicated by 7 zero-
coupon bonds, of which 6 will have a face value equal to the coupon payment and the
seventh one will have a face value equal to the maturity value of the coupon bond.
In general, if the maturity of the bond is N years, with semi-annual coupon payments,
cash flow of this coupon bond can be replicated by 2N + 1 zero-coupon bonds where 2N
zero-coupon bonds will have consecutive 6 month maturity with a face value equal to
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coupon payment and the other zero-coupon bond will have a maturity of N years with a
face value equal to the maturity value of the coupon bond.
STRIPs are also known as treasury zeros or treasury zero-coupon bonds. This stripping
of coupons from the bond provides advantages to different groups of buyers. Those who
require only large one time payment such as insurance companies would prefer to receive
only the maturity value and not coupon payments. Those who want to invest for short-
term periods such as commercial banks would prefer to receive the coupon payments in
the early days of the bond. Those companies, which have requirements of different cash
flows in different periods such as pension funds, can buy treasury zeros such that cash
inflow will match the estimated cash outflows.
STRIPs are not directly sold to investors. They can only be bought through financial
institutions and government security dealers and brokers who purchase the original T-
notes and T-bonds and then create STRIP components. Once the financial institution
creates STRIP components, they inform the treasury about the STRIP so that the treasury
can record them as separate securities in their system. Only then can financial institutions
sell the STRIP components to investors.
The two major advantages of STRIP as opposed to coupon bonds are:
i. One can purchase the STRIP components to match the exact cash needs of the
firm.
ii. Since STRIPs will be held till maturity and the investor does not receive any
interim coupon payments, there is no interest rate risk.
Most T-notes and T-bonds are eligible for the STRIP programme. The components of
STRIP are sold with a minimum face value of $1000 or multiples of $1000.
6.6.3 Primary Market Issue of T-bonds and T-notes

The government uses competitive and non-competitive auctions, similar to the procedure
used for T-bills, to issue T-notes and T-bonds. The US Treasury will issue a notification
about a week before the date of auction. The notification will provide details of auction
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date, the amount to be sold and other details. A sample of the auction announcement is
shown below:
Announcement date: August 18th, 2011
Offering amount: $35000 million
Maximum award (35% of offering amount): $12,250 million
Maximum recognisable bid at a single yield: $12,250 million
Description of offering
Term and type of security: 2 year notes
Auction date: August 23rd, 2011
Issue date: August 31st, 2011
Maturity date: August 31st, 2013
Interest rate: Determined based on the highest accepted competitive bid
Yield: Determined at auction
Interest payment dates: February 29th and August 31st
Minimum bid amount: Multiples of $1000
Premium or discount: Determined at auction
NLP reporting threshold: $12,250 million
Submission of bids
Non-competitive bids accepted in full up to $5 million at the highest accepted yield.
Competitive bids must be expressed as yield with three decimals. Net long position (NLP)
for each bidder must be reported when the sum of the total bid amount, at all yields and
the NLP equals or exceeds the NLP threshold stated above.
Non-competitive closing time: 12noon ET
Competitive closing time: 1pm ET
As can be seen from the announcement, both competitive and non-competitive bids can
be made with a maximum single bid from the former at $12,250 million and $5 million for
the latter.
The results of the auction are shown below:
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Type Tendered Accepted
Competitive $120,327,500,000 $34,852,330,000
Non-competitive $147,747,900 $147,747,900
Subtotal $120,475,247,900 $35,000,077,900
SOMA $1,070,488,700 $1,070,488,700
Total $121,545,736,600 $36,070,566,600
Primary dealer $87,379,500,000 $18,287,395,000
Direct bidder $16,386,000,000 $5,535,935,000
Indirect bidder $16,562,000,000 $11,029,000,000
Total competitive $120,327,500,000 $34,852,330,000
Interest rate: 0 – 1/8%

High yield: 0.222%
Allotted at high: 73.87%
Price: 99.806537
Median yield: 0.209%
Low yield: 0.147%
(Source: www.treasurydirect.gov)
All the bidders pay the same price, which is the price that is equal to the lowest price of
the competitive bids accepted. In the above example, the highest yield was 0.222% and
73.87% of all bids were accepted. This resulted in the price of $99.806537 per face value of
$100. The coupon rate is 0.125%.
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6.6.4 Primary Market Issue of Treasury Bond in Singapore

In Singapore, 15-year bonds are issued. These are also issued through the auction process
similar to T-bill issue. The MAS announces the auction a week before the auction takes
place. A sample announcement is shown below:
Date of announcement: 19th August 2011

Tenure: Approximately 15 years
Total amount offered: SGD 1,600,000,000
Minimum denomination: SGD 1000
Issue date/Settlement date: 01 September 2011
Maturity date: 01 September 2024
Coupon rate: 3% per annum
Yield and price: To be determined at auction
Coupon payment dates: 01 September and 01 March
Next coupon payment date: 01 March 2012 calculated from 01 September 2011
Method of sale: Uniform price auction
Competitive applications: Must be expressed as an annual yield to 2 decimals Non-

competitive applications: Accepted at the cut-off yield of successful competitive
applications with prorated allotments if applications exceed 40% of amount offered.
Accrued interest: None

Closing date of application: 12noon, 26 August 2011
Mode of application: SGS eApps facility for primary dealers on SGS website
Results of this auction

Tenure: Approximately 15 years
Total amount offered: SGD 1,600,000,000
Amount allotted to:
Non-competitive applications: SGD 123,475,000
Total amount applied: SGD 2,958,426,000
Coupon rate: 3% per annum
Cut-off yield and price: 2.02% per annum and 111.155
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Median yield and price: 1.96% and 111.884

Average yield and price: 1.96% and 111.884 %
Competitive applications at cut-off yield: Approximately 31%
% Non-competitive applications allotted: 100%
Maturity date: 01 September 2024
(Source: https://www.mas.gov.sg/bonds-and-bills)
6.6.5 Secondary Market for Treasury Bonds and Notes

The primary dealers and brokers create the secondary market in Treasury bonds and notes
as is done in the case of T-bills. The minimum denomination for each note and bond is
$1000. The details of the bond quotes are printed in the financial section of newspapers.
The quotes show the maturity coupon rate, bid price, asked price and asked yield. As can
be seen, the yield is negative for some of the bonds, especially those that have very short
maturities. This happens because these bonds pay substantial coupon payments when the
level of interest rate in the market is very low.
6.6.6 Treasury Inflation Protection Securities (TIPS)

Started in January 1997, the US Treasury issued inflation-indexed bonds called Treasury
inflation protection securities (TIPS). These securities provide return, which is tied to the
inflation rate. The coupon rate on these bonds is determined at the auction. The principal
value of the bond can increase or decrease as the change in the consumer price index (CPI)
every six months. Thus, the coupon rate on TIPS is fixed, while the principal is adjusted
for inflation. These are useful for investors who would like to get a return that keeps up
with the inflation.
Example:
Assume that an investor buys TIPS for $1 million with a coupon rate of 1% on January
1, 2011. The inflation for the period from January 1, 2011 to June 30, 2011 is 0.5% on June
30, 2011. The value of the principal will be adjusted for inflation as $1,000,000 * 1.005
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= $1,005,000. The coupon payment on June 30 will be based on the inflation adjusted
principal and the amount of coupon will be 1,005,000 * 1% = $10,050.
6.7 Corporate Bonds

Corporate bonds are long-term bonds issued by corporations. The minimum
denomination of publicly traded corporate bonds is $1000 and coupon is paid semi-
annually on coupon bearing bonds.
Corporate bonds are issued in two ways, namely:
i. Private placement
ii. Public offering
6.7.1 Private Placement

When a corporation is planning a private placement, it will try to find large institutional
buyers or group of buyers to purchase the whole issue. Usually, the number of buyers
would not exceed ten. The private placement is unregistered and it is assumed that the
buyers would be able to analyse the risks of the issue and issuer.
Privately placed bonds have a very inactive secondary market. They can be resold only
to large financial institutions that are willing to buy and hold them. However, in the
United States, regulations have been changed in relation to privately placed bonds.
Regulation 144A was introduced in 1990, under which large investors could trade these
bonds amongst themselves even though these issues do not require stringent disclosure
requirements that bonds face when issued to the public.
In general, the issuers of privately placed bonds are not well known and interest rate paid
on these bonds tends to be higher than the rate on publicly placed bonds.
6.7.2 Public Offering

When a corporation is planning to issue bonds to the public, it needs to register the
issue with the Securities and Exchange Commission (SEC). Registration will require
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stringent disclosure requirements. Once registration is completed, the company will

appoint an investment banker to manage the issue. The investment banker will be asked
to underwrite the issue. The underwriting could be either firm commitment underwriting
or best efforts underwriting.
In the firm commitment underwriting, the investment banker guarantees the corporation
a price for the newly issued bonds by purchasing the whole issue at a fixed price, known
as the bid price. By purchasing the whole issue, the corporation is guaranteed that it will
sell the whole issue and receive the funds it required. The investment banker will then
sell the bonds in the secondary market to investors at a price known as asked price. The
asked price will generally be higher than the bid price and the difference between asked
price and bid price, known as the bid-asked spread, is the profit made by the investment
banker.
Even though the underwriter would like to sell the bonds at a higher asked price than the
bid price paid to the issuer, sometimes, the asked price could be lower than the bid price.
This is likely if the interest rate in the market increases considerably so that prices of all
the bonds decrease. In such a case, the underwriter can make a loss. The underwriting can
be arranged through competitive bids or non-competitive negotiation. In non-competitive
negotiation, the company planning to issue these bonds to the public will contact an
investment bank to discuss the details of the issue and the bid price that is satisfactory to
both parties. Both parties will agree upon the final details through negotiation.
In competitive bids, many investment bankers will be invited to submit sealed bids for
the bid price and other details. The corporations will then choose the underwriter who
has submitted the highest bid price. In some cases, especially with issues of large size, a
syndicate of underwriters would be formed, as the risk of the issue not being sold is higher.
In syndicated underwriting, one of the investment bankers would be the lead underwriter
who is responsible for contact with the issuing company.
In best-efforts undertaking, the investment bank does not buy the whole issue at a fixed
price. Instead, the investment bank agrees to put in its best efforts to sell the whole issue
in the secondary market and the company will pay a fee to the underwriter. While firm
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commitment underwriting guarantees that the while issue will be sold at a known price,
best-efforts underwriting does not guarantee the sale or the price. However, it is more
expensive for the company to go for a firm commitment underwriting compared to a best-
efforts underwriting.
6.7.3 Secondary Market Trading

Corporate bonds that are publicly issued are traded in the secondary market, either
in over-the-counter market through broker-dealer network, or in exchanges, where the
bonds are listed. The liquidity of the bond market is very high in the USA. However, the
bond market in Asia is still developing and the activity is low.
6.7.4 Bond Indenture

Since corporate bondholders receive fixed payments irrespective of the performance of
the company, there is a likelihood that managers may act in the best interest of the
shareholders who benefit in case the company performs really well. This means that the
shareholders will benefit at the expense of the bondholders and there could be transfer of
wealth from the bondholders to the shareholders. This is known as the agency problem,
which is always present, whenever a company issues bonds.
The bondholders are aware of such a possibility and therefore would like to protect
themselves against such action by managers. One of the ways in which bondholders can
protect themselves is through bond indentures. Bond indentures are legal documents
that specify the rights and obligations of the bond issuer as well as the bondholders.
This indenture will include a number of covenants associated with the bond issue. The
covenants can include:
i. Right of the bond issuer to call the bond prior to maturity

ii. Restriction on the issuer on the ability to increase dividends
iii. Restriction on the company to raise additional funds
iv. Restrictions on the various ratios that the company has to maintain
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Since the rights of the issuer and bondholder are legally documented, the bond indenture
will assist in lowering the risk of the bond and hence the interest rate. A trustee is
appointed as the representative of bondholders to oversee that the company is honouring
the provisions of the indenture. The trustee will act as the transfer agent for the bonds
when ownership of the bonds changes because of secondary market trading. In case the
company is not able to meet its obligations spelled out in the indenture, the trustee will
inform all the bondholders and will initiate legal action, if necessary. The trustee will
continue to act as an agent of the bondholders in case of reorganisation or liquidation of
the company.
6.7.4.1 Sinking Fund Requirement

One of the conditions that may be included in the bond indenture is that the company
maintains a sinking fund. Under the sinking fund requirement, the issuer will be required
to retire a certain amount of the bond issue over a number of years. The bond issuer will
provide the funds necessary to purchase the bonds by making frequent transfers to the
sinking fund. The amount available in the sinking fund is invested such that enough funds
will be accumulated to retire the whole issue. If the requirement is to retire a certain portion
of the issue periodically, the company will purchase these bonds in the secondary market,
which is known as redeeming the bonds. Once the bonds are redeemed they are written
off in the balance sheet and no interest will be payable on these bonds.
Sinking fund provision reduces the risk for the bondholders because the probability of
default decreases. Due to the lower risk of bonds that have the sinking fund provision,
the yield on these bonds is generally lower than the yield on bonds that have no sinking
fund provision.
6.7.5 Bond Ratings

In order to provide liquid markets where bonds are actively traded, it is important for the
investors to have information relating to the risk of the bond, especially the default risk. It
is possible for the prospective investor to conduct analysis of default risk. However, with
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lack of information, it may be very difficult to assess the default risk effectively. Many
large investment companies have divisions, which are involved in collecting relevant
information and assessing default risk. For small investors, this process could be time
consuming as well as costly. Instead, small investors rely on credit ratings provided by
rating agencies such as Moody’s, Standard and Poor (S&P), and Fitch. The table below
shows the details of ratings provided by these three agencies:
The ratings are based on the probability of default. The highest credit quality bonds that
have low probability of default are rates as Aaa by Moody’s and AAA by both S&P and
Fitch. As the rating falls lower, the probability of default increases and yield on the bond
increases.
The rating agencies use several factors in calculating these credit ratings. It includes
– issuer’s operations, position in the industry, overall financial strength, ability to
pay interest and principal amount, liquidity, profitability, debt capacity and corporate
governance structure. The agencies continuously monitor companies and change the
ratings when the conditions change.
In 2009, rating agencies came under fire when they provided AAA ratings to the mortgage
backed securities while the actual default risk was very high, contributing to the financial
crisis of 2008.
6.7.6 Classification of Bonds

Corporate bonds can have different characteristics that distinguish one from another.
These are discussed below:
6.7.6.1 Bearer Bonds and Registered Bonds

When an investor buys a registered bond, the details of the investor’s information is kept
in the records of the issuer and coupon payments are made to the registered owner.
If the bond is a bearer bond, the issuer does not keep the buyer’s details. Instead, coupons
are attached to the bond relating to various payments and the holder of the bond will
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send the corresponding coupon to the issuer and will receive the payment. Bearer bonds
provide anonymity, as the details of the holder are not known.
6.7.6.2 Term Bonds and Serial Bonds

If the bond is term bond, all bonds in the issue mature on the same date, which is the
maturity date, specified at the time of issue.
If it is a serial bond issue, there will be many maturity dates specified whereby a portion
of the issue is redeemed at each maturity date. This is useful for the issue as the company
does not have to keep funds to redeem the whole issue at one time.
Moody’s S&P Fitch Grade
Long Short Long Short Long Short

term term term term term term
Aaa AAA AAA High

grade
Aa1 AA+ AA+
Aa2 P -1 AA A – 1+ AA F1+
Aa3 AA- AA-
A1 A+ A–1 A+ Upper
medium
A2 A A F1
grade
A3 A- A–2 A- F2
Baa1 P-2 BBB+ BBB+ Lower

medium
Baa2 BBB A–3 BBB F3
grade
Baa3 P-3 BBB- BBB-
Ba1 BB+ BB+ Non-

investment
Ba2 BB BB
grade
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Moody’s S&P Fitch Grade
Ba3 Not BB- B BB- B

prime
B1 B+ B+ Highly
speculative
B2 B B
B3 B- B-
Caa1 CCC+ Substantial

risk /
Caa2 Not CCC
Extremely
prime
speculative
Caa3 CCC- C CCC C In default

with little
Ca CC
prospect
C C DDD
for
recovery
/ D DD / In default
/ D /
6.7.6.3 Mortgage Bonds or Secured Bonds

There are bonds issued by corporations to finance specific projects and the assets
underlying the projects are used as collateral to the issue. In case the issuer defaults on
either coupon payment or principal payment, bondholders have the right to take title to
the collateral and dispose off the collateral in order to recover the amount. The collateral
attached to the bonds reduces risk and hence the yield on mortgage bonds will be lower
than the yield on non-mortgage bonds.
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6.7.6.4 Debentures
Debentures are bonds issued by corporations without any collateral attached to them. The
debentures are backed by general credit-worthiness of the issuing firm. The holders of
debentures are eligible to receive promised payments only after the holders of mortgage
bonds are paid. In case the issuer is not able to pay the debenture holders, they will become
general creditors and payment will be made according to the rights of general creditors.
6.7.6.5 Subordinated Debentures

A company may issue additional debentures after debentures have been issued at an
earlier time. Since new debentures are issued at a later time, the new debenture holders
do not have the same right as the original debenture holders and the right of the new
debenture holders is subordinated to that of the original debenture holders. In case of
default, subordinated debenture holders will be paid only after the original debenture
holders are paid. Thus, subordinated debentures are more risky and hence the yield will
be higher.
6.7.6.6 Convertible Bonds

Convertible bonds are bonds that can be exchanged for another security issued by the
same corporation, which is usually the common stock of the corporation, if the convertible
bondholders desire to do so. At the time of issue, the corporation will provide the
conversation ratio, that is, how many shares will be provided for each bond converted. A
bondholder will convert the bond to shares only when the market value of the converted
shares exceeds the market value of the convertible bonds (if it is not converted). Thus,
conversion will be done only when the holder of the bond benefits from conversion. Due
to this, yield on convertible bonds is generally lower than non-convertible bonds.
Example:
Consider a convertible bond issued by XYZ Corporation in January 2011. Each bond has a
face value of $1000 and can be converted into 50 common shares of $20 per share. In June
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2011, the common shares were selling at $23.50 per share. At the same time, the convertible
bonds were selling at $1175.00. Should the bondholder convert the bonds into shares?
To decide whether the bond can be converted, we need to calculate the market value of
the bond and conversion value of the bond.
Conversion value of the bond is calculated as the market price per share multiplied by
conversion ratio. In this example, conversion ratio is 50 shares per bond and market price
per share is $23.50. Thus, conversion value = $23.50 * 50 = $1175.
Market value of convertible bond = $1175. This shows the conversion will not provide any
benefit and hence conversion may not take place. If the market price per share was $24;
conversion value would be $24 * 50 = $1200 which is more than the market value of the
bond which is $1175. In this case, the bond will be converted.
6.7.6.7 Bond with Warrants

Bonds can also be issued with warrants attached. The warrants provide the right to the
bondholders to purchase the shares of the corporation that issued the bond at a fixed price.
Though it is similar to a convertible bond, the difference is that the holder of the bond
need not surrender the bond. Warrants would be exercised only when the market price
per share is more than the fixed price specified in the warrant to purchase the shares. The
warrants can be detached from the bond and can either be converted into shares or can
be traded in the market. Corporations use warrants to increase the marketability of the
bonds when the projects are of high risk. The bondholders are likely to institute very strict
covenants for the risk and including the warrant will reduce the risk for the bondholders.
6.7.6.8 Callable Bonds

These are bonds that include a call provision. The call provision provides a right to the
issuer of the bonds under which the issuer can redeem the bond at a known price, known
as the call price, prior to the maturity of the bond.
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Callable bonds are usually issued when the interest rate is high and expected to fall in the
future. If the interest rate falls, the bond price in the market will increase. If the market
price of the bond is higher than the call price, the issuer can call the bond and redeem
the same by paying the call price to the bondholder. Furthermore, the issuer can raise the
funds required to redeem the bonds at a lower interest rate.
Typically, callable bonds are non-callable for a certain time period from the issue. The call
provision may provide for calling the bond at only one time or at different time before
maturity. The price at which the call is made will be higher than the face value. The yield
on callable bonds will be more than yield on non-callable bonds because of the risk due
to the call provision.
6.7.6.9 Put Bond

A put bond has a provision whereby the holder of the bond has the right to sell the bond
back to the issuer at the face value. These bonds are issued when the interest rates are low
and are expected to increase. When interest rates increase, the market value of the bonds
will decrease which can lead to losses for the holder. In this case, the holder can reduce the
losses by selling the bond back to the issuer at face value. Moreover, the funds received
can be invested at a higher interest rate.
6.8 Bond Funds

There are a number of mutual funds that invest in a mix of Treasuries and corporate
bonds by raising funds from small investors through issue of shares. The periodic coupon
payments received from these bonds can be either invested in more bonds or distributed
to the bond fund shareholders as dividends. Capital gains from the bond portfolio are
usually distributed to the shareholders.
A special case of a bond fund is a Bond Index fund, which is constructed such that the
return from the Index fund tracks the Index on which the fund is created. Bond Indexes
are created and managed by major investment banks.
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6.9 International Bond Market

These markets include:
i. Bonds underwritten by international underwriting syndicate

ii. Bonds issued to investors in many countries
iii. Bonds issued outside the jurisdiction of any single country
iv. Bonds offered in bearer form
The demand for international bonds has risen due to need for international portfolio
diversification and the need for funds in developing economies. The major currencies in
which international bonds are issued – US dollar, Euro, Japanese Yen and Pound Sterling.
The bonds can be issued as fixed coupon rate, floating coupon rate or equity related,
which include convertible bonds and bonds with warrants. Financial institutions,
government, government agencies and international institutions, such as the World Bank
and corporations, issue and trade international bonds.
6.9.1 Domestic Bonds, Foreign Bonds and Euro Bonds

In classifying a bond as a domestic or foreign bond, or a Euro bond, two aspects are to be
noted:
i. The place where the corporation is registered

ii. The currency of denomination of the bond
When a corporation is registered in a country and denominates the cash flows in the
currency of that country, the bond will be called a domestic bond, for example, Ford Motor
issuing US dollar bonds in USA, Singapore Airlines issuing SGD bonds in Singapore and
Sony issuing JPY bonds in Tokyo.
When domestic bonds are issued, the issuer needs to follow all the regulations relating to
the bond issue in that country.
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A bond is considered as a foreign bond if a corporation registered in one country issues

bonds in another country and these bonds are denominated in the currency of the country
where these bonds are issued.
Examples:
Ford Motor issuing bonds denominated in Euro in Frankfurt, Singapore Airlines issuing
USD bonds in New York and Sony issuing AUD bonds in Sydney.
Note that the difference between domestic and foreign bond is only in the domicile of the
issuer. In cases of the domestic bond, the domicile is local whereas in foreign bonds, the
domicile is a foreign country. The currency denomination will be the same as the currency
of the country in which the bond is issued. Bonds issued in New York are called Yankee
bonds, issued in Japan are called Samurai bonds and in the UK are called Bulldog bonds.
The issuers of foreign bonds also need to follow all the regulations relating to the bond
issue in that country.
Eurobond is a bond issued by a corporation in a country where bonds are denominated

in a currency other than the local currency. The domicile of the corporation is not relevant
and only the currency denomination is relevant.
Example:
Singapore Airlines issuing USD bonds in Singapore, Sony issuing USD bonds in Sydney.
Sometimes, Eurobonds can also be issued with a multi-currency clause. These bonds will
be denominated in a single currency but the bondholders are free to choose to receive
coupon payments and principal payment in some other currency specified.
Example:
Sony issues USD bonds in Sydney but payments can be made in Euro or AUD or USD.
The investor can choose to receive payments in any of the three currencies.
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6.9.2 Junk Bonds

The bonds that are rated as Baa or better by Moody’s and BBB or better by S&P and
Fitch are considered as investment grade bonds. Financial institutions such as banks and
pension funds are allowed to invest only in investment grade bonds.
All bonds that have a rating below BBB are called speculative bonds. These bonds offer
high yields and, of course, face higher risks. Some of these bonds are also called junk
bonds.
Lesson Recording
Bond Markets and Instruments
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1. Instruments traded in a money market include all of the following except

a. 180-day Treasury Bills
b. Commercial paper
c. Negotiable Certificate of deposit
d. 5-year Treasury bond
2. A pure discount security

a. Always sells at par with face value prior to maturity
b. Always sells at a discount from face value prior to maturity
c. Always sells at a premium to face value prior to maturity
d. Always provides a return equal to risk-free rate
3. A security with a maturity of 90 days is selling at a discount yield of 8%. The price at
which the security will be selling per $100 face value is:
a. $92
b. $96
c. $98
d. $100
4. Yield to maturity of a bond is

a. Average annual return from investing in the bond and selling the bond before
maturity
b. Average annual return from investing in the bond and holding the bond till
maturity
c. Always equal to the coupon rate
d. Higher than the coupon rate if the bond is selling at a premium
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5. A 5-year 8% coupon bond with face value of $1000 is selling at a yield to maturity
of 8%. Its price is
a. $950
b. $970
c. $1000
d. $1020
6. A 5-year 8% coupon bond with face value of $1000 is selling at $970.

a. The yield to maturity is equal to 8%
b. The yield to maturity is higher than 8%
c. The yield to maturity is lower than 8%
d. The yield to maturity cannot be calculated
7. The major risks in investing in bonds include all of the following except,
a. Default risk
b. Coupon rate risk
c. Interest rate risk
d. Liquidity risk
8. A STRIP is a
a. Zero-coupon treasury bond
b. A series of zero-coupon bonds created from a Treasury bond
c. A treasury bond protected for inflation
d. A corporate bond issued by a company with AAA rating
9. In a treasury bond auction,

a. The competitive bids are allocated first
b. The non-competitive bids are allocated first
c. The price for each bidder will be based on that bidder’s bid
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d. Banks receive priority allocation
10. Bond rating provides a measure of

a. Liquidity risk
b. Default risk
d. Call risk
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1. Instruments traded in a money market include all of the following except
a. 180-day Treasury Bills
Incorrect. Answer is wrong as money market securities have a maturity of 1
year or less and 180-day T-bill is a money market security
b. Commercial paper
year or less and commercial paper is a money market security
c. Negotiable Certificate of deposit

year or less and negotiable certificate of deposit is a money market security
d. 5-year Treasury bond

Correct. Answer is correct as money market securities have a maturity of 1
year or less and 5 year Treasury bond is not a money market security
2. A pure discount security

a. Always sells at par with face value prior to maturity
Incorrect. Answer is wrong as pure discount security sells as par only at
maturity
b. Always sells at a discount from face value prior to maturity

Correct. Answer is correct as a pure discount security sells at a discount at
all times prior to maturity and at par on maturity
c. Always sells at a premium to face value prior to maturity
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Incorrect. Answer is wrong because a pure discount security never sells at a

premium to face value
d. Always provides a return equal to risk-free rate

Incorrect. Answer is wrong because the return is based on the risk of the
security
3. A security with a maturity of 90 days is selling at a discount yield of 8%. The price at
which the security will be selling per $100 face value is:
a. $92
Incorrect. Answer is wrong as the discount yield is stated in annual terms
and the amount of discount has to be taken for 90 days
b. $96
and the amount of discount has to be taken for 90 days
c. $98
Correct. Answer is correct as the discount yield is stated in annual terms
and the amount of discount has to be taken for 90 days which is 2%. Thus
the price = 100 – 100 * 8% * 90/360 = $98
d. $100
and the amount of discount has to be taken for 90 days. It cannot sell at par
4. Yield to maturity of a bond is

a. Average annual return from investing in the bond and selling the bond before
maturity
Incorrect. Answer is wrong. If the bond is sold before maturity, the return
depends on the price at which the bond is sold which depends on the yield
to maturity prevailing at the time of selling the bond
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b. Average annual return from investing in the bond and holding the bond till
maturity
Correct. Answer is correct as the yield to maturity is the return only if the
bond is held till maturity
c. Always equal to the coupon rate

Incorrect. Answer is wrong because coupon rate is stated by the issuer while
yield to maturity is determined in the market which can be different from
the coupon rate
d. Higher than the coupon rate if the bond is selling at a premium

Incorrect. Answer is wrong because the bond will sell at a discount if the
yield to maturity is higher than the coupon rate.
5. A 5-year 8% coupon bond with face value of $1000 is selling at a yield to maturity
of 8%. Its price is
a. $950
Incorrect. Answer is wrong because the bond will sell at par of $1000 as the
coupon rate equals the yield to maturity
b. $970
c. $1000
Correct. The bond will sell at par of $1000 as the coupon rate equals the
yield to maturity
d. $1020
6. A 5-year 8% coupon bond with face value of $1000 is selling at $970.
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a. The yield to maturity is equal to 8%

Incorrect. Answer is wrong as the bond will sell at par if the yield equals the
coupon rate of 8%
b. The yield to maturity is higher than 8%

Correct. Answer is correct as the bond will sell at discount if the yield is
higher than the coupon rate of 8%
c. The yield to maturity is lower than 8%

Incorrect. Answer is wrong as the bond will sell at premium if the yield is
less than the coupon rate of 8%
d. The yield to maturity cannot be calculated

Incorrect. Answer is wrong as the bond yield to maturity can be calculated
as the discount rate that equates the price and the present value of future
cash flows.
7. The major risks in investing in bonds include all of the following except,
a. Default risk
Incorrect. Answer is wrong as default risk is one of the risks of investing in
bonds
b. Coupon rate risk

Correct. Answer is correct as coupon rate risk is not a risk because coupon
rate is stated and is constant

Incorrect. Answer is wrong as interest rate risk is one of the risks of investing
in bonds
d. Liquidity risk
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Incorrect. Answer is wrong as liquidity risk is one of the risks of investing

in bonds
8. A STRIP is a
a. Zero-coupon treasury bond
Incorrect. Answer is wrong as a STRIP is not a simple zero coupon bond
b. A series of zero-coupon bonds created from a Treasury bond

Correct. Answer is correct as STRIP is created by stripping each coupon
payment and principal payment from the Treasury bond and selling a zero
coupon bond for each of the future coupon/principal payment
c. A treasury bond protected for inflation

Incorrect. Answer is wrong as the treasury bond protected for inflation is a
TIPS
d. A corporate bond issued by a company with AAA rating

Incorrect. Answer is wrong as STRIP is created from Treasury bonds
9. In a treasury bond auction,

a. The competitive bids are allocated first
Incorrect. Answer is wrong as competitive bids are not allocated first
b. The non-competitive bids are allocated first

Correct. Answer is correct as non-competitive bids are allocated first
c. The price for each bidder will be based on that bidder’s bid
Incorrect. Answer is wrong as the price paid by all the bidders will be based
on the lowest bid among all bids accepted
d. Banks receive priority allocation

Incorrect. Answer is wrong as banks are not provided any priority
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10. Bond rating provides a measure of

a. Liquidity risk
Incorrect. Answer is wrong as bond rating does not measure liquidity risk
b. Default risk
Correct. Answer is correct as bond rating provides a measure default risk

Incorrect. Answer is wrong as bond rating does not measure interest rate risk
d. Call risk
Incorrect. Answer is wrong as bond rating does not measure liquidity call risk
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Study
Unit
FIN301
Learning Outcomes
• Analyse the characteristics of equity market and equity market instruments

• Describe how equity market securities are issued in the primary market
• Examine the secondary market trading procedure for equity market instruments
• Analyse the characteristics of equity related securities
• Describe how these securities are issued in the primary market
• Examine the secondary market trading procedure for these securities
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Overview
Equity markets are where equity securities such as common stock and preferred stock
are traded. In Chapter 7, we will discuss the characteristics of equity markets and related
instruments. The procedure for issue of equity market instruments as well as how they
are traded in the secondary market will be discussed.
In addition to regular equity securities such as common stock and preference stock, there
are many securities related to equity securities that are traded. In Chapter 8, we will
discuss the different equity related securities and how they are created and traded.
Read
Edition, (2015).
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Chapter 7: Equity Markets
7.1 What are Equity Securities?

One of the components of capital markets is the debt market in which debt securities
issued by the government and corporations are traded. The other component of capital
markets is the equity market where equity securities issued by corporations are traded.
When a business is started, the owners of the business use their own funds and funds
borrowed from their friends, relatives and banks, as well as funds provided by venture
capitalists to run the business. As the business grows and requires more funds, they
usually raise the funds through issuing shares to the general public. This is known as the
initial public offering (IPO). When the corporation issues shares, it receives funds, which
are called share capital funds. In return for providing the funds, investors who are also
called the shareholders get the following:
i. Right to elect the Board of Directors

ii. Right to vote in the general body meetings
iii. Right to a share of the profit
iv. Residual value of the business in case of liquidation
These shares are called common shares of the business.
In addition to common shares, the businesses can also issue preference shares where
preference shareholders are entitled to receive a fixed amount of dividends every year. In
this chapter, we will discuss how common shares are issued in the primary market and
how they are traded in the secondary market. We will also discuss the characteristics of
preference shares.
7.2 Rights of Common Shareholders

i. The holders of common shares have ownership stake in the company.
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ii. They have the right to share the company’s profits, which are paid out as
dividends after payments for interest and tax are made.
iii. They receive residual claim on company’s assets in case of liquidation. This
means all the assets of the business will be sold and liabilities will be paid with
the proceeds. The common shareholders will receive a share of the funds leftover.
iv. They have voting rights on major issues of the corporation such as election of
Board of Directors. The Board of Directors appoint the managers to take care
of the day-to-day operations and thus shareholders have no direct control over
how the corporation is run on a day-to-day basis. However, they have the right
to change the management if they believe that the latter is not acting in their best
interests.
7.3 Preference Shares

Preference shares are also called preferred stock. These shares have the characteristics of
both bond and common shares and can be considered as a hybrid security.
They are like common shares because these shares are ownership shares and they are
like bonds because they pay a constant amount periodically to the owners. However,
preference shares are junior to bonds because preferred dividends can be paid only
after payment of coupon interest to the bondholders is made. The other difference
between bonds and preference share is that interest will have to be paid to bondholders
irrespective of whether the corporation makes a profit or not whereas the corporation
can pay preferred dividend only if there is profit after paying interest and taxes. Also
preference shareholders can claim only after all the claims of bondholders are met in case
of liquidation. Thus, preference shares can be considered junior to bonds.
On the other hand, they are senior to common shares. This is because dividends to
common shareholders can be paid only after the preference shareholders are paid their
dividends and in case of liquidation, claim of preference shareholders must be met before
common shareholders can claim from the liquidation.
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Firms issue preference shares instead of bonds as the dividend can be missed without
worrying about default of interest payment. It is also helpful for bonds because funds
raised through preferred stock can be used to finance assets that would produce a cash
flow to pay the interest on bonds. However, issue of preference stock also poses some
risks. In case a corporation misses payment of preferred dividend, it can send a negative
signal to the market and the corporation will find it difficult to raise funds at a future time.
As preferred stocks have a higher risk than bonds, the cost of funds from preferred stock
will be higher than the cost of raising funds through bond issue. The interest payment on
debt is deductible as expense for tax purposes and hence there is a tax benefit from the
issue of bonds. This tax benefit is foregone if the corporation issues preferred stock, as
preferred dividends are not considered as an expense and hence is not tax-deductible.
The preferred dividend is paid periodically, usually every quarter. It is usually expressed
as a dollar amount or as a percentage of the face value of preferred stock. If the corporation
issues 8% preferred stock, it means that preferred dividend per year is 8% of the face value.
If the face value is $1000, annual preferred dividend will be $80, which will be paid as $20
every quarter.
In general, preferred stockholders do not have voting rights. However, there could be
exceptions to this and the preferred stockholders may receive voting rights in case the
corporation misses payment of dividends for a certain period, say two years.
Preferred stocks can be either non-participatory or participatory in nature. If the preferred

stock is non-participatory, the preference shareholders will receive only the stated
dividends irrespective of the performance of the company. If the preferred stock is
designated as participatory, the corporation can pay a higher dividend if the profits are
exceptionally high.
Preferred stock can be either cumulative or non-cumulative. As was discussed earlier, the
preferred dividend can be paid only when the corporation makes sufficient profit. In case
the corporation makes a loss, preferred dividend cannot be paid. What will happen to this
missed dividend if in the following year, the company makes exceptionally high profits?
Are the preference shareholders eligible to receive the missed dividends? This will depend
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on whether preferred shares are cumulative or non-cumulative. Cumulative shares will

receive missed dividend when there is sufficient profit made by the corporation at a future
time. For non-cumulative shares, on the other hand, missed dividends will be foregone
and the preference shareholders are not entitled to receive these missed dividends in the
future.
7.4 Return from Investing in Equity Securities

When one invests in equity securities, whether common stock or preferred stock, the cash
flow from owning the stock comes in two forms:
i. Periodic dividends that are paid by the company

ii. Capital gains or loss from selling the security in the market
Capital gain is the difference between the price at which the security is sold and the price
at which it was bought. For example, if an investor buys the shares of DBS bank at $14 on
January 1, 2011 and sells the same at $16 on December 31, 2011, the capital gains would
be ($16 - $14) = $2.
Note that there is a difference between equity securities and bonds. Bonds have a stated
maturity and the bondholders receive periodic coupon payments and the maturity value
if they hold the bond till maturity. On the other hand, if they decide to sell the bond
before maturity, the cash flow to bondholders will be coupon payments from the time
they bought the bond till the time they sold the bond and capital gain or loss which is the
difference between the price at which the bond is sold and the price at which the bond is
purchased. In case of equity securities, there is no specified maturity for these securities
and hence the shareholders will not receive the maturity value. Of course, if a stockholder
continues to hold the common shares or preference shares till liquidation of the company,
common shareholders will receive the residual value while preference shareholders will
receive the face value at that time.
Cash flows associated with equity securities are:
i. Price paid to purchase the security
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ii. Periodic dividend payments that will be paid to the equity shareholders
iii. Price received at the time the security is sold
Consider the case where the security is held exactly for one year. Let P0 be the price paid
to purchase the security, D1 be the dividend received at the end of the year and P1 the
price at which the security is sold at the end of the year.
Since the investor received D1 when he invests P0, the return to the investor through
dividend alone is D1 / P0. This is known as dividend yield. As the security is bought for
P0 at the beginning of the year and sold for P1 at the end of the year, capital gains is P1 -
P0. The capital gains as a fraction of the price paid is the return to the investor from capital
gains alone, which is known as capital gains yield. Capital gains yield is given by (P1 -
P0) / P0.
Thus the total return from investing in equity securities which are held for one year will
be:
Annual return = Dividend yield + Capital gains yield
= (D1 / P0) + (P1 - P0) / P0
If the securities are held for different periods other than exactly one year, the return
calculated would be for the period during which the security is held and will then be
converted to annual yield. However, this process is complicated and will be explained in
other courses.
Example:
XYZ Company shares are selling at $10 on Jan 1, 2011. It is estimated that the company
will pay a dividend of $0.50 on December 31 and the price on December 31 will be $10.50.
What is the return from this investment?
Annual return = Dividend yield + Capital gains yield
= (0.50 / 10) + (10.50 - 10) / 10
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= 0.05 + 0.05 = 0.10
In this example, dividend yield is 5% and capital gains yield is 5%; total yield is 10%. It is
considered that the security will pay $0.50 on December 31. However, in real life, it is very
difficult to estimate either the amount of dividend or the price at which the security will
trade in the market at a future time. In order to understand why it is difficult to estimate
the dividends, let us discuss the nature of dividends.
7.4.1 Dividends
Estimation of dividends is very difficult for both preference shares and equity shares.
Though preference shares are issued with the amount of dividends it would pay (for
example, 10% preference share with face value of $1000 will pay a dividend of $100 each
year), it is difficult to estimate the preferred dividends. This is because preferred dividends
can be paid only if the company makes profits. If it makes loss in any year, the preferred
dividends will be foregone. Therefore, it is necessary to forecast the profits of the company
to estimate the preferred dividends. If we assume that the company will be profitable such
that preferred dividends will be paid, then we can estimate preferred dividends.
On the other hand, estimating dividends for common shares is very difficult even if we
assume that the company will be profitable. This is because:
i. Even though the shareholders have the right to share the profits of the company,
there is no guarantee that the company will pay any dividend. This is because
the amount of dividends is decided by the management based on the need for
funds for future operations.
ii. Dividends are discretionary payments and could vary in different periods
depending on the operational needs for funds.
iii. Dividends can be paid only from profits of the company both current and past.
This means that all unpaid dividends will be kept by the company as retained
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earnings and in years the company makes losses, the company can use the
retained earnings to pay dividends to common shareholders.
Discussion Question
Preference shareholders have priority claims compared to common

shareholders. Preference shareholders will be paid dividends only if a company
makes profits. However, common shareholders can receive dividends even if a
company makes losses provided the company has sufficient past profits held as
retained earnings. Therefore, common shareholders have priority in dividend
payments. Comment on this statement.
iv. Dividends are not deductible for tax purposes as expense by the firm. Actually,
dividends are paid from the after-tax profit. When dividends are paid to the
shareholders, what taxation policy should apply? It varies from country to
country. In many countries, dividends are considered as a part of the income
earned by the investor and the investor is taxed on the dividend income; thus
having double taxation. This is because dividends are paid after the company
pays tax on the income earned and the shareholder pays tax again on that part
of the income that is distributed as dividends. In order to avoid such double
taxation on the same income, some countries such as Australia use a system
known as franked dividend. When a company decides to pay dividends, the
amount of dividends is franked and this amount is exempt from corporate
taxation. However, when the shareholders receive the franked dividend, the
shareholders need to pay taxes on the amount of franked dividend. This system
is called tax imputation system in which income earned to pay dividends by
the company is taxed, not at the corporate rate but at the individual tax rate
of the shareholders. In Singapore, imputation system was practised until 2003.
Since 2003, the amount of dividends paid by the company is from the after-tax
income, which means, the amount of income used to pay dividends is taxed at
the corporate rate and the dividend received by the shareholders is tax-exempt,
which means that the shareholders need not pay any tax on the dividend income.
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This differential tax treatment which can have an impact on the dividend policy of the
company will be discussed in corporate finance.
7.5 Primary Market for Equity Securities

The equity securities channel funds from investors to the company, which is issuing
securities through the primary market. By issuing new securities in the primary market,
the company increases share capital as well as the number of shares outstanding. Investors
buy these outstanding shares, thus providing the increased share capital to the company.
The primary market transaction can be for the “first-time issue” of shares to the public
by a business, which is privately owned, or for issue of additional shares by a company,
which has already issued shares to the public. When a company issues shares for the first
time, it is called “initial public offering” (IPO). If the company issues additional shares,
it will be referred to as “seasoned offering”. Whether an IPO or a seasoned offering, the
issuing company will receive funds from investors and will issue shares to them.
The primary market transaction can be either a public offering or a private placement. If
it is a public offering, the whole offer is made to the general public whereas if the offer is
made only to a few large investors, the issue will be a private placement.
The company uses investment bankers for underwriting and selling the shares. The
underwriting can be either a firm commitment underwriting or best efforts underwriting.
In firm commitment underwriting, the underwriter will purchase the whole issue of
shares from the issuer at a negotiated price and will then sell them in the market,
preferably at a higher price. The difference between the price at which the shares are
sold to the investors and the share bought from the company will be the profit for the
underwriter. In case of best efforts underwriting, the underwriter will agree to put his
best efforts to sell the shares to investors at an agreed price for which he will receive a
commission from the issuer.
Very often, a number of underwriters join together to form an underwriting syndicate,

especially when the issue size is large. The lead underwriter will be the direct contact with
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the issuer and the level of commission to each of the underwriters in the syndicate will be
based on the level of participation.
7.6 Rights Offering

Many companies in their charter may require that any additional shares to be issued
should first be offered to the existing shareholders. Since the shareholders have the right
to share in the profits of the firm as well as have voting rights, if the additional shares
are offered to new shareholders, the rights of the existing shareholders will be diluted.
To mitigate this dilution effect, when new shares are issued, the charter will indicate that
any new shares should first be offered to the existing shareholders in the same proportion
as the existing proportion of shares of the company held by the shareholder. This means
that a shareholder who owns 1% of the existing shares should be offered 1% of new shares
that are to be issued. In order to accomplish this purpose, the company will issue “rights”,
known as pre-emptive rights to the existing shareholder.
A “right” issued to the existing shareholder allows the shareholder to purchase a specified
number of shares at a specified price (which is usually below the market price) within a
specified time. Since it is a right, the existing shareholders can either exercise the right of
purchasing the additional shares, or they can sell the right in the secondary market and
receive the proceeds. The person who bought the right in the secondary market can then
exercise the right and purchase the security from the company. Issue of rights is beneficial
to the company, as it does not need to have to go through the expensive underwriting
process.
7.7 Issue Procedure

Once the issuing company and the investment bankers agree to the details of the security
issue, the investment banker must first get the approval from the SEC in accordance with
the Securities and Exchange Act of 1934.
A registration statement, which includes details of the nature of the business, key
provisions of the security being issued, risks involved in the security and details of the
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management must be submitted to the SEC. The purpose of the registration statement
is to provide a complete and comprehensive disclosure about the company and security
to be issued. A preliminary prospectus known as a “red herring” is prepared alongside
the registration statement by the issuer and investment banker, which is provided to
prospective buyers of the security.
The SEC has 20 days from time of receipt of the registration statement to ask for additional
information to be provided by the issuer. In general, it takes 20 days from the time the
registration statement is lodged with SEC for it to become effective. In cases where it is
an IPO or issue by an infrequent issuer, it may take months for SEC registration as they
may require additional information. Once the SEC is satisfied and registers the issue, the
issuer and investment banker will set details such as the final issue price of the security
and then send the “red herring” prospectus to potential buyers.
The time interval between lodging of registration statement with SEC and the actual
registering of issue is known as the waiting period. The time period between the lodging
of registration statement with SEC and actual sale of shares is known as the quiet period.
During this period, the company cannot send any written communication to the public
apart from information about the normal course of business. After the issue is registered,
oral communication is allowed whereby executive of the company can arrange for road
shows to reach out to investors. However, in 2004, the SEC modified rules so that
companies with market capitalisation in excess of $700 million or debt exceeding $1 billion
could communicate with the public even during the quiet period.
In 1992, the SEC allowed use of shelf registration in order to reduce waiting time. This
allows an issuer who is planning multiple issues of shares over a two-year period to
submit only one registration statement that covers all issues.
7.7.1 Issue of Securities in Singapore

IPOs
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There are two different methods of listing in the Singapore exchange, namely, main board
and catalist.
The main board listing requires for the company that plans to issue shares to satisfy the
quantitative requirements as follows:
i. The company should have cumulative pre-tax profit of at least $7.5 million over
the last three consecutive years, with a pre-tax profit of at least $1 million in each
of the three years (or) The company should have a market capitalisation of at least
$80 million at the time of initial public offering (IPO) based on the issue price.
ii. 25% of the issued shares must be in the hands of at least 500 shareholders.
iii. There should be at least 2 independent directors who are resident in Singapore.
iv. The company should agree to honour continuous listing obligations, which
require the company to disseminate all material information on a timely basis.
When the company wants to list in the main board, Singapore Exchange will review all
IPO documents and decide on the listing. Once the company’s shares are listed, SGX will
monitor and supervise the company with powers of discipline. The issue managers have
no supervisory roles and are not subject to the SGX rules.
The catalist method of listing is based on sponsor supervision. Sponsors are qualified
professional companies experienced in corporate finance who are authorised and
regulated by the SGX. There are no quantitative requirements and sponsors decide
whether the applicant is suitable to list its shares. It is taken up by small but fast growing
companies.
The procedure for IPO is as follows:
The company will conduct a due diligence, which is the analysis and valuation of the
company by a professional accounting firm. The purpose of due diligence is to provide
all material information to the public. Once value is established, appropriate number of
shares to be issued is decided.
The next step is to appoint an underwriter, who underwrites the issue based on firm
commitment or best efforts (as discussed previously). The company will then find a
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sponsor who is a Singapore-based financial institution and a lead manager. This lead
manager will submit the listing application to SGX and maintain all contacts in relation
to the application for listing. The company may also appoint a lawyer, certified public
accountant as well a public relations firm.
The listing process consists of pre-submission preparations, post-submission approval

and listing. The pre-submission preparation will take an average of 4 to 9 months and
post-submission approval takes an average of 5 to 7 weeks. The listing process time may
vary between 4 months and 2 years.
Issue of additional shares
In order to issue additional shares, the company must get approval from the shareholders
in a general meeting. The new shares must not be priced at more than 10% discount to
weighted average price of trades done on the Exchange for the full market day on which
the placement agreement is signed.
An issuer who is planning a rights issue must provide:
i. The price, terms and purpose of issue

ii. Whether the issue will be underwritten
iii. Whether it has obtained or will obtain approval from the Exchange for listing of
new shares arising from the rights issue
The issuer must get approval from the Exchange before announcing the rights issue. The
issuer must inform the existing shareholders within 2 market days or such a longer period
as the Exchange may approve about the entitlement.
The listing process for a non-rights issue is:
i. Issuer will make the appropriate announcement.

ii. Submit one copy of additional listing application with supporting documents.
iii. The exchange will review the application and approve additional issue of shares.
The exchange will normally decide on the application within 3 weeks from date
of submission.
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iv. Once the application is approved, the issuer will use an underwriter to sell the
shares.
7.8 Secondary Market Trading

Secondary market for equity securities is the market in which shares that are already
issued can be either bought or sold by investors. When a share is traded in the secondary
market, the firm that issued the share is not directly involved in the sense that it neither
issues the share nor gets any money. The participants in the market are mainly investors
who could be either individuals or institutional investors.
When a trade takes place in the stock market, funds and shares are exchanged with brokers
acting as intermediaries to bring about the transactions between the buyer and seller of
stock. The major secondary market for common shares is the stock exchange. The largest
stock exchange in terms of value traded is the New York Stock Exchange (NYSE). Stocks
are traded through the Singapore Exchange (SGX) for the Singapore equity market.
7.9 Orders
While trading in stock exchanges, an investor can place a number of orders. These types
are:
Market order
Market order is an order that should be fulfilled at the best possible price immediately.
The market order does not specify any price.
Limit order
A limit order specifies a price called limit price and this order can only be executed at the
limit price or better. For example, a limit buy at $15 means that the order will be executed
only at a price of $15 or lower. Similarly, a limit sell at $15 means that the order will be
executed only at a price of $15 or higher. If the price does not move to limit price or better,
the order will not be executed.
Stop-loss order
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A stop-loss order is one in which the trader will place a price known as a stop price. If the
market price reaches this price, the order will become a market order and will be executed
at the best possible price. If the stop price is not touched, the order will not be executed.
Immediate or cancel order
This order is one in which the order should be executed immediately; if not done, the
order will be cancelled.
A good-till-day order will have to be executed within the day the order is placed; if not, the
order will be cancelled. A good-till-cancelled order will remain open unless the original
trader cancels the order. A good-till-date order will remain open until a given date. If it is
not executed within the date specified, it will be cancelled.
7.10 Order Matching Rules

The best buy order will be matched with the best sell order. An order may match partially
with another order, which can result in multiple orders. For example, best buy order may
be for 5000 shares whereas, best sell order maybe for 2000 shares. In this case, 2000 shares
of the buy order will be matched with the 2000 shares of the sell order and the remaining
3000 shares will remain open to be executed later. For order matching, the best buy order
is the one with the highest limit price and the best sell order is the one with the lowest
limit price.
7.11 Order Conditions

Orders can be categorised on the basis of either time or price.
On the basis of time: Day orders are valid only for the day on which it was entered into.
If the order is not matched during the day, the order gets cancelled automatically at the
end of the trading day.
Immediate or cancel orders will be executed immediately and if not matched, it is

cancelled. If there is a partial match, the unmatched portion will be cancelled while the
matched portion will be executed.
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On the basis of price: This includes market orders, limit orders and stop-loss orders as
was discussed earlier.
7.12 Trading Procedure

There are two systems used in stock exchanges to trade stocks. The first system that
was prevalent in all the exchanges was called “open-outcry” auction system. With the
advances in computer technology, most exchanges have moved towards developing their
own “electronic” trading systems. Open-outcry auctions are still used in the NYSE.
7.12.1 Open-outcry Auction System

In this system, all trades take place on the floor of the exchange. For each stock traded in
the exchange, a specialist is appointed by the exchange. The specialist is the market maker
in that stock who is responsible to provide an active market for that stock. This specialist
has a register known as “the limit book”.
Suppose there are two investors – John and Mary. John finds the price of Microsoft in the
market to be $75. He believes that the stock is overvalued and would buy the stock only
if the price is $73 or below. Therefore, he would like to place a limit buy order at $73.
As only members of the exchange can trade in the market, John will have to find a broker
who has access to trade in the exchange. He will then call up his broker and place a limit
buy order at $73. This broker may belong to the brokerage house, which is a member of
the exchange. In that case, he will call up his colleagues on the floor and pass this order.
If the broker does not represent a firm that is a member of the exchange, he will contact
another house that is a part of the exchange and pass this order. Once the order reaches
the broker on the floor, the order will be taken to the trading post of the specialist who is
in charge of Microsoft. The specialist will then look at the book to see what the best limit
sell order is and try to match the order and execute it. If it is executed, this information
will be transmitted to the exchange. Otherwise, the limit buy order will be entered and
kept for fulfilment at a later time when matching occurs with an appropriate sell order. If
the order had been immediate or a cancel order, the order will be cancelled.
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Consider Mary who plans to place a market order. Like John, Mary will call a broker who
will contact one transacting at the exchange. The broker at the exchange will approach the
specialist and ask for the best price at which shares can be bought. The specialist will look
up the limit book and see where the lowest limit sell and the highest limit buy prices are.
If the lowest limit buy is $73 and the lowest limit sell is $75, the quote will be given as
73.5 – 74.5 where 73.5 refers to the bid price and 74.5 is the asked price. This means that
the specialist will buy the share at bid price of $73.5 and sell the shares at asked price of
$74.5. Since Mary placed a market order to buy, her broker will execute the order at the
best possible price, which is $74.50.
The specialist will have to maintain the limit book, keep inventory of stocks, provide
quotes for stock prices and provide liquidity to the market. Since the specialist maintains
the limit book and also knows the range of limit prices, this system is often criticised for
its lack of transparency. Thus, the electronic trading platform has been offered as a more
viable alternative.
7.12.2 Electronic Trading Platform

With electronic trading platform, the brokers who want to trade in the exchange are
provided access to the trading books of the exchange. The trades of John and Mary will
be handled in the following manner:
John contacts the broker with the limit order and the broker will access the order books
of the exchange. This order book will provide the details of all limit orders including the
limit price and volume of the order. The broker will enter the limit buy order in the book
and the computer of the exchange will automatically execute the order entered if there is a
matching sell order. If there is no matching order, the order will remain in its book system.
Similarly, Mary will contact the broker to place her market order. Since this is a market
order, the broker needs to find the best price. For each stock, the exchange designates a few
market makers who are required to provide bid-ask quotes when requested. The broker
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will contact these market makers to find the best-asked quote and will execute the order
with the brokers who provide the lowest asked price.
7.13 Program Trading

Program trading is the simultaneous buying and selling a portfolio of at least 15 different
stocks valued at more than $1 million, using a computer program to trigger the trade.
Typically, program trading is used for portfolio insurance.
Program trading has been criticised for its influence on stock prices and increased
volatility. Due to this, the exchange has introduced circuit breakers or trading curbs on
program trading, especially when the index falls substantially.
7.14 Trading on Margin / Margin Trading

Trading in equity securities can also involve margin trading. Assume that an investor has
placed an order to buy 1000 shares at $20 each. This means that the trader needs to pay
$20,000 when the order is executed. He does not, however, need to pay the whole amount
if he is trading on margin. He can borrow a certain percentage of the total amount from
the broker and will use his own funds for the rest. Suppose the maximum allowed is 40%
of the value; he can borrow 40% of $20,000 = $8,000 from the broker and pay the remaining
$12,000 from his own funds. Thus margin trading leverages his investment that can either
provide higher return on investment or lead to losses. The broker will charge interest for
the amount lent and the broker will also maintain a margin account.
The maximum fraction that is allowed is known as the initial margin. Whenever the
stock price increases, the increase in value accrues to the investor. Similarly, if stock price
decreases, the decrease in value affects the investor. However, decreased value of the stock
can also affect the broker who has lent the money because margin trading is equivalent to
borrowing by the investor, using the shares bought as collateral. If the value of collateral
decreases, the margin of safety for the lender decreases and if the value of collateral goes
below the borrowed amount, the borrower can default on the loan amount causing losses
to the lender. In order to see how the collateral is performing, the broker will update the
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value of this collateral everyday using the closing price of the stock. This process is known
as “marking-to-market”.
If the price of stock increases, value of the collateral will also increase, causing an increase
in the margin. Margin is the ratio between the value of the collateral and the amount
borrowed. When the actual margin is more than the initial margin for the stock, the
investor can let the margin increase or can ask the broker to pay cash so that the actual
margin remains at the initial level.
If the price of the stock decreases, the value of the collateral will decrease, causing decline
in margin. When this happens, there will be no necessity for the investor to provide
additional cash. However, in order to see that collateral value does not decrease too much,
the broker will also provide a maintenance margin percentage. This maintenance margin
is the minimum margin that should be present at all times in the margin account. In case
the actual margin falls below this, the broker will issue a margin call. A margin call is a
notification to the investor informing that the margin has fallen below the maintenance
margin and the investor needs to pay additional cash such that the actual margin plus the
additional cash equals the maintenance margin. If the investor does not pay the additional
cash on receipt of margin call, the broker is authorised to sell the stock and recover his
loan amount and pass the rest to the investor.
7.15 Short Selling

Short selling is a concept used only with trading of equity securities. Normally, a trader
can sell only when he owns an asset. However, in stock markets, a trader is allowed to sell
a security that he does not currently own. How is it possible and why should a trader try
to sell a security that he does not own?
Assume that Singapore Airlines shares are selling at $22 and you believe that the price of
this share will drop to $21 in two days. One way to make money from this information is
that you can sell the share today, if you own them, at $22 and buy it back at $21 when the
price drops. In this case, you will still hold the share and you would also have made $1
per share. What happens if you do not own the shares?
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Assume that you can borrow the shares required from the broker for a few days. In this
case, you can sell the shares at the current price of $22 and then buy the shares back
at $21 when share price falls to $21. This bought share can be returned to the broker
from whom the shares were borrowed. This is what is called short selling. Thus, in short
selling, a trader would borrow securities from the broker and sell them in the market at
the prevailing market price and would return the borrowed shares at a future time. As the
example showed, the short seller would gain only if the share price falls in the market so
that the short seller can buy the shares at a price lower than the price at which they were
sold. Thus, short selling will be undertaken only when the price of the share is expected
to decrease.
What happens if the share price increases to $23 in the market? Since the share was sold
at $22 and the short seller has to buy it back at $23, the short seller would suffer a loss of
$1 per share. How can be protected from losses while short selling?
Generally, short selling order is accompanied by a stop-loss order. In case the short seller
is willing to take a maximum loss of $0.50 per share, he would place a stop-loss order at
$22.50. If the price decreases as expected, the short seller will buy the shares back at the
lower price and will gain. In case the price increases and touches $22.50, stop-loss order
will kick in, making the stop-loss order into a market order and order will be executed
close to $22.50. This will protect the short seller from accumulating huge losses.
Exchanges often put restrictions on short selling. If there is a huge volume of short selling,
supply of shares will increase, causing the share price to fall, which will benefit the short
seller. In order to avoid this, exchanges will allow short selling only when there is an uptick
in share price.
A tick is the minimum amount by which the share price can change. Depending on the
share price, the tick can be 1¢ or 5¢ or 25¢. If tick size is 5¢, the price can change by 5¢
every trade. If the price decreases from the previous trade, it will be termed as downtick
and if the price increases from the previous trade, it will be termed as an uptick. If there
is no change in price, it will be called an even tick.
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If the change in price is downtick, this means that the price has decreased and if short sales
are made at that time, it can be a signal to the market that the price would decrease further,
which would benefit the short seller. In order to avoid this, exchanges restrict short sales
to be made only when there is an uptick. Exchanges may also state the time period within
which the shares borrowed through short sales be returned to the broker.
Lesson Recording
Equity Markets
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Chapter 8: Stock Index Related Securities
There are other equity-related securities in addition to common shares and preference
shares. These can be investment company shares, shares of index funds, company funds
and exchange traded funds.
8.1 Investment Company Shares

An investment company invests in a portfolio of stocks. In order to raise money for
investment, the investment company will issue shares to the public.
Investment company can either be an open-end fund or closed-end fund. Open-end fund
is also called unit trust or mutual fund. The difference between an open-end fund and
closed-end fund is based on how these shares are traded.
An open-end fund shares are to be bought directly from the fund itself and if the
shareholders want to sell the shares, they need to sell them to the fund only. The shares
are dealt directly with the fund; therefore, the total investment in the fund could vary at
different times. The total value of the assets held by the fund will be the sum of the market
value of all the various investments made by the fund. The value per share of the fund is
calculated as total value of assets held by the fund divided by the number of shares issued
by the fund and is called the net asset value per share.
The investor usually pays a price, which is higher than the net asset value, which is called
the front-end load. However, the shares are redeemed or sold back to the fund at the net
asset value. The shares of open-end funds can be bought directly from the fund or through
brokers authorised by the fund.
Promoters form the closed-end fund by issuing shares to the public and investing the
funds in portfolio of shares. The shares of the closed-end fund are listed in stock exchanges
and are traded like shares of the company. The investors need to trade these shares in the
exchange with other investors. Since these shares are traded in exchanges, share price is
determined in the market and the share price need not have to be equal to the net asset
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value of the share. The fund share price may be higher than the net asset value in which
case it is said to sell at a premium to net asset value and if the fund share price is less than
the net asset value, it is said that the fund shares are selling at a discount from net asset
value.
8.2 Stock Indexes

A stock index is a portfolio of stocks traded in the exchange whose performance is
expected to represent the performance of a broader group of securities. Index can be
created such that it represents the market as a whole or a particular sector or a particular
group of securities.
Index can be created by the exchange or by any other agency which creates the index in
collaboration with the exchange.
In the US, the major indexes are Dow Jones Industrial Average (DJIA), S&P 500 Index and
the NASDAQ Index. In Singapore, the major index is the Straits Times Index (STI).
Index can be created in two ways. It can be price-weighted or can be value-weighted. Of

all indexes, only the DJIA uses the price-weighted method and all other indexes are based
on value-weighted method.
8.2.1 Price-weighted Index

To understand the price-weighted index creation, consider an example with 3 stocks. Stock
1 is currently selling at $10, stock 2 is selling at $20 and stock 3 is selling at $24. Then the
value of the index will be calculated as the average of the prices of the three securities as:
Index value = 10 + 20 + 24 = 54 / 3 = 18.
If on the next day, the prices of the 3 stocks are $11, $21 and $25, the average price will be
(11 + 21 + 25) / 3 = 19 and the index value will increase from 18 to 19.
However, there could be problems in calculating the index value in case there is a stock
split in any of these shares. When a company announces a stock split, the stock price in
the market will change to account for the stock split. If the stock split is 2 for 1, it means
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that each share of the company will be split into 2 shares. In this case, the share price will
decrease such that the position after the stock split is the same as the position prior to stock
split.
For example, if the share priced at $11 announces a 2 for 1 stock split, the market price
after split would be $11/2 = $5.50.
If we now use the price to calculate the index value, the average price will equal (5.5 + 21
+ 25) / 3 = 17.17 which will indicate that the value of the index has decreased from 18.
However, comparing the prices of shares, it can be seen that the prices actually increased.
In order to adjust for changes in price due to stock split, the denominator is recalculated
so that index value remains the same before and after stock-split. The adjustment is made
as follows:
Index value before stock split = 19

Prices after stock split are: $5.5, $21 and $25.
Denominator will be calculated as: (5.5 + 21 + 25) / 19 = 2.71
The denominator will be decreased from 3 to 2.71 and will continue at 2.71 until some
other stock has a stock split. Implication of price-weighted index is that any change in the
index indicates the percentage change in the average price of the stock in the market.
8.2.2 Value-weighted Index

In case of value-weighted index, a base date is first designated and the total market value
of all the stocks included in the index is calculated as share price multiplied by the number
of shares outstanding for each company included in the index and a base value is given
for the index that day.
On a subsequent day, t, the market value of all stocks included in the index is calculated
and the index value for that day, t, is calculated as:
Index value t = (Market value of all assets on day t * base value) / Market value of all
assets on base day.
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For example, assume there are 3 stocks – A, B and C, the details of which are given below
on day 0:
Stock Price # of shares Market value
A $10 10,000 100,000
B $20 20,000 400,000
C $25 15,000 375,000
Total 875,000
Assume base value is 100.

On day 1, the share prices are $12, $21 and $26.
The total market value will be: 120,000 + 420,000 + 390,000 = 930,000
Index value on day 1 = 930,000/875,000 * 100 = 106.28
Increase in index value = 106.28/100 = 6.28%
The changes in index value shows that the market value of securities in the index increased
by 6.28% on day 1.
The market index indicates the changes in the broad market. The securities are chosen to
be in the index such that the market capitalisation of these securities forms a very high
percentage of the total market capitalisation of all stocks listed in the exchange.
8.3 Index Fund

An index fund is a collective investment scheme, which is usually a mutual fund that aims
to replicate movements of an index of a specified market. The idea of an index fund is
that the return from the fund would replicate the return of the index. Trying to hold all
of the securities that are in the index in the same proportion can create the index fund.
Statistically sampling the market and holding only a few representative securities in the
index can also create it. Computer programs decide which securities should be bought or
sold and the fund is usually managed passively.
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Since the index fund is managed passively, the fees are quite low. Moreover, it is very
difficult to exactly mirror the index. The difference between the return on the fund and
the return on the index is known as the tracking error.
Index fund can be created on any index. In Singapore, index fund is available on the Straits
Times Index.
There are many methods used for indexing, namely, traditional indexing, synthetic
indexing and enhanced indexing.
Traditional indexing is the practice of owning a representative collection of securities in

the same ratio as the target index and security holdings are changed only when companies
periodically enter or leave the index in which case securities of the companies that enter
the index will be bought and the securities of the companies that leave the index will be
sold.
In synthetic indexing, index futures and investment in low risk bonds are combined to
replicate the performance of an index.
Enhanced index funds use a number of enhancement techniques including customised

indexes, trading strategies, exclusion rules and timing strategies. The enhanced funds are
actively managed but have lower tracking costs.
The major advantages of index funds are low costs, lower turnover of securities in the
fund and no style drift of the fund. However, the fund cannot outperform the target index
and tracking error could be high.
8.4 Exchange Traded Funds (ETF)

An exchange traded fund is an investment fund traded on stock exchanges, similar to the
way stocks are traded. An ETF can hold stocks, commodities or bonds and trade at a price
close to its net asset value over the trading day. Most exchange-traded funds are based on
an index.
Authorised participants who are large institutional investors buy or sell shares of an
ETF directly from or to the fund manager in creation units, which are blocks of tens
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of thousands of ETF shares which are exchanged with baskets of underlying securities.
Authorised participants may wish to invest in ETF shares for long-term and usually act as
market makers in the open market. By using their ability to exchange creation units with
the underlying securities, they provide liquidity to ETF market and ensure that intra-day
market price is close to the net asset value of underlying assets.
Other investors such as individuals can trade ETF shares on stock exchanges using
brokers. ETFs can be created using many assets as follows:
i. Index ETFs – These are index funds that hold securities and attempt to replicate
the performance of a stock market index. The index ETFs can be created
by replicating the index or through representative sampling. If it is through
replication, the securities in the index with the same proportion as in the index
will be bought and held. In case of representative sampling, about 80% to 90% of
the investment will be in the stocks in the index and the rest invested in futures,
options, swaps and securities not in the index.
ii. Commodity ETFs – These invest in commodities such as precious metals and
futures. Of these, most common is the Gold ETF, which is traded in many
countries. Commodity ETFs trade just like shares and provide exposure to
commodities and commodity indexes.
iii. Bond ETFs – Bond ETFs use bonds as the underlying securities. They do well
during economic recessions when many investors pull their money out of stocks
and put it into bonds. Thus, performance of bond ETFs are considered as
indicative of broader economic conditions.
iv. Currency ETFs – Euro Currency Trust was introduced in 2005. These funds are
total return products where the investor gets access to foreign currency spot rate
changes, local institutional interest rates and a collateral yield.
v. Leveraged ETFs – This is a special type of ETF that attempts to provide returns
that are more sensitive to market movements. They can be marketed as bull funds
or bear funds. If it is a bull fund, the returns will be higher than the index return
and if it is a bear fund, the return will be considerably lower than the index
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return. These funds use financial engineering and use equity swaps, derivatives
and rebalancing.
8.5 American Depository Receipts (ADRs)

American depository receipts are the shares of a company that is domiciled in another
country. For example, the share of Singapore Airlines will be known as ADR if it is traded
in the NYSE.
In creating ADR, the issuer appoints a depository bank and provides a number of shares
to this depository bank. On receipt of the shares, the depository bank creates ADRs on
these shares and offers them to shareholders through a custodian in the other country.
Once the ADR is issued, they are traded as ordinary shares in the foreign stock exchange
where it is listed. The ADR holder is eligible to receive dividends. The ADRs may sell at
the same price as the underlying shares after adjusting for exchange rate, which is the net
asset value of the ADR. Some ADRs also sell at a premium or at a discount in relation to
the net asset value.
8.5.1 Global Depository Receipts

Global depository receipts are similar to American depository receipts in the sense that
these are shares of companies domiciled in a foreign country. The difference is that GDRs
are offered in many countries at the same time instead of in a single country as with ADRs.
Since GDR is offered in many countries at the same time, the price may be denominated
in either local currencies or a common currency such as the USD in each of the countries.
GDRs are created the same way as ADRs are and can be traded in stock exchanges.
8.6 Exchange Traded Notes (ETNs)

It is a senior, unsecured and unsubordinated debt security issued by an underwriting
bank. ETNs have a stated maturity and backed by the credit of the issuer.
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ETNs provide access to returns of various benchmarks and return on ETN is linked to
the performance of the market benchmark less investor fees. When an investor buys ETN,
underwriting bank promises to pay the amount reflected in the index minus the fees. Thus
the ETN holder also faces default risk of the underwriting bank.
ETNs are traded on the stock exchanges just like stocks. ETNs, however, do not own the
securities they are tracking. The major advantage of ETN is that there are no tracking
errors. It is also a liquid structured product. The major disadvantage is the default risk.
8.7 Real Estate Investment Trusts (REITs)

REIT is a certificate issued by a trust that holds real estate properties. The real estate
properties can be commercial properties or residential ones. The trust owns these
properties and manages them and earns cash flows through rental income as well as
through capital gains attained through sale of the properties. Generally, at least 90% of the
earnings are distributed to the shareholders.
8.8 Stapled Securities

A stapled security is an arrangement under which different securities are quoted jointly.
An example would be shares issued by a company and units issued by a trust. The
securities cannot be traded separately and the combined entity will be traded under one
name. These are traded like a stock in the stock exchange.
The trust component is managed by a responsible entity, which is the legal owner of the
assets of the trust and the manager of the trust.
Lesson Recording
Equity Related Securities
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1. Which of the following statement is correct?

a. Preference shareholders will always receive dividends
b. Preference shareholders will never get voting rights
c. Preferred dividends will be paid from before-tax income
d. Preferred shareholders will be paid before common shareholders in case of
liquidation
2. Initial Public offering

a. requires approval from existing public shareholders
b. requires approval from the exchange in which it will be listed
c. is offered only to financial institutions
d. will first be offered to existing shareholders
3. Rights of common shareholders include all of the following except,

a. Right to receive residual claims
b. Right to receive dividends
c. Right to elect the board of directors
d. Right to appoint managers
4. Which of the following statement is wrong?

a. Preference share is a hybrid security having the characteristics of both bond
and equity share
b. Preferred dividend will be paid only after bond coupons are paid
c. Both preference shares and bonds have stated maturities
d. In general, both bonds and preference shares make fixed payments every
period
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5. Which of the following statement is wrong with respect to a firm commitment

underwriting?
a. Underwriter receives a commission for the underwriting services provided
b. Underwriter takes the risk of the whole issue of the security not being sold
c. Underwriter makes money by buying the whole issue at a lower price from
the issuer and selling the same to investors at a higher price
d. Underwriter assures the issuer that the issuer will receive money for the whole
issue
6. Which of the following statements is wrong?

a. A rights offering provides the right for the existing shareholders to purchase
additional shares
b. Rights can be sold in the secondary market
c. By exercising the right, the shareholder can purchase additional shares at a
fixed price
d. Rights offering is used in initial public offering

a. An open-end fund share can be bought only from the fund itself whereas a
closed-end fund share is traded in exchanges
b. The shares of both open-end fund and closed-end fund will always bought at
the net asset value plus the front-end load specified
c. Closed-end fund shares can sell at net asset value or at a discount or at a
premium
d. The size of open-end fund can change based on the demand for the shares

a. An Index fund replicates the movement of the index
b. An index fund is passively managed
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c. The return from the index fund need not exactly equal the return from the
return on the index itself
d. An index fund is always based on the market index only

a. An exchange traded fund can be based on stocks or commodities or bonds
b. Exchange traded funds can be traded like stocks in stock exchanges
c. Exchange traded funds always trade at the net asset value of the fund shares
d. Most exchange traded funds are based on some index

a. Return from real estate investment trusts are based on the operation of real
estate properties owned by the trust
b. REITs can be issued as staples securities along with shares of the issuing
company
c. REITs generally provide a large dividend yield
d. Return from REITs come only from the rental income derived from the
properties
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1. Which of the following statement is correct?
a. Preference shareholders will always receive dividends
Incorrect. Answer is wrong because preference shareholders will receive
dividends only when the company makes profits
b. Preference shareholders will never get voting rights

Incorrect. Answer is wrong because preference shareholders will get voting
rights if the decision affects them
c. Preferred dividends will be paid from before-tax income

Incorrect. Answer is wrong because preferred dividends are paid from after-
tax income
d. Preferred shareholders will be paid before common shareholders in case of

liquidation
Correct. Answer is correct because the preferred shareholders must be paid
before common shareholders in case of liquidation
2. Initial Public offering

a. requires approval from existing public shareholders
Incorrect. Answer is wrong because shares are offered or the first time to the
public shareholders
b. requires approval from the exchange in which it will be listed

Correct. Answer is correct as IPO must be approved by the exchange in
which these shares will be traded
c. is offered only to financial institutions
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Incorrect. Answer is wrong because the shares are offered to the public and
not just financial institution in an IPO
d. will first be offered to existing shareholders

Incorrect. When shares are first offered to existing shareholders, it is called
rights offering and not IPO
3. Rights of common shareholders include all of the following except,

a. Right to receive residual claims
Incorrect. Answer is wrong as the common shareholders have the right to
residual claims
b. Right to receive dividends

Incorrect. Answer is wrong as common shareholders have the right to receive
dividends
c. Right to elect the board of directors

Incorrect. Answer is wrong as common shareholders have the right to elect
the board of directors
d. Right to appoint managers

Correct. Answer is correct as the common shareholders have the right to
only elect the board of directors and not the managers.

a. Preference share is a hybrid security having the characteristics of both bond
and equity share
Incorrect. Answer is wrong as the statement “Preference share is a hybrid
security having the characteristics of both bond and equity share” is correct
b. Preferred dividend will be paid only after bond coupons are paid
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Incorrect. Answer is wrong as the statement “Preferred dividend will be paid

only after bond coupons are paid” is correct
c. Both preference shares and bonds have stated maturities

Correct. Answer is correct as the statement “Both preference shares and
bonds have stated maturities” is wrong. Only bonds have stated maturities
and preference shares do not have any maturity
d. In general, both bonds and preference shares make fixed payments every
period
Incorrect. Answer is wrong as the statement “In general both bonds and
preference shares make fixed payments every period” is correct. Bond pays
coupon payment based on the coupon rate and preference share pays
preferred dividend at the rate indicated.
5. Which of the following statement is wrong with respect to a firm commitment

underwriting?
a. Underwriter receives a commission for the underwriting services provided
Correct. Answer is correct as the statement “Underwriter receives
commission for the underwriting services provided” is wrong. In a firm
commitment underwriting, the underwriter makes money by buying the
issue at a lower price from the issuer and selling them to investors at a
higher price. Through this, the risk of the issue not being sold fully rests
with the underwriter and the issuer is assured of receiving money for the
whole issue
b. Underwriter takes the risk of the whole issue of the security not being sold
Incorrect. Answer is wrong as the statement “underwriter takes the risk of
the whole issue of the security not being sold” is correct
c. Underwriter makes money by buying the whole issue at a lower price from
the issuer and selling the same to investors at a higher price
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Incorrect. Answer is wrong as the statement “underwriter makes money by

buying the whole issue at a lower price from the issuer and selling the same
to investors at a higher price” is correct
d. Underwriter assures the issuer that the issuer will receive money for the
whole issue
Incorrect. Answer is wrong as the statement “underwriter assures the issuer
that the issuer will receive money for the whole issue” is correct

a. A rights offering provides the right for the existing shareholders to purchase
additional shares
Incorrect. Answer is wrong as the statement “rights offering provides the
right for the existing shareholders to purchase additional shares” is correct
b. Rights can be sold in the secondary market

Incorrect. Answer is wrong as the statement “rights can be sold in the
secondary market” is correct
c. By exercising the right, the shareholder can purchase additional shares at a

fixed price
Incorrect. Answer is wrong as the statement “by exercising the right, the
shareholder can purchase additional shares at a fixed price” is correct
d. Rights offering is used in initial public offering

Correct. Answer is correct as the statement “rights offering is used in initial
public offering” is wrong. Rights offering is used for issue of additional
shares after initial public offering.

a. An open-end fund share can be bought only from the fund itself whereas a
closed-end fund share is traded in exchanges
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Incorrect. Answer is wrong as the statement “An open-end fund share can be
bought only from the fund itself whereas a closed-end fund share is traded
in exchanges” is correct
b. The shares of both open-end fund and closed-end fund will always bought
at the net asset value plus the front-end load specified
Correct. Answer is correct as the statement “The shares of both open-end
fund and closed-end fund will always bought at the net asset value plus
the front-end load specified” is wrong. The closed-end fund share is priced
in the market which may be equal to net asset value or a premium or at
discount
c. Closed-end fund shares can sell at net asset value or at a discount or at a

premium
Incorrect. Answer is wrong as the statement “Closed-end fund shares can sell
at net asset value or at a discount or at a premium” is correct
d. The size of open-end fund can change based on the demand for the shares
Incorrect. Answer is wrong as the statement “The size of open-end fund can
change based on the demand for the shares” is correct because the managers
of open-end fund will receive all money given to them as investment.

a. An Index fund replicates the movement of the index
Incorrect. Answer is wrong as the statement “An Index fund replicates the
movement of the index” is correct
b. An index fund is passively managed

Incorrect. Answer is wrong as the statement “An index fund is passively
managed” is correct
c. The return from the index fund need not exactly equal the return from the
return on the index itself
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Incorrect. Answer is wrong as the statement “The return from the index
fund need not exactly equal the return from the return on the index itself”
is correct. The return from index fund may not equal the return from the
index because of management expenses as well as because of the strategy of
creating the index through synthetic securities
d. An index fund is always based on the market index only

Correct. Answer is correct as the statement “An index fund is always
based on the market index only” is wrong. Index fund can be created on
commodities or sector indexes also

a. An exchange traded fund can be based on stocks or commodities or bonds
Incorrect. Answer is wrong as the statement “An exchange traded fund can
be based on stocks or commodities or bonds” is correct
b. Exchange traded funds can be traded like stocks in stock exchanges

Incorrect. Answer is wrong as the statement “Exchange traded funds can be
traded like stocks in stock exchanges” is correct
c. Exchange traded funds always trade at the net asset value of the fund shares
Correct. Answer is correct as the statement “Exchange traded funds always
trade at the net asset value of the fund shares” is wrong. The ETFs may
sell at a price different from the net asset value because of management
expenses
d. Most exchange traded funds are based on some index

Incorrect. Answer is wrong as the statement “Most exchange traded funds
are based on some index” is correct
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a. Return from real estate investment trusts are based on the operation of real
estate properties owned by the trust
Incorrect. Answer is wrong as the statement “Return from real estate
investment trusts are based on the operation of real estate properties owned
by the trust” is correct
b. REITs can be issued as staples securities along with shares of the issuing
company
Incorrect. Answer is wrong as the statement “REITs can be issued as staples
securities along with shares of the issuing company” is correct
c. REITs generally provide a large dividend yield

Incorrect. Answer is wrong as the statement “REITs generally provide a large
dividend yield” is correct. REITs are expected to pay at least 90% of the
earnings as dividends to REIT holders
d. Return from REITs come only from the rental income derived from the
properties
Correct. Answer is correct as the statement “Return from REITs come only
from the rental income derived from the properties” is wrong. The return
comes not only from rental income but also from capital gains derived from
selling properties
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5
Study
Unit
FIN301
Learning Outcomes
• Analyse the characteristics of derivatives markets

• Describe the nature of forward contracts and futures contracts
• Examine how forward contracts and future contracts are created
• Examine how futures contracts are traded
• Analyse the characteristics of Options and Swaps markets
• Examine how option contracts, swap contracts and credit derivatives contracts are
created
• Discuss how options contracts are traded
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Overview
Derivative markets are created to trade derivative instruments such as forward contracts,
futures contracts, options contracts and swap contracts. These markets allow individuals
and businesses to hedge risks of changing prices. In Chapter 9, we will discuss how
forward contracts and futures contracts are created and traded.
In Chapter 10, we will discuss how options contracts and swap contracts are created and
traded as well as how these contracts are used to hedge risk. We will also discuss the
nature of credit derivatives.
Read
Chapter 10 of “Financial Markets and Institutions”, Saunders and Cornett, Sixth

International Edition, (2015).
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Chapter 9: Derivatives Market and Instruments
All investors have an opportunity to invest in real assets or financial securities. Real assets
are assets such as land, buildings, precious metals and machinery. An investor would get
returns from the investment in real assets from changes in the price of these assets.
A financial asset, on the other hand, is a claim on the issuer of financial security. Examples
of financial security would be bonds or equity securities issued by corporations. The issuer
of the bond will issue a piece of paper to the buyer indicating that the company is indebted
to the buyer for the face value of the bond and will promise to make periodic coupon
payments as stated in the paper. Thus, the buyer of the bond is eligible to receive the
amount that was stated by the issuer at the time of issue of the bond. The issuer will use
the funds raised through the issue of bond to purchase real assets in business and generate
cash flow, which would then be used to make payments to the bondholders.
Equity securities provide ownership stake in the business. Through issue of shares, the
company raises funds to purchase real assets and by using these real assets, the company
will generate profits. The issuer of share promises to provide a share of the profits as
dividends and also allow residual claim on the assets.
Thus, the proceeds from bond and equity issue are used to purchase real assets and
use them to generate cash flows. Though the return to the bondholder is fixed if the
company is able to make periodic payments, the return will be uncertain if cash flows
generated by real assets are not sufficient to make payments due to the bondholders. The
return to shareholders depends on the profits, which, in turn, are dependent on the cash
flow generated through the use of real assets. Therefore, bonds and equity shares can be
considered, as claims on the cash flow generated by companies utilising the real assets,
which are procured by funds raised through the issue of these securities and the value of
these securities will depend on the cash flows generated from using real assets.
A derivative security realises its value from the value of the asset, which forms the basis
of the derivatives contract. The asset whose value determines the value of the derivatives
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contract is known as the underlying asset and the value of the derivative security will
change depending upon the changes in the value of the underlying asset. The underlying
asset could be a real asset such as gold, oil or other commodities, in which case they are
called commodity derivatives. If the underlying asset is a financial security, the derivatives
are called financial derivatives. Derivatives can also be based on changes in the credit-
worthiness of the companies and these are called credit derivatives. Derivatives can also
be created on events, which can have an impact on the operations of the business. For
example, weather derivatives are used when a company’s business and cash flows are
subject to changes in the weather pattern.
9.1 Derivative Markets

Derivatives are traded in either over-the-counter market or in organised exchanges. Over-
the-counter market contracts are between private parties and the terms and conditions of
the contract are decided between the two parties of the contract. The major problem in
over-the-counter market is searching for a party willing to enter into the contract. Brokers
solve this problem by bringing these parties together. Over-the-counter market contracts
are generally unregulated and less transparent.
Exchange-traded contracts are traded on derivatives exchanges. These exchanges decide

on the terms of the contract and the parties can trade these contracts in a manner similar to
the trading of shares in a stock exchange. Exchanges are regulated and offer transparency.
9.2 Major Derivatives Contracts

There exist a large number of derivatives contracts but they can be grouped together to
form four distinct classes of derivative securities. They are:
i. Forward contracts
ii. Futures contracts
iii. Options contracts
iv. Swap contracts
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Of these, forward contracts are traded mainly in the over-the-counter market whereas
futures contracts trade mainly in derivatives exchange. Option contracts are traded both in
over-the-counter market and derivatives exchanges. Swaps are generally traded in over-
the-counter markets.
While commodity and financial derivatives are traded in both over-the-counter and
derivative exchanges, credit derivatives trade mainly in over-the-counter markets.
9.3 Risks faced by Hedgers

Participants in derivative markets can be classified into hedgers, speculators and
arbitragers, based on the motive with which they trade in the market.
Hedgers are traders who face a risk and would like to reduce the risk. The major risks
faced by hedgers are commodity price risk, financial security price risk, interest rate risk,
exchange rate risk and credit risk.
9.3.1 Commodity Price Risk

This risk is faced by both producers of commodity and users of the commodity; if the
commodity is an agricultural product such as rice, farmers who produce rice are not sure
what the price of rice would be at a future time and the price could increase or decrease
from the existing price level. If the price increases, it is beneficial to the producer who
plans to sell the asset at a future time whereas cash flow from sale of asset would be lower
if the price decreases. This unknown future price causes price risk for the producer of the
commodity. For the user of the commodity, the unknown price in the future will have
impact on future cash flow required to buy this commodity. Any price increase would
require higher cash outflow whereas a price decrease would need lower cash outflow.
9.3.2 Financial Security Price Risk

Fund managers, individuals and institutional investors in financial securities will face
price risk from financial securities. If the price of financial securities increases, the value
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of the portfolio will increase which will increase the return from the portfolio whereas any
decrease in the price of financial securities will decrease portfolio value and the return.
9.3.3 Interest Rate Risk

Interest rate risk affects individuals and institutions that have borrowed or lent money. If
the loan terms are based on a floating interest rate, both borrowers and lenders will face
interest rate risk as future cash flows based on unknown future interest rate is uncertain.
Even if the loan terms are on fixed interest rate, the lender faces interest rate risk because
periodic coupon payments will have to be reinvested at an unknown interest rate. If
lending or borrowing is planned for a future time, this will have to be done at an unknown
interest rate. Bond fund managers face interest rate risk as value of bonds is based on
interest rate and if interest rate increases, the value of the bond portfolio will decrease.
9.3.4 Exchange Rate or Currency Risk

Individuals and companies who have future cash flows denominated in a foreign currency
face exchange rate risk or currency risk. An importer of goods needs to pay foreign
currency at a future time and faces a higher cash outflow if the foreign currency
appreciates whereas an exporter of goods who would receive foreign currency at a future
time will have a lower cash inflow if the foreign currency appreciates. Investors who have
invested in financial securities denominated in foreign currency also face the currency
risk.
9.3.5 Credit Risk

Creditors to a company face credit risk. If the credit rating of the company goes down, or
if the company gets into financial trouble, the company may not be in a position to make
payments to creditors devaluing the claim against the company, leading to credit risk.
The derivative securities allow hedgers to reduce the risk. The derivative securities are
valued such that their value is related to the value of the underlying securities. If any
change in price of underlying asset is likely to affect the hedger such that a loss will be
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made, he can trade in derivative securities such that the latter will provide a gain. If the
gain from the derivative security exactly matches the loss from the underlying security,
that is, net gain or loss is zero, it is considered a perfect hedge. If the gain from derivative
security is less than the loss from the underlying security, there will be a net loss but this
loss would be smaller than the loss for the hedger than if he did not use derivatives at all.
Such hedges are called partial hedges.
If the hedger owns an asset and plans to either sell the same at a future time or hold it for
a long-term, the value of the holding will depend on the movement in price. In this case,
the hedger is said to have a long position in the asset. If the hedger currently does not own
an asset but plans to buy it at a future time, he runs the risk of paying a higher price at a
future time in case the price increases. Such hedgers are said to have a short position in
the asset. The motive for hedgers to enter the derivatives market is to reduce the risk from
changing prices of the underlying asset.
9.4 Role of Speculators

Speculators, on the other hand, hold no position in the asset – neither long, nor short.
Instead, they enter the market to make a profit by betting on the movement of the price
of the underlying asset. While they can take a position in the underlying asset to make a
profit, taking a position in the derivative market is advantageous as the cost of trading as
well as the amount of cash needed to trade derivatives is much lower than trading in the
underlying derivative markets. In addition, speculators also provide for an active market
and contribute towards higher liquidity in the market.
9.5 Role of Arbitragers

The role of arbitragers is very important. Since the derivative security is written on an
underlying security, the value of the derivative security and the value of the underlying
security are related. For a given price of the underlying security in the market, the value
of the derivative security can be estimated using the relationship between the two prices.
If the actual market price of the derivative security deviates from the price calculated
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based on the relationship, there will be an arbitrage opportunity and an arbitrager will be
able to make a profit with no risk and no net investment. No net investment will occur
because arbitrage transactions require simultaneous buying of the asset that is relatively
undervalued and selling the asset that is relatively overvalued. Thus, arbitragers eliminate
mispricing in the two markets.
9.6 Forward Contract

A forward contract provides the holder of the contract the right to buy or sell the
underlying asset at a future time at a price that is agreed upon at the time of entering into
the contract. Typically, forward contracts are short-term and are non-negotiable, and the
two parties who enter into the contract will have to fulfill their obligations at the maturity
of the contract. Private parties generally enter into forward contracts and hence they are
over-the-counter market contracts. Typically, forward contracts result in perfect hedges.
Example:
James is a rice farmer and has planted rice, which will be harvested in January and will
be ready for sale on February 1. On November 1, rice is selling in the market at $2 per kg
and he expects that he will have 20,000 kg of rice to sell on February 1. However, he faces
price risk because he does not know what the price of rice will be on February 1.
John, the manager of a rice noodle factory plans to buy 10,000 kg of rice on February 1
when rice comes to the market and he also faces a price risk as he does not know what
price he needs to pay on February 1.
Suppose John and James meet on November 1 and agree that James will sell 10,000 kg of
rice to John and the price at which the rice will be sold is fixed at $2.50.
Consider what happens on February 1. John will have to pay $25,000 to James and James
will have to deliver 10,000 kg of rice to John irrespective of the market price of rice. If the
market price is $2.50, both James and John are happy as entering into a forward contract
resulted in the same cash flow as trading in the market on February 1. If the market price
is $2.25 on February 1, James is better off as he received $25000 under the forward contract
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compared to $22,500 he would have received if he had sold at the market price. On the
other hand, John needs to pay $25,000 rather than $22,500 he would have paid at the
market price. Similarly, if the market price was $2.75, John would benefit from forward
contracting whereas James would receive a lower amount compared to what he would
have received if he sold at market price.
This example shows that one party could gain at the expense of the other when entering
into a forward contract but both parties can be sure of the exact cash flow that would
occur on February 1. That is the purpose of a forward contract; even though it may result
in a gain or a loss compared to trading in the market without entering into the forward
contract.
Forward contracts are available to hedge price risk of commodities, interest rates and
exchange rates. Commodity forwards are used to hedge commodity price risk, forward
rate agreements are used to hedge interest rate risk and currency forwards are used to
hedge exchange rate risk.
The major advantages of a forward contract are:
i. These can be structured to the needs of the hedger. Note that hedgers are the
main users of forward contracts. Due to the non-negotiability of these contracts,
speculators will not use these contracts because if the price moves against them,
which will result in a loss, they cannot get out of the contract. Arbitrage is
possible only when the contracts are negotiable.
ii. They always result in perfect hedges as the contract fixes the price at which the
exchange will take place.
However, there are a number of drawbacks while using forward contracts:
i. Non-negotiability – Since the party entering into the contract has to fulfil the
obligation and cannot transfer the obligation to a third party, the party cannot
get out of the contract even if the party knows that the price is moving against
him over time.
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ii. Counter party risk – This is the risk that one of the parties to the contract may
not fulfil the obligations under the contract. If this happens, the other party will
have problems and also will face losses. Only remedy for the party is to take legal
action against the other party, which could be expensive and time consuming.
iii. There could be cash needs when the party is entering into a forward
contract. Even though the exchange takes place at maturity of the contract, the
counterparty may require some assurance that the obligation will be fulfilled.
The cash needs may be in the form of compensating balance if the counterparty
is a bank or it could be some form of performance letter of credit.
9.7 Futures Contract

A futures contract is an agreement between two parties in which one party agrees to buy
or sell a fixed quantity of a specified underlying asset at a fixed future time at a price
determined at the time of entering into the contract.
If the definition of the futures is compared to that of the forward contract, it can be seen
that both are defined exactly the same way. There are, however, a number of significant
differences between a futures and forward contract:
i. The forward contracts are non-negotiable. This means that one of the parties to
the contract cannot transfer the obligations under the contract to a third party.
However, futures contracts are negotiable. The contract can be transferred to
another party before maturity through trading in the exchange and in many cases
it is quite likely that the contract changes hands many times before maturity.
ii. Forward contracts are over-the-counter contracts between two private parties.
Futures contracts are traded in organised derivatives exchanges in which one can
trade the futures in a similar manner as shares are traded in stock exchanges.
iii. Forward contracts are custom made contracts in which the underlying asset,
maturity of the contact, quantity of the underlying asset and the forward price
which is the price at which future exchange will take place are negotiated
between the two parties. It is possible that A and B can entire into a forward
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contract to trade 1000 kg of Grade A rice on April 15 with a forward price of $2

per kg while C and D can enter into a forward contract to trade 1000 kg of Grade
A rice on April 15 with a forward price of $2.10 per kg when both contracts are
entered into on the same day. In forward contracts, the quantity and quality of
the underlying asset, maturity of the forward contract and forward price can be
different as forward contract terms are set by the two parties and these contracts
are non-negotiable.
However, since futures contracts are negotiable and are traded on derivatives exchanges, it
is necessary that all traders are aware of the terms of the contract. The terms of the futures
contracts are determined by the exchange and details of the contract specifications are
made available to all participants. Since the purpose of trading in exchanges is to provide
an active market, the exchange will introduce futures only on those underlying securities
for which there is an active demand and the quantity of the asset is determined so that
it will attract large number of traders. The contract specifications provide details of the
following:
9.7.1 The Underlying Asset

If the underlying asset is a commodity, there may be quite a variation in the quality of
what is available. Therefore, the futures contract must specify the grade or grades of a
commodity that can be delivered under the contract. For example, a gold contract will
state, “not more than 999.9 fineness bearing a serial number and identifying the stamp of
a refiner approved by the exchange.”
In case of financial futures, futures contracts are well defined and there may be no need
for specifying the grade. In case of currency futures, underlying currency will be stated. In
case of single stock futures, the name of the stock will be specified. If it is an index future,
the name of the underlying index will be specified. However with bond futures, it may
be necessary to specify a coupon rate of the bond, as there may be many bonds available
with different coupon payments.
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9.7.2 Contract Size

The contract size specifies the amount of the asset that is deliverable under the contract.
This size needs to be determined carefully by the exchange such that a large number of
traders will be attracted to provide for active trading.
In commodity contracts, the contract size will be based on the standard units in which they
usually trade in spot market. For example, a cashew contract may be 50 cartons with each
carton having a net weight of 22.68 kg. In currency futures, the contract size will be stated
as value of the currency on which futures are written on, for example, USD 1000 for US
dollar futures. In bond futures, size will be in terms of the face value of the bonds, say face
value of $50,000. In case of single stock futures, the contract size will indicate the number
of shares; say 1000 shares of Singapore Airlines. In case of index futures, a multiplier will
be used. It can be stated as 100. If STI is at 2000, the size of the contract will be 2000 * 100
= $200,000.
9.7.3 Delivery Arrangements

a. Location ‒ This is the location at which the person who has a short position should
deliver the underlying asset to the person who has a long position. This is very important
for commodities where transportation costs could be high.
However, the exchange will also provide alternative locations where delivery can take
place. If the commodities are delivered in alternate location, the price at which delivery
will take place will be adjusted appropriately by the exchange according to the location
chosen for delivery.
In case of financial futures, delivery is usually in the form of book entry. In order to trade
financial futures, traders will open an account with the clearing system of the exchange
and in case of delivery, sellers’ account will be debited and the buyer’s account will be
credited with the asset and simultaneously, the buyer’s bank account will be debited and
seller’s bank account will be credited.
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b. Alternative Grade ‒ In case of commodities and financial assets where different grades
are available for delivery, a range of grades can be delivered with the price of the contract
adjusted by the exchange, depending on the grade chosen for delivery. The alternative
grades that are accepted for delivery are also provided by the exchange. The option to
deliver at alternative location or alternative grade is given to the person who has a short
position in futures who has to make delivery of the asset.
9.7.4 Maturity
The maturity of the contract is also specified by the exchange. Usually, maturity is stated
as the month in which the contract expires such as January futures or June futures. For
the same underlying asset, there can be many futures contracts with different maturities.
Commonly, most futures contracts have maturity in 3-month cycles such as January,
April, July and October or February, May, August and November cycles. At any one
time, there will be 4 futures contracts available, which in the case of January cycle in
the month of January will be, futures expiring in January, February, March and April.
When January contract expires, May contract will be introduced letting four contracts
available for hedging over a 12-month period. There can also be longer-term contracts if
the exchange believes there is a need from hedgers for such longer-term contracts.
Though the contract is referred to by its delivery month, the exchange also specifies the
exact date during the month on which delivery will take place. For example, the delivery
date may be stated as 20th day of the delivery month and 20th turns out to be a holiday;
delivery would be on the next working day.
9.7.5 Delivery Notification

In futures contracts, most of the contracts are closed-out before maturity (closing-out a
position will be discussed in the next section). Moreover, when one enters into a futures
contract with another party, the details of the trade will be entered into books of the
exchange with the exchange as the counter party. For example, A may buy the contract
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from B but books will just enter A as the buyer and B as the seller. Since these contracts
are negotiable, B may sell the contract to C in which case C is the person to deliver.
Assume that A decided to purchase the asset under the futures contract. Then he needs
to notify the exchange that he intends to take delivery. This period during which notice
should be given to the exchange is known as the tender period. The tender period will be
for five working days, during the trading hours, prior to and including the expiry date
of the contract. Once the person with a long position has tendered the intention to take
delivery, the exchange will randomly assign a person with a short position to fulfil the
contract. The person chosen randomly has the obligation to deliver the asset. The day on
which the contract will be settled through delivery is known as pay-in and payout. It is
stated as (T+n) basis where n is the number of days from the delivery date by which the
seller delivers the asset and the buyer pays cash. If n=1, the contract will be settled the
day after the delivery date.
9.7.6 Daily Price Movement Limits

When futures are traded, speculative action is likely to cause substantial price movements.
In order to protect traders from wide fluctuations on a single day, daily price movement
limits will be specified by the exchange.
If the price moves down equal to the daily price limit, the contract is said to be limit down,
while it is limit up if the price moves up by an amount equal to the daily price limit. In
either case, trading will be halted for the day. However, the exchange has authority to
change the limits. As the price of futures is related to the spot price of the underlying asset,
if there is substantial price movement in the spot market, it will lead to substantial price
movement in futures exchanges. In such cases, stopping the trade in futures market will
prove to be unwise and the exchange can step in and change the limits.
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9.7.7 Position Limits

The position limit refers to the maximum number of contracts that can be held by a
single trader. The purpose of position limits is to prevent speculators from exercising any
influence on the market or to prevent any particular trader from cornering the market.
9.7.8 Closing out the Position

Closing out the position means that the trader has entered into an offsetting transaction. A
person is said to open a position when he enters into a future contract. The position could
be a long position in which case he agrees to buy the underlying asset or a short position
in which case he agrees to sell the asset. When a trader enters into a futures contract, he is
said to have an open position.
If a person with short position in futures holds the contract, he needs to make delivery
and if the open position is a long position, he needs to take delivery on expiry date of
the contract. However, if the trader does not want to take delivery on expiry date, he
can always enter into an offsetting position by taking a short position in the contract
before expiry date. This short position will match the original long position resulting in
no position in futures for the trader. This is known as closing out the position.
If the trader is a speculator, he enters the futures market based on his expectation about
how the futures price will move. If he believes that the futures price will increase in a
short time period, he will take a long position and if price does increase in a short-time
period, he will close the position by taking a short position at a higher price. The difference
between the price at which he closed out and the price at which he opened the position
will be his gain. Thus closing out the position is normal for a speculator.
How about the hedger who is trying to fix a price for the asset at a future time? If he keeps
the contract till maturity, he knows the exact price at which he will buy or sell the asset
whereas he may face the risk of unknown price if he decides to close the position before
maturity. Under what circumstances would a trader close the position?
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Consider a hedger who takes a long position in future whereby he agrees to buy the asset at
a future time at a given price. In case futures price increases over time, it is beneficial for the
hedger because he can buy the asset at a lower price through futures. On the other hand, if
the futures price decreases, the hedger will be paying a higher price through futures. Note
that changes in future price will mirror the changes in the spot price. If the spot price and
future price have decreased and if the hedger believes that the spot price will decrease
further by the time the contract expires, the best option for him to limit the losses is to
close the position at the current time and buy the asset in the spot market. Thus closing
out the position may result in lowering the losses.
Another reason for closing out would be because of the delivery option given to the person
who has a short position. Since the seller can either deliver at alternate location or deliver
an alternate grade, the buyer may not want to take a chance and instead close out the
position and buy in the spot market. The seller may also close the position out because of
transportation cost involved in delivery and closing out may be a better option. Hedgers
usually close out their position close to the expiry date of the contract and unless there is
a substantial price movement in a short time period between closing out the position and
the expiry date, the actual price will be closer to the contracted price.
9.7.9 Arbitrage between Futures Market and Spot Market

During the delivery period, the futures price should be equal to the spot price of the
underlying asset. If the two prices are not the same, there will be an arbitrage opportunity.
If the futures price is more than the spot price, one will take a short position in futures
promising to sell at futures price and simultaneously buy the asset in spot market at a
lower price and deliver at a higher price earning a profit. If futures price is less than spot
price, one can take a long position to buy at a lower futures price and sell the same at the
higher spot price, earning profit.
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9.7.10 Performance of Contracts

The major advantage of futures traded on the exchange is that the futures exchanges
have instituted mechanisms by which non-performance of contracts is eliminated. This is
accomplished through:
• Creation of a clearing house

• Institution of margins
• Marking-to-market all contracts
9.7.10.1 Clearinghouse
The exchange-clearing house is a part of the futures exchange and acts as an intermediary
in all transactions. If A goes long in futures and B goes short in futures, the clearing house
will interpose itself in the contract such that the counter party to A as well as for B is
the clearing house. Since the counterparty to each transaction is the clearinghouse, the
performance is guaranteed. Even if one of the parties defaults on the obligation, the other
party will not suffer.
The clearinghouse has members called clearing members. All transactions taking place
in the exchanges will have to be cleared through clearing members before they can be
recorded in the books of the exchange. By clearing the transaction, clearing member
guarantees the clearinghouse that the clearing member will fulfil the obligation even if
the party that enters into the contract defaults.
Each clearing member is required to maintain a margin account with the clearinghouse.
Margin is a certain percentage of the contract value that is cleared by the clearing member
and this amount will have to be provided by the clearing member to the clearinghouse.
The margin percentage for each contract is provided by the exchange, usually calculated
on the basis of price volatility of futures. This margin amount is known as clearing margin.
Since clearing members are clearing transaction for others, clearing member will require
that the broker who requested clearing to provide the margin amount which will be
collected by the broker from the trader.
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9.7.10.2 Margins and Marking-to-market

The margin amount in futures contract is more like a ‘good-faith’ deposit made by the
trader to the broker whereby the trader indicates his intention to fulfil the obligations
under the contract. This amount is known as the initial margin.
The margin account will be maintained by the broker from the time the trader took an
open position and will be kept until the trader closes the position or until the expiry of
the contract whichever occurs first. The broker also updates the margin account every
day using the closing price of the futures contract. The process of updating the margin
account on a daily basis is known as marking to market. If there is a gain to the trader on
a given day, the gain will be added to the existing margin balance whereas any loss to the
trader will be subtracted from the existing margin balance. Note that any price increases
will result in gain to the trader with long position and result in loss to the trader with the
short position. Similarly, price decrease will provide gain to the trader with short position
and loss to the trader with long position. The price could move in such a way that the
losses accumulate causing the margin balance to be very low. In this case, the possibility
that the trader would default would increase. Since the purpose of margin is to show
good faith that trader will fulfil the obligations, exchange also requires that the margin
balance should not go below a certain level. This minimum level of margin that should
be maintained is known as the variation margin. If the margin balance goes below the
variation margin, the broker will issue a margin call, which requires the trader to provide
additional funds so that margin balance reaches the level of initial margin. If the trader
does not respond to the margin call, the broker is authorised to close out the position and
return the margin account balance to the trader.
This process will continue till the day on which the trader closes out the position or the
day of expiry of the contract. If the trader closes out the position, the amount in the margin
account will be returned to the trader.
In case the trader wants to take delivery, cash will be paid to the broker and the balance
in the margin account will be returned to the trader.
Example:
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Assume that John has entered into 5 long gold contracts at $100 each on June 1, a Monday,
each gold contract is for 100 grams and the price is quoted per gram. He closes out the
position on June 12, which is a Friday. There is no trading on Saturday or Sunday. The
initial margin is 6% of the value of the contract and variation margin is $1000.
The price of gold for June 1 to June 12 is given below:
Date Futures Price
June 1st 100
June 2nd 102
June 3rd 98
June 4th 97
June 5th 95
June 8th 96
June 9th 98
June 10th 100
June 11th 101
June 12th 102
Since the contract is long contract, price increases will result in gain and price decrease
will result in losses. On June 1, value of contract= price per gram * contract size* number
of contracts, i.e., 100* 100* 5= $50,000
Initial margin = 6% of value= $50,000* 6%= $3,000
The margin account will be as follows:
Date Futures Total Daily Cumulative Margin Margin

Price Value of 5 Gain/ Gain/ Account Call
Contracts Loss Loss Balance Amount
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June 1st 100 50,000 ----- ----- 3,000
June 2nd 102 51,000 1,000 1,000 4,000
June 3rd 98 49,000 (2,000) (1,000) 2,000
June 4th 97 48,500 (500) (1,500) 1,500
June 5th 95 47,500 (1,000) (2,500) 3,000

2,500
th
June 8 96 48,000 500 (2,000) 3,500
June 9th 98 49,000 1,000 (1,000) 4,500
June 10th 100 50,000 1,000 ----- 5,500
June 11th 101 50,500 500 500 6,000
June 12th 102 51,000 500 1,000 7,000
On June 12, when the trader closes out the position, he would receive $7,000 made up of
the initial margin of $3,000, amount provided at margin call of $2,500, and gain of $1,500.
9.7.11 Price Quotes

The futures quote includes the following:
• Asset underlying the futures contract

• Contract size
• How the price is quoted (in kg, tons, ounces, etc.)
• Maturity of the contract in month of expiry
• Opening price
• Highest price during the day
• Lowest price during the day
• Settlement price
• Change in settlement price
• Open interest
• Volume of trading
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Settlement price is normally the average of the prices at which the contract was traded
immediately before the end of trading for the day. Each exchange has its own procedure
to calculate the settlement price.
Marking-to-market of margin accounts is done using the settlement price. In case there is
no trade during the period in which settlement price is calculated, the settlement price will
be the theoretical futures price calculated using the spot price. Volume of trading is the
total number of contracts traded during the day. Open interest refers to the number of long
or short contracts outstanding on any given day. Open interest is of importance in futures
trading as it provides an indication of the liquidity of the contract. If there is an increase
in open interest, it indicates that more number of contracts is available for delivery and
when open interest is high and if a trader wants to close the position, it will be easy to do
so as compared to a situation when open interest is low. Typically, open interest increases
over time but starts decreasing as the expiry date nears when many traders close their
position.
9.7.12 Delivery
The period during which delivery can be made is decided by the exchange and varies
from contract to contract. The party that holds a short position in futures will determine
the exact delivery time. When a party decides to deliver, he will inform the broker and
broker will inform the clearinghouse through a clearing member. The notice of intention
to deliver will state the number of contracts, location of delivery and grade of the asset
that will be delivered. The exchange will randomly choose a party with a long position
to take delivery. The exchange will adjust the price of the contract according to the notice
of intention. Not all contracts require delivery of the asset. Some contracts such as index
futures are based on non-traded assets and hence cannot be delivered. In some exchanges,
even if the assets are traded, exchange may decide on non-delivery of the asset. In these
cases, the contracts will be based on cash settlement.
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9.7.12.1 Cash Settlement

When futures contracts are subject to cash settlement, the contract will be marked-to-
market on the expiry date using the settlement price on that day which is usually the
closing spot price of the underlying asset. There will be no delivery of the asset and balance
in the margin account will be returned to the trader.
9.7.13 Trading System

The trading system could be either open-outcry system or electronic platform similar to
the systems used in stock exchanges. Almost all exchanges use the electronic platform
utilising order driven strategies.
Orders as they arrive are stamped with the time of order and are immediately processed
for potential matches. If a match is not found, the orders are stored in different books.
Orders are sorted according to the time priority in the following sequence:
• First, according to the best price

• Second, according to time
Whether it would be stored according to the best price or time depends on the type of
order placed.
The various types of orders used in future exchanges are:
i. Market order that will be executed immediately at the best possible price.
ii. Limit order in which a limit price will be set by the trader and will be executed
at the limit price or better.
iii. Stop-loss order in which the trader will set a stop price and if the market price
touches the stop price, the order will become a market order.
iv. Immediate or cancel order in which order will be executed immediately and if
not, the order will be cancelled.
v. Good-till-day order in which order will have to be executed within the day on
which the order is placed and if not, the order is cancelled.
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vi. Good-till-cancelled order in which order will be on the books until the trader
cancels it.
vii. Good-till-date order is an order, which will remain on the books until the date
mentioned in the order.
All these orders are similar to the orders used in stock exchange. In addition to these
orders, traders can also place spread orders. Since there are many futures available on the
same underlying asset with different maturities, a trader can place two orders at the same
time to trade two futures contracts with different maturities on the same underlying asset.
This is known as spread order. Usually an order will be to buy futures with one maturity
date and the other order will be to sell futures with different maturity. In case of spread
orders, margin account will be maintained for both orders together.
The order matching rules are similar to the rules in the stock exchange. First, the best buy
order will be matched with the best sell order and partial matching is also possible. The
orders that are not matched will remain in the system until they are matched at a future
time or until the trader cancels them.
9.7.14 Clearing and Settlement System

Clearing means that the transactions concluded in the exchange are clearly recorded and
when a trader closes the position, the resultant cash and delivery arrangements, known as
settlement, are carried out. Futures exchange has a clearing corporation as its subsidiary
that carries out these functions.
The clearing and settlement system is the most important part of a derivatives exchange.
When traders enter into derivatives contract, the system should be such that their orders
are correctly entered into the system and when the contract expires or when the trader
closes out the position, there is no default and traders receive the money made from the
contracts. The clearing and settlement system is designed to provide for this.
The main function of clearinghouse is to guarantee the performance of all contracts

entered into by the traders on the exchange. This is performed by the clearing members
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who clear the trade by taking the position of counterparty for that trade. In addition,
clearing corporation uses margins and marking-to-market of margin to ensure that the
traders have the intention to fulfil the contracts.
Settlement means that the parties settle their obligations under the contract. In futures,
there are two settlements: (a) daily mark-to-market settlement, and (b) final settlement.
Margin accounts are updated daily using the settlement price of that day. This is known
as the mark-to-market settlement. The final settlement takes place on the expiry of the
contract. If the contract is for physical delivery of the asset, the final settlement will require
one party to deliver the asset and the other party to provide the agreed upon cash. If the
contract is cash-settled, the party that loses will pay the other party. However, all payments
will be made to the clearinghouse, which will pass the money to the other party. The
amount that is to be paid to the exchange by any outside party is known as pay-in and the
amount that is paid by the exchange is known as payout.
9.7.15 Trading Process

The mechanism of trading, clearing and settlement in a futures exchange is explained
through an example.
John, manager of a mutual fund, wants to reduce the risk of the value of portfolio going
down through futures contracts. The steps in trading are:
Step 1: John will contact a broker who is authorised to trade in derivatives. John can place
either market order or limit order. We will discuss the procedure for both market order
and limit order.
Step 2: The broker will access the order book of the exchange and key in the order placed
by John. The market order specifies the quantity and not the price. The order book will
contain details of all orders received from different brokers classified on the basis of both
time and price. If there is a corresponding matching order available in the books, the
broker will match the order and the information will be recorded in the computer of the
exchange. If the order is a limit order, the broker will enter the order in the order book and
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the system will try to find a matching order. If a matching order is found in the system, the
computer will automatically match the two orders. If there is no matching order found,
the order will remain in the book until a match is found at a later time or until the trader
cancels it.
Step 3: If the order is executed, the broker will have to get the order cleared by a clearing
member. The broker will approach a clearing member to clear the trade and when it is
cleared, the exchange will notify the broker that the order has been cleared.
Step 4: The broker will notify John that the contract has been cleared and ask John to post
the necessary margin.
Step 5: The broker will maintain the margin account and mark-to-market the margin
account daily. Broker will issue a margin call in case the margin balance goes below
variation margin, requiring John to provide additional money equal to the difference
between the initial margin amount and the margin account balance.
Step 6: At maturity, the contract will be settled. The settlement price will be notified by the
exchange and the margin account will be updated using the final settlement price. In case
John decides to close out the position before maturity, he will notify the broker and the
broker will trade in the exchange in a similar manner as when John opened the position.
The margin account will be updated using the settlement price of the trade. If the margin
balance is positive, the broker will credit the bank account of John with that amount. If
the margin balance is negative, the broker will debit the bank account of John with that
amount.
If, at maturity, John needs to make delivery of the asset, John will deliver the asset as per
the delivery notification and cash will be credited to his bank account by the exchange on
the payout date. Similarly, if John needs to take delivery, his bank account will be debited
by the exchange on pay-in date. In both cases, the amount remaining in margin account
will be returned to John.
Many exchanges allow online trading by investors. In order to do so, customers will have
to sign up with the brokerage firm and the brokerage house will provide the software
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necessary that allows the customer to trade using the broker’s platform. The customer can
place the order to buy or sell derivative contracts using the software provided. Once the
orders are matched, the broker initiates the procedures to clear the transaction. The broker
will be responsible for maintaining the margin account.
9.7.16 Futures Contracts Traded

Common futures contracts traded in the exchanges are:
i. Commodity futures written on commodities

ii. Currency futures written on foreign currencies
iii. Single stock futures written on individual stocks
iv. Index futures written on stock indexes
v. Interest rate futures written on Treasury bonds
vi. Eurodollar futures written on Eurodollar interest rate movement
Lesson Recording
Derivatives Markets and Instruments
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Chapter 10: Options, Credit Derivatives and Swaps
10.1 What is an Option?

One of the major problems with forward and futures contracts is that these contracts will
provide gains if the underlying asset price moves against the hedger leading to losses
in underlying asset which will be compensated by gains from futures and losses if the
underlying asset price moves in favour of the hedger leading to gains in underlying asset
which will be compensated by losses in futures so that the final price will be the same as the
futures price contracted. Futures contracts can also lead to huge losses for the speculators
if they do not guess the direction of the price movement of the underlying asset. This
is where options come in. The options will provide gains if the underlying asset price
moves against the hedger just as forwards and futures do. However, if the underlying asset
price moves in favour of the hedger, losses will be limited in case of options compared to
unlimited losses connected with forwards and futures.
An option contract gives the buyer of the option the right to either buy or sell underlying
asset at a specified price on or before a specified date. Since the buyer of the option gets
the right, there is no obligation for the buyer option to either buy or sell the underlying
asset at the specified price. The buyer of the option will exercise the option and buy or sell
the underlying asset at the specified price only if it does not result in a loss.
Options can be classified into three categories:
i. Options issued by corporations

ii. Options between private parties in the over-the-counter markets
iii. Options that are traded in exchanges
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10.2 Options Issued by Corporations

The options issued by corporations are also called option-embedded securities, which
provide an option to the issuing corporation or to the buyer of these securities. The
common option-embedded securities are discussed below:
10.2.1 Bonds with Warrants attached

The warrants provide a right to the bondholders to buy the shares of issuing corporation
at a price specified in the warrant and warrants can be detached from the bond. If a
bondholder desires, he can sell the warrant to others in the secondary market like an
option.
10.2.2 Convertible Bonds

When an investor buys the convertible bond, the bond buyer gets the right to convert this
bond into shares of the issuing corporation at the conversion ratio (which specifies the
price at which the shares can be bought). Thus an option is embedded in the convertible
bond.
10.2.3 Rights
When a corporation plans to issue additional shares, it may first offer them to the existing
shareholders in the form of rights. Each right will provide the details of number of shares
that can be bought with each right and the price that should be paid for each share if rights
are used. The shareholder who receives the right can either exercises the right or buy the
shares at the specified price or can sell the right in the market.
10.2.4 Callable Bond

A callable bond provides a right to the issuer of the bond whereby the issuer can buy the
bond back from the bondholder at a specified price known as call price. Thus, a right is
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embedded in the bond, which is an option. The issuer will call and buy the bond when
the call price is lower than the market price.
10.2.5 Put Bond

A put bond provides a right to the buyer of the bond to sell the bond back to the issuer
at the face value. A bondholder will exercise the right and sell the bond back to the issuer
only if the market price of the bond is lower than the face value and by selling the bond
to the issuer at the higher face value the bondholder will benefit.
10.3 Options traded in Over-the-Counter Markets

Many options are traded in over-the-counter markets. These are contracts between
two private parties, usually brought together by brokers. The option contracts can be
constructed based on the needs of the two parties. In general, one of the parties is a hedger
and the other party is a financial institution and contracts are designed based on the needs
of the hedger.
10.4 Options traded in Exchanges

These option terms are decided by the exchange in which they are traded and trading
takes place according to the rules and regulations of the exchange.
10.5 Example of an Option Contract

You are interested in buying a house and you have looked at a number of houses and have
decided on a particular house. However, you do not have sufficient financial resources
now and you expect to receive a bonus in three months. The owner of the house is willing
to provide you with an option to buy the house at the end of three months and you enter
into a three-month options contract to buy this house at $900,000. You are aware that the
price of the house may change during the next three months. If the price increases to
$960,000 at the end of three months, it is advantageous to buy the house using the option
as you need to pay only $900,000. If the price decreases to $850,000 you will be paying
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$900,000 if you use the option which will lead to a loss. Instead, you will not exercise the
option but buy the house at the market price of $850,000. However, seller of the options
contract will suffer a loss of $50,000, as he could not sell it $900,000 because he gave you
an option. Therefore he will ask you to pay a certain amount upfront to buy this option.
Assume that you need to pay $20,000 to buy this option. If the price is $960,000 you need to
pay $900,000 under the option to buy the house. Since you paid $20,000 to buy the option,
your effective cost is $920,000. On the other hand, if price drops to $850,000 you can buy
the house at $850,000 but net cost will be $870,000 inclusive of the option premium paid.
In case you expect the price to fall after buying the house, you may decide not to buy it at
all and will be willing to take a loss of $20,000 paid for buying the option. This shows that
the maximum loss will be $20,000 whatever action you take.
On the other hand, if you had entered into a forward contract to buy the house at $900,000,
you need to pay $900,000 irrespective of the market price. If market price was $960,000
your gain is $60,000, which is $20,000 more than the gain under option because of the
premium paid for the option. If the market price was $850,000 you face a loss of $50,000
and if price falls further, you would face a higher loss.
Thus options contract result in a fixed loss, which is the premium, paid for the option;
if price moves against the trader, losses could be huge if you entered into a forward or
futures contract.
10.6 Option Terminologies

There are a number of terminologies associated with options, which are explained in this
section.
10.6.1 The Underlying Asset

An options contract provides the buyer of an option with the right to buy or sell a specified
asset. The asset on which the option is written is known as the underlying asset.
Options are commonly available on the following assets:
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a. Commodities
b. Individual stocks
c. Stock indexes
d. Foreign currencies
e. Bonds
f. Interest rates
g. Credit
h. Futures
10.6.2 Call and Put Options

In case of futures, a trader agrees to buy the underlying security if he takes a long position
in the futures while he agrees to sell the underlying asset if he takes a short position in the
futures. Thus one can know the obligations of the futures trader by looking at the position
he holds, whether long or short. Thus there is only one specification for futures contract
and futures price or the price at which the asset will be bought or sold is determined in
the market.
In case of an options contract, only one party has the obligation and the other party has
the right to decide whether they want to fulfil the obligations. Because of this distinction,
an options contract has to state whether the seller of the options contract is obligated to
sell the underlying asset or buy the underlying asset if the option is exercised. Therefore
it becomes necessary to have two types of option contracts: one indicating that the option
buyer has the right to buy the underlying asset and the other indicating that the option
buyer has the right to sell the underlying asset. These two types of contracts are known
as call option contracts and put option contracts.
A call option gives the buyer of the option the right to buy the underlying asset at a
specified price at a future time.
A put option gives the buyer of the option the right to sell the underlying asset at a
specified price at a future time.
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10.6.3 Option Premium

In case of futures contract, the person with long position will gain if the price of underlying
securities increases and the person with short position will lose the same amount of
money. If the price of underlying security decreases, the person with short position will
gain and the person with the long position will lose the same amount of money. Thus
futures will result in a “zero-sum” game where gain of one party equals the loss of another
party and the total gain or loss for both parties will be zero.
In options, consider the case of call option buyer. If price increases, the buyer will exercise
the option and gain which will equal to the loss of the seller of the option. If price decreases,
the buyer will not exercise the option, resulting in no loss to the buyer and causing loss to
the seller. Thus, the buyer always gains in option contract and seller always loses based
on the payoff to the option buyer and seller.
However, at the time of entering into the options contract, future price is not known with
certainty except that seller has potential losses to bear and the seller would like the buyer
to compensate the seller for the potential loss he faces. This is similar to an insurance
contract in which risk is transferred from a person who faces the risk to the insurance
company by the insured paying a premium to the insurer. Therefore, the seller would
require the buyer to pay a premium to sell the option to the buyer. This premium is
determined in the market based on the price of the underlying security and the volatility
of the price and is known as option premium or option price.
10.6.4 Exercising an Option

An option buyer is said to exercise the option when he decides to either buy (in case of
call option) or sell (in case of put option) using the option. By exercising the option, call
buyer would be able to buy the underlying security at the specified price in the options
contract and put buyer would be able to sell the underlying security at the specified price
in the options contract.
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Since an option buyer would exercise only if it is beneficial to exercise, a call buyer would
exercise only when the market price is higher than the specified price because he can buy
the asset at the lower specified price. Similarly, the put buyer would exercise the option
only when the specified price is higher than the market price. If the market price is below
the specified price, a call buyer will face a loss and hence will not exercise. Similarly, a put
buyer will not exercise if the market price is higher than the specified price.
10.6.5 Exercise Price

The exercise price is also known as the strike price. Exercise price is the specified price in
the options contract at which the option buyer can buy the asset (in case of call option) or
can sell the asset (in case of put option). Note that the exercise price of the option remains
constant during the maturity of the option, unless the exchange changes the exercise price
during the life of the option. Thus all traders who buy call options at different periods
during the life of the option will pay the same price to purchase the underlying asset if
they exercise the options. However, the option premium they paid for the option can be
different.
On the other hand, the price of futures is determined in the market. This is the price at
which the person with the long position will have to buy the underlying asset at maturity.
Since futures price can change over time, traders who took long position in futures at
different times during the life of futures may pay different prices for purchasing the asset
at maturity of futures.
10.6.6 Exercise Date or Maturity Date

Also known as strike date, the exercise date specifies the date on which the option contract
expires. This is the date on which the option buyer has to decide on exercising the option.
10.6.7 American and European Options

Options are classified into American options and European options depending on when
the buyers of the options can exercise their right during the life of the option. If an option
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is a European option, it can be exercised only on the exercise date and not before. If it is an
American option, the option can be exercised at any time during the life of the option.
In general, over-the-counter market options are usually of European type whereas

exchange traded options are of American type.
10.6.8 Buyers and Writers of the Option

The person, who purchases an option, whether it is a call or a put option, is called an
option buyer and said to hold the option long. The person who sells the options, whether
it is a call or put option, is called an option writer, and is said to hold the option short.
In the options market, anyone can be an option buyer or writer depending on the
expectation about the price movement of underlying asset. Sometimes, the same
individual may buy as well as write options at the same time.
It is very important to distinguish between option writer and option buyer. The option
writer has to fulfil his obligations whenever the option buyer exercises the right to either
buy or sell. Since the option buyer will exercise only when it is beneficial for him, it is
clear that option writer will always face a loss if option is exercised without considering
the option premium.
10.6.9 Contract Size

The contract size specifies the number of units of underlying asset that can be bought
or sold under the options contracts. In case of exchange traded options, contract size is
specified by the exchange. In case of OTC option, the two parties will negotiate the contract
size.
10.6.10 In-the-money, At-the-money and Out-of-money Options

Whenever the price of the underlying asset is such that exercising the option will provide
a gain, the option is said to be in-the-money and if exercise is expected to result in a loss,
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the option is said to be out-of-money. If the price is close to the exercise price, it is said to
be at-the-money.
A call option will be in-the-money whenever the market price of the asset is more than
the exercise price and will be out-of-money when the market price of the asset is less than
the exercise price.
A put option will be in-the-money whenever the exercise price is more than the market
price of the asset and out-of-money when exercise price is less than the market price.
If there is a put and a call on the same asset with same exercise price, and if call is in-the-
money, put will be out-of-money and vice-versa.
10.7 Comparison of Exchange-traded and OTC Options

In OTC options, brokers and dealers bring together the parties of buyers and writers
and arrange the contract terms. In exchange traded contracts, the contract terms are
determined by the exchange and trading takes place in exchanges according to the rules
and regulations of the exchange.
The volume of transactions is comparatively low and commission expenses are high in
OTC options whereas the commission expenses are low and volume of transactions is very
high in exchange traded options.
Most of the OTC options are either interest rate options or currency options whereas
options on many assets including commodities, stock and stock index are traded in
exchanges. One of the parties in OTC contracts generally tends to be a financial institution.
Through option contract, the hedger transfers the risk to the financial institution and
this requires the financial institution to hedge this acquired risk. Therefore, financial
institutions would go for only European options, as they can know the date on which the
risk may arise. On the other hand, exchange traded options are generally American type.
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There is no transparency in OTC contracts and similar trades may happen at different
option premium. In case of exchange-traded options, all traders know the details of all
trades and the option premium is determined in the market.
OTC options can result in counterparty risk as one of the parties may default. The
financial institutions would require the hedger to show that the latter has a position and is
interested to hedge the position. Therefore, OTC options are available for only bona fide
hedgers. On the other hand, the exchange-traded options are negotiable and hence, can
be used by hedgers and speculators.
10.8 Guarantee of Performance in Exchange Traded Options

Similar to trading in futures, the options exchange guarantees the performance of the
contract through:
a. Creation of a clearinghouse
b. Instituting margins
c. Marking-to-market
Like futures trading, clearing members will have to clear all the trades and thus will
guarantee the trades.
Margin is to be posted only by writers of options because only they face obligations. The
buyers of options get the right and not the obligation and hence are not required to post
any margin. Similar to futures, the margin account will be marked-to-market everyday
and if the actual margin balance is less than variation margin, the trader will get a margin
call.
Margin amount in options trading is to cover the financial loss due to an adverse market
movement. For a writer of a call option, loss arises when the price of the asset increases
while loss arises to a put writer if the price decreases. Since the loss is difficult to estimate
due to volatility of the asset price, the margin amount is calculated by the exchange
using a mathematical model that uses volatility of the underlying asset price. The basic
methodology in these models is to estimate the loss for a given range of possible prices on
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the next day, given the current day’s price of the underlying asset. This margin is known
as the risk margin. Risk margin is calculated by the exchange everyday on the basis of
the closing price of the underlying asset on that day and variability estimated from the
historical data.
In addition to the risk margin, option writers need to post a margin known as the premium
margin. Premium margin is the amount that the writer would receive for the options they
have written. If the price of underlying asset changes, the premium will also change hence
the premium margin will be adjusted daily on the basis of option premium. If premium
increases, the writer would face a loss.
The writer will also need to post a margin called the assignment margin if the option is an
American option. An American option can be exercised at any time and when an option
buyer exercises the option, a writer with an option position will be randomly chosen
to fulfil the obligation. Since all writers have equal chance to being chosen, they have a
chance to lose money on exercise. This is known as assignment margin.
Thus margin in options is made up of premium margin, risk margin and assignment
margin and each of these will be marked-to-market every day.
10.9 Standardisation of Option Contracts

Standardisation requires all parties to know exactly what they are contracting for and the
exchange should clarify the following:
• Option type: put or call option

• The name of the underlying asset
• Contract size
• Exercise date or strike date
• Exercise price or strike price
• Rule for exercise: European or American
• Mode of settlement
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10.9.1 Underlying Asset

The underlying asset can be any of the following:
• Commodities
• Individual stock
• Stock indexes
• Bonds
• Interest rates
• Foreign currency
• Futures contracts
10.9.2 Contract Size

Contract size refers to the quantity of the asset that the option buyer can buy or sell using
the options. In case of commodities, the quantity is specified in standard units in which
they are traded and the grade of the commodity is also specified.
In case of options of individual stock, the number of shares on which each contract is
written is specified. In case of stock index options, a contract multiplier is specified. In case
of bonds, the face value of bonds and coupon rate is specified as contract size. In interest
rate options, contract size refers to a notional face value and reference rate such as LIBOR.
In case of foreign currency option, it is the number of units of foreign currency. In case of
option on futures, it is the same as the contract size in the futures contract.
10.9.3 Exercise Date

The exchange provides options for hedgers to hedge over a period of time. Typically,
exercise date is specified in terms of the month in which the contract expires. The exact
expiration date during the month of expiry will be specified by the exchange. Typically,
options have a 3-month trading cycle, namely, the near month, the next month and the far
month. There will be three expiry dates for each option at any given time. For example,
in the month of January, there will be three options with expiry in January, February and
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March. In February, when January option expires, options will be available with maturity
in February, March and April. The exchange also can provide for long-term options.
10.9.4 Exercise Price

Generally, exchange introduces options with different exercise prices. Typically, when an
option is introduced, there will be options with seven different exercise prices with three
options which are out-of-money, three options which are in-the-money and one option
which is at-the-money. The intervals between the exercise prices will depend on the price
of the underlying asset. If the underlying asset price is low, the interval will also be small.
If the underlying asset price is high, the interval will also be high.
The exchange has the right to introduce additional options with different exercise price
based on the movement of the price of the underlying asset. An additional out-of-money
option will be introduced, if the underlying asset price moves in such a way that an
existing out-of-money option becomes in-the-money option. Similarly, an additional in-
the-money option will be introduced, if the underlying asset price moves in such a way
that an existing in-the-money option becomes out-of-money option.
Example:
Assume that the underlying asset price is $20 on January 1 and the exercise price interval is
$1. When this option is introduced, there will be call options and put options with exercise
dates in January, February and March and with exercise prices of $17, $18, $19, $20, $21,
$22 and $23. Thus, there will be a total of 2 * 3 * 7 = 42 options available. If the asset
price increases to $21, an additional call and put option with exercise price of $24 will
be introduced with maturity in January, February and March, increasing the number of
options to 48.
10.9.5 Mode of Settlement

The exchange will also specify how the contract will be settled. Settlement could be either
through delivery of the asset or through cash settlement. If the contract is settled through
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delivery, the option buyer will indicate to the exchange that he plans to exercise the option.
The exchange will randomly assign a writer to make or take delivery. The writer needs to
deliver the specified quantity of the asset and the option buyer will pay cash at the rate of
the exercise price per unit.
If the settlement is through cash, the option buyer would receive cash and the amount of
cash received will be the gain to the buyer. The writer will have to make cash payment
equal to the loss suffered.
10.9.6 Option Class and Option Series

For a given asset at any given time, there may be many different option contracts traded.
If there are three exercise dates and seven exercise prices, and puts and calls trade for each
of these exercise prices, there will be 42 options traded on the same asset.
All options of the same type (calls or puts) are called option class. Calls are one class and
puts are another class for each asset. An option series consists of all options in a given
class with the same exercise date and exercise price. An option series refers to a particular
contract that is traded.
10.10 Trading of Options

Trading of options is similar to trading in futures. Trading will involve the following steps:
i. Contact the broker to place the order.

ii. Broker fulfils the order. If the order is a market order, the broker will contact
market maker and find the best possible price to execute the order. If the order
is limit order, the order will be keyed in the system of the exchange. If there is a
matching order, the order will remain in the system for future matching.
iii. Once the order is executed, the broker will contact a clearing member to clear
the order.
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iv. Once the order is cleared, the writer of the option will be asked to post the margin.
The buyer of the option will pay premium to the broker and the broker will
maintain an account showing the position of the buyer. For a writer, the broker
will maintain the margin account.
v. The writer’s margin account will be marked-to-market daily and if the margin
balance goes below the variation margin, the writer will get a margin call which
requires additional payment from the writer to reach the initial margin.
For American options, the option buyer will inform the broker that he intends to exercise
that right. In this case, the broker will inform the exchange and the exchange will randomly
select one of the writers to make delivery in case of asset delivery or arrange for cash
settlement.
For European options, the exchange will automatically exercise the option if it is beneficial
for the option buyer. In case exercise would result in a loss to the buyer, the option will
expire without exercise. The option buyer does not have to inform the exchange about
exercise.
10.10.1 Types of Orders

The types of orders a trader can place are similar to the orders used for futures.
They are:
i. Limit order
ii. Stop order
iii. Good-till-cancelled order
iv. Spread order – A trader can place orders to trade options with different exercise
prices or to trade options with different exercise dates.
10.10.2 Price Quotes

The details of price quotes are as follows:
• Symbol
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• Expiry date
• Strike price
• Option type: Whether call or put and whether American or European such as CE,
CA, PE, PA representing European call, American call, European put and American
put.
• Open price
• High price during the day
• Low price during the day
• Settlement price
• Trading volume as number of contracts
• Trading value as value of contracts traded
• Open interest
• Changes in open interest
10.10.3 Settlement Price

Settlement price is calculated by the exchange by taking the average of the price during
the last 30 minutes, if there is trading in options. If there is no trade during this period,
the settlement price is calculated using a theoretical model.
10.10.4 Open Interest

Open interest in options is similar to open interest in futures. This refers to the number of
open contracts that is the number of contracts that have been traded but not liquidated by
an offsetting trade or exercise. Open interest shows the liquidity of the contract.
Changes in open position provide information as to whether new contracts were opened
during the day. If change is positive, the interest is high in the option and if change is
negative, traders are closing their position and interest in option is decreasing. Usually,
open interest is high for the near-month contract and low for far-month contracts.
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10.11 Adjustment of Option Terms

The option terms with respect to contract size and exercise price can be changed by the
exchange when the underlying asset price is affected. This is particularly true for options
on individual stocks where number of corporate actions can have significant impact on
the share prices. The corporate actions where adjustment is necessary include:
• Issue of bonus shares

• Issue of rights
• Mergers and acquisitions
• Amalgamation
• Stock splits
• Consolidation of stock
• Issue of warrants
• Cash dividends
In case of cash dividends, the terms are not generally adjusted unless the dividend amount
exceeds 10% of the market value. In adjusting the terms of the contract, the exchange will
adjust either the contract size or exercise price or both, such that the position of the option
buyer after adjustment is the same as the option of the buyer before adjustment.
10.12 Exotic Options

In regular options, also called plain vanilla options, the payoff from the option is based on
a single specific contingent agreed-upon event. If that event occurs, the option buyer will
receive a positive payoff and if the agreed event does not occur, the payoff to the option
buyer will be zero.
Hedging needs of corporations have resulted in the development of a number of options in

which the terms are arranged between the hedger and a counterparty whereby the payoff
structure can be determined to the basis of the occurrence of various events during the life
of the option instead of a single event and the payoff can be structured in a manner that
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is different from the structuring of a plain vanilla option. These options are called exotic
options.
Exotic option market originally developed in the foreign exchange market and in recent
years, a number of exotic options have been developed in the commodity market. Since
payoffs from exotic options are based on the occurrence of a number of events, it is very
important for any party entering into exotic options contract to clearly understand the
nature of payoffs and risks. While exotic options can lead to positive payoffs, they can also
lead to huge losses if the nature of the contract is not clearly understood.
Exotic options are tailor-made for hedging the risk as perceived by the hedger. Most exotic
options are typically non-negotiable. The terms of the option are generally negotiated by
brokers and dealers and are not standardised. They can also include embedded options
in securities such as bonds and equity securities.
Examples of exotic options include:
i. Asian options where strike price is replaced by the average of the asset prices
during the life of the option.
ii. Barrier options in which the option will come into existence or will be knocked
out if the price of the underlying asset reaches a price known as barrier price.
iii. Chooser option in which the option buyer can choose whether the option will be
a call or put option at a specified time during the life of the option.
iv. Compound option is an option on an option. It could be a call option on a call
option or a call option on a put, put option on a call or a put option on a put.
If the buyer of the compound option exercises the first option, he will hold the
second option. Otherwise, the option will expire.
v. Digital or binary option in which the payoff will be a fixed amount of the asset
or a fixed amount of cash or nothing.
vi. Look back option in which payoff is dependent upon the maximum or minimum
price of the asset over the life of the option.
There are many other exotic options available as well.
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10.13 Structured Warrants

A third party financial institution issues a structured warrants on the shares of an
unrelated company, a basket of companies’ shares or an index. Structured warrant is an
option to either buy or sell the underlying asset at a specified price on or before the expiry
date. These can be either call or put warrants.
Structured warrant is similar to an option with slight differences. Unlike options, which
are traded in options exchanges, structured warrants are traded in stock exchanges just
like ordinary shares. As these are traded in stock exchanges, all traders are only buyers of
options and the financial institution that creates this warrant is the writer. The financial
institution will buy a quantity of the asset and keep them under a trust and issue warrants
against these shares. Like regular options, a call warrant would provide gains if the asset
price exceeds the exercise price and the maximum loss would be the premium paid for
the warrant.
10.14 Credit Derivatives

Credit derivatives emerged in 1993-94 and are continuing to enjoy significant growth in
financial markets, aided by sophisticated product development and expansion of product
applications beyond price management to the strategic management of portfolio risk.
The beginnings of credit derivatives can be traced to two major market developments,
namely:
i. Packaging of mortgage bonds in the USA to create collateralised debt obligations;

and
ii. Selling of default protection in the 90s as credit default swaps (CDS) to trade
credit risk.
When CDS was introduced, banks mainly used them to hedge their loan exposure. By
the mid-90’s, many fixed-income investors were starting to enter the credit derivatives
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market. By the end of the decade, credit derivatives made their way into mainstream
financial markets.
The growth in total market size of credit derivatives has been phenomenal. According
to the International Swap and Derivatives Association (ISDA), the national amount of
outstanding CDS was USD 38.56 trillion by the end of 2009.
The major users of credit derivatives are banks, security houses, corporations, insurance
companies, mutual funds, pension funds and hedge funds. The product range includes
basket products, credit-linked notes, credit spread options, equity-linked credit products,
single name CDS, synthetic CDOs.
Credit derivatives provide a means to transfer credit risk between two parties through
bilateral agreements. Contracts are based on a single credit or on a diverse pool of credits
such as synthetic collateralised debt obligations (CDOs), which transfer risks on an entire
credit portfolio.
Credit derivatives are over-the-counter contracts and can be tailored to individual

requirements. However, in practice, the majority of market transactions are standardised.
Credit derivatives provide the following benefits:
i. Hedge or mitigate credit exposure

ii. Generate leverage or enhance yield
iii. Transfer credit risk
iv. Separate risks embedded in securities such as convertible bonds
v. Synthetically created loans
vi. Manage regulatory capital adequacy ratios
The major characteristic of credit derivative is that it can decouple credit risk from funding.
The entities can alter the credit risk exposure without actually buying or selling bonds or
loans in the primary or secondary markets. Basic credit derivative structures are based on
the following:
i. Credit default swaps
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ii. Credit options

iii. Total return swaps
iv. Credit linked notes
10.14.1 Credit Default Swap

A credit default swap (CDS) is a bilateral contract in which one party, called the protection
buyer, pays a periodic fee, typically expressed in basis points per annum, on a notional
amount in return for a contingent payment by the other party, called the protections seller,
following the occurrence of a credit event with respect to a reference entity.
The definition of the credit event, the relevant obligations, and settlement mechanism to
determine the contingent payment are determined by negotiation between the parties to
the agreement at the inception of the contract.
In a credit default swap, the party that faces a credit risk or requires protection will transfer
the credit risk to another party that sells this protection by paying periodic premium to
the protection seller. In case the credit event occurs, which can be default of the credit, the
full risk will be borne by the protection seller and protection seller will pay the protection
buyer the contingent payment agreed upon.
10.14.2 Credit Options

Credit options are either put or call options on the price of either:
i. A floating rate note or bond or loan, or

ii. An asset swap package
If it is an option on a floating rate obligation, credit put provides the buyer with right to
sell a specified floating rate reference asset to the option seller at a pre-specified exercise
price. If it is a call, the option buyer has the right to buy the specified floating rate reference
asset at a pre-specified exercise price. Settlement could be through cash or delivery of the
asset.
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In asset swap package, the put buyer will pay a premium for the right to sell a specified
reference asset to the put seller and will simultaneously enter into a swap in which put
seller pays the coupon on the reference asset and receives LIBOR plus a predetermined
spread known as the strike spread. The put seller will make an upfront payment of par
value for this combined package upon exercise.
Options can be either American or European type. They can also be structured to survive
a credit event involving default or bankruptcy of the issuer or guarantor of the reference
asset in which case the default risk and credit spread are transferred between the two
parties. They can also be structured as a barrier option in which case option can be knocked
out upon occurrence of a credit event.
10.14.3 Total Return Swaps

Total return swap (TRS) is a bilateral contract that is designed to transfer credit risk from
one party to another. The total return swap exchanges the total economic performance
of a reference asset for cash flow from another asset, irrespective of whether the credit
event takes place or not. Payments between the parties to a total return swap are based on
changes in the market valuation of a specific credit asset over the period of the agreement.
Protection buyer or a total return buyer will pay the other party (known as the total
return seller) the total return on a specified credit asset known as the reference obligation.
The total return will comprise the sum of interest payments, fees and change-in-value
payments with respect to the reference obligation. The change-in-value payment is equal
to depreciation or appreciation in the market value of the reference obligation and is
calculated from the quotes provided by the dealers agreed upon by the two parties. If there
is a net depreciation in value or a negative total return, the protection buyer will receive
payment. The change-in-value payment can be paid either at maturity or at specified
periods during the life of the contract. Change-in-value payment can be cash-settled or
settled through delivery of the reference obligation at maturity by the protection buyer
in return for payment of the reference obligation’s initial value to the protection seller. In
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return, the protection buyer will make a regular payment to the protections seller on the
basis of a reference rate such as LIBOR. Maturity of total return swap does not need to
match the maturity of reference obligation.
10.14.4 Credit Linked Notes

These are funded balance sheet assets that offer synthetic credit exposure to a reference
entity in a structure designed to resemble a synthetic corporate bond or loan. These
are normally issued by a special purpose vehicle that will hold some form of collateral
securities financial through the issue of notes or certificates to investors. Investors are
eligible to receive periodic coupons and the face value at maturity, provided there had
been no occurrence of a credit event of the reference entity.
The investors of a credit-linked note will assume the credit risk of the reference entity as
well as the credit risk of the underlying collateral assets. If the reference entity defaults, the
underlying collateral will be liquidated and investors will receive the proceeds only after
the credit swap counterparty is paid the contingent payment. If the underlying collateral
assets default, the investor is exposed to its recovery, irrespective of the performance
of the reference entity. This dual risk results in a higher yield for credit linked notes
when compared to yield on underlying collateral or the premium on credit swap when
considered separately.
10.15 Swaps
Forward contracts and futures contracts help the hedgers to hedge risk over a short-term
period. The hedgers can use these contracts to hedge over a long-term by rolling over
the contract from one short-term to another, but this strategy can result in losses if the
underlying asset prices move against the hedger. Swap contracts help the hedgers to hedge
long-term risks.
Swaps are private agreements between two parties to exchange one stream of future cash
flows for another stream of cash flows in accordance with a pre-arranged formula. The
agreement provides details of how the cash flows will be calculated and the dates on which
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the cash flows will be exchanged. At the time the contract is entered into, at least one of the
cash flows will be determined on the basis of an uncertain variable such as interest rate,
exchange rate, equity price or commodity price, while the other could be a fixed payment
or could be determined on the basis of another uncertain variable.
Swap contracts are private, over-the-counter agreements and are not traded on exchanges.
There are no restrictions governing swap contracts, and they can be customised to the
needs of the parties.
10.15.1 Types of Swaps

There are many types of swaps that are used to hedge risks. Most commonly used swaps
are:
• Interest Rate Swaps

• Currency Swaps
• Commodity Swaps
• Equity Swaps
The first swap transaction was between IBM and World Bank in 1981, which was a
currency swap, to swap cash flow denominated in Swiss francs and Deutschmarks. Since
then, the swap market has grown considerably with total market value of USD 15.27
billion and notional value of USD 360 billion.
10.15.1.1 Interest Rate Swap

In interest rate swap, one party agrees to exchange interest payments based on a fixed rate
with another party for interest payments based on a floating rate.
Consider a bank that receives deposits and pays interest on deposits. Since these deposits
are short-term in nature, the banks need to pay short-term interest rates. On the other
hand, banks issue long-term loans receiving interest based on long-term interest rates. This
mismatch can be hedged by using an interest rate swap. The bank will swap fixed interest
payment received with another party to receive interest payments based on a floating rate.
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The rates at which parties exchange cash flows are known as swap rates. The bank will
pay the other party a fixed interest rate and the other party will pay the bank a floating
rate. The other party could be a swap dealer or a hedger who borrows on a floating rate
but would prefer to borrow based on fixed rate of interest.
In an interest rate swap, the principal amount is not exchanged and only the interest
payments are exchanged. These interest payments are calculated on the basis of an
assumed principal amount, known as the notional principal. Usually, the notional
principal is USD 1 million.
When the interest payments are calculated, only the net cash flow is exchanged. For
example, if fixed rate is 6% and the floating rate is 5%, the party that pays fixed rate needs
to pay USD 30,000 while the party that pays floating rate needs to pay USD 25,000 if the
notional principal is USD 1 million and interest is paid every six months. The actual cash
flow will be $5000 from fixed-rate payer to floating rate payer.
10.15.1.2 Currency Swap

Currency swap is similar to an interest rate swap in the sense that different cash flows
are swapped between two parties. However, in a currency swap, the two cash flows are
denominated in two different currencies.
Currency swaps are used for two purposes:
Consider the case where a company based in Singapore has cash flows denominated in
a foreign currency, say USD, and also requires funds for investment in USD. At the same
time, there could be a US company that has cash flow in Singapore dollars and also plans
to invest in SGD. These two companies can meet their investment needs in two ways:
a. Singapore Company borrows in SGD and US Company borrows in USD. In this

case, loan payments can be met by cash flows generated in their own currencies;
however, both companies will face currency risk for the cash flows denominated
in the other currency.
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b. Singapore Company can borrow in SGD and the US Company can borrow in
USD and then can swap loans. In this case, the Singapore company will pay the
US company at swap USD rate and US company will pay Singapore company at
swap SGD rate. Since both companies have cash flows in the other currency, the
payments under the swap can be made from the cash flow in the same currency
that needs to be paid under the swap. Thus, a currency swap aids in reducing
currency risk.
An investor in Singapore is planning to make investment in USA, which requires cash in

US dollars, and the future cash flow will also be in US dollars. This exposure to current
and future cash flows in USD will cause currency risk. If there is a US investor who has
exposure to Singapore dollar, the Singapore and US investors can enter into a currency
swap in order to reduce the risk as the swap would require payments in the currency in
which the two investors will have cash flows.
There are some differences between a currency swap and an interest rate swap.
• In an interest rate swap, the currency denomination of the loan is the same for both
parties whereas the loans are denominated in different currencies in a currency
swap.
• An interest rate swap deals with swapping a fixed interest rate for a floating interest
rate. Currency swap can be any of the following: fixed rate to fixed rate, fixed rate
to floating rate, floating rate to fixed rate, floating rate to floating rate.
• In an interest rate swap, the principal amount is not swapped and only the interest
payments are swapped at the swap rate.
In a currency swap, the two parties swap the principal amount at the initiation of the swap
at the exchange rate prevailing at that time; the interest payments are swapped at the swap
rates periodically. The principal payments are swapped again at maturity of the swap, at
the exchange rate at which the principal payments were swapped at the initiation of the
contract.
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Through a currency swap, the two parties can reduce the currency risk and the currency
swap can also result in lower funding costs.
10.15.1.3 Commodity Swap

Commodity swaps are designed to hedge risk associated with the prices of input resources
such as energy, precious metals and agricultural products. Most for the commodity
swaps involve energy-related products such as crude oil. A commodity swap transaction
involves exchange of payments between two parties at set time periods. One leg of the
swap is determined by the price of the commodity and the other leg of the swap usually
involves a fixed rate. For example, if Singapore Airlines requires 2 million barrels of
aviation fuel, it can enter into a commodity swap in which Singapore Airlines will pay a
fixed rate and the counterparty will make payments on the basis of the price of aviation
fuel.
Since commodity price is highly volatile, usual practice is to use the average price over a
prescribed period of time rather than the price on the day of settlement. The performance
of the swap is related to the average performance of the asset.
10.15.1.4 Equity Swap

An equity swap is a transaction in which one party agrees to make a series of payments
determined by the return on the stock, or a group of stocks or a stock index, to another
party in return for a cash flow that could be based on a fixed rate, floating rate, or a return
on another stock or stock index.
An example of equity swap would be where one party promises to receive the return on
Straits Times Index by paying 8% fixed to the other party. By entering into an equity swap,
one can get an exposure to the stock without actually owning the stock. Equity swap also
allows an investor to avoid exposure to stock price volatility.
An equity swap may require the receiving party to make payments rather than receive
payments if the equity return is negative. Thus, in an equity swap, it is possible that one
party may be making payments in both legs of the swap.
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Lesson Recording
Options
Credit Derivatives and Swaps
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1. Derivative securities are used by all of the following, except,

a. Hedgers to reduce risk
b. Speculators to earn abnormal return
c. Investors to earn normal return
d. Arbitragers to earn a return based on risk-free arbitrage

a. Both forward contract and futures contract are contracts for future exchange
at a price determined at the current time
b. Both forward contract and futures contract can be tailored to meet the needs
of the traders
c. Forward contracts are mainly used by hedgers while futures are used both by
hedgers and speculators
d. Forwards are non-negotiable whereas futures are negotiable contracts
3. The purpose of margins in futures is

a. To provide extra money to the exchange
b. To act as a good-faith deposit
c. To minimise the chance of default by the trader
d. To provide trading access to the trader
4. Settlement in futures contract

a. Can be through cash only
b. Can be through delivery only
c. Can be through both cash or delivery
d. Will be based on the specifications of the contract
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5. The major advantage of options over futures is that

a. Options are traded in over-the-counter market only
b. Options can preserve the upside potential while protecting against the
downside risk
c. Option buyers and sellers need not post margin
d. Cost of trading in options is lower
6. Which of the following statements is correct?

a. A call will be exercised when the market price is higher than exercise price and
a put will be exercised when market price is higher than exercise price
b. A call will be exercised when the market price is higher than exercise price and
a put will be exercised when market price is lower than exercise price
c. A call will be exercised when the market price is lower than exercise price and
d. A call will be exercised when the market price is lower than exercise price and
7. In option trading,
a. Both buyers and sellers need to post margin
b. Only buyers of option need to post margin
c. Only sellers of option need to post margin
d. Both buyers and sellers need not post margin
8. Credit derivatives
a. Allow for transfer of credit risk between two parties
b. Are traded on derivatives exchanges
c. Are only options
d. Are similar to insurance contracts
9. A swap transaction
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a. Allows one of the parties to receive the cash flow desired

b. Allows both parties to exchange cash flows based on pre-agreed formula
c. Allows one party to exchange cash flow by paying the other party a premium
d. Allows both parties to exchange cash flows only at the time contract is entered
into
10. Difference between interest rate swap and currency swap is

a. Only interest payments are swapped in currency swap while interest and
principal are swapped in interest rate swap
b. Only interest payments are swapped in interest rate swap while principal and
interest payments are swapped at the exchange rate prevailing at the time of
each exchange in a currency swap
c. Only interest payments are swapped in interest rate swap while principal
payments are swapped at the exchange rate prevailing at the time contract is
entered into both at the start and the end of the swap in a currency swap
d. Interest rate swap is used to hedge interest rate risk in one currency while
currency swaps are used to hedge interest rate risk in two currencies
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1. Derivative securities are used by all of the following, except,
a. Hedgers to reduce risk
Incorrect. Answer is wrong as derivative securities are used by hedgers to
reduce risk
b. Speculators to earn abnormal return

Incorrect. Answer is wrong as derivative securities are used by speculators
to earn abnormal return
c. Investors to earn normal return

Correct. Answer is correct as derivatives are not used by investors to earn
a normal return
d. Arbitragers to earn a return based on risk-free arbitrage

Incorrect. Answer is wrong as derivative securities are used by arbitragers to
earn return based on risk-free arbitrage

a. Both forward contract and futures contract are contracts for future exchange
at a price determined at the current time
Incorrect. Answer is wrong as the statement “Both forward contract and
futures contract are contracts for future exchange at a price determined at the
current time” is correct
b. Both forward contract and futures contract can be tailored to meet the needs
of the traders
Correct. Answer is correct as the statement “Both forward contract and
futures contract can be tailored to meet the needs of the traders” is wrong.
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While forwards can be tailored to meet the needs of the traders, futures are
standardised by the futures exchange
c. Forward contracts are mainly used by hedgers while futures are used both
by hedgers and speculators
Incorrect. Answer is wrong as the statement “Forward contracts are mainly
used by hedgers while futures are used both by hedgers and speculators” is
correct
d. Forwards are non-negotiable whereas futures are negotiable contracts

Incorrect. Answer is wrong as the statement “Forwards are non-negotiable
whereas futures are negotiable contracts” is correct
3. The purpose of margins in futures is

a. To provide extra money to the exchange
Incorrect. Answer is wrong as the purpose of margin is not to provide extra
money to the exchange
b. To act as a good-faith deposit

Correct. Answer is correct as the purpose of margin is to act as a good faith
deposit that the trader will fulfil the obligations under the contract
c. To minimise the chance of default by the trader

Incorrect. Answer is wrong because placing the margin does not minimise
the chance of default
d. To provide trading access to the trader

Incorrect. Answer is wrong because it does not provide trading access
4. Settlement in futures contract

a. Can be through cash only
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Incorrect. Answer is wrong because delivery need not have to be through

cash only
b. Can be through delivery only

Incorrect. Answer is wrong because delivery need not have to be through
delivery only
c. Can be through both cash or delivery

Incorrect. Answer is wrong because settlement can be either cash or delivery
and not both
d. Will be based on the specifications of the contract

Correct. Answer is correct because the settlement mode for any contract is
specified in the contract specification
5. The major advantage of options over futures is that

a. Options are traded in over-the-counter market only
Incorrect. Answer is wrong as options can be traded in exchanges also
b. Options can preserve the upside potential while protecting against the
downside risk
Correct. Answer is correct as options provide for preserving upside
potential while protecting against the downside risk
c. Option buyers and sellers need not post margin

Incorrect. Answer is wrong because option sellers need to post margin
d. Cost of trading in options is lower

Incorrect. Answer is wrong as cost of trading options is higher due to
payment of option premium
6. Which of the following statements is correct?
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a. A call will be exercised when the market price is higher than exercise price
and a put will be exercised when market price is higher than exercise price
Incorrect. Answer is wrong as the statement “A call will be exercised when
the market price is higher than exercise price and a put will be exercised when
market price is higher than exercise price” is wrong. Put will be exercised
when the market price is lower than exercise price
b. A call will be exercised when the market price is higher than exercise price
and a put will be exercised when market price is lower than exercise price
Correct. Answer is correct as the statement “A call will be exercised when
the market price is higher than exercise price and a put will be exercised
when market price is lower than exercise price” is correct
c. A call will be exercised when the market price is lower than exercise price
the market price is lower than exercise price and a put will be exercised when
market price is higher than exercise price” is wrong. A call will be exercised
only when the market price is higher than exercise price and put will be
exercised only when market price is lower than the exercise price
d. A call will be exercised when the market price is lower than exercise price
the market price is lower than exercise price and a put will be exercised when
market price is higher than exercise price” is wrong. A call will be exercised
only when market price is higher than exercise price
7. In option trading,
a. Both buyers and sellers need to post margin
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Incorrect. Answer is wrong as only the party that has an obligation need to
post margin. Since buyers get the right and not obligation, buyers need not
post margin
b. Only buyers of option need to post margin

Incorrect. Answer is wrong as only the party that has an obligation need to
post margin. Since buyers get the right and not obligation, buyers need not
post margin
c. Only sellers of option need to post margin

Correct. Answer is correct as only the party that has an obligation need
to post margin. Since writers do not get the right but obligation if buyers
exercise, sellers need to post margin
d. Both buyers and sellers need not post margin

Incorrect. Answer is wrong as only the party that has an obligation need
to post margin. Since writers do not get the right but obligation if buyers
exercise, sellers need to post margin
8. Credit derivatives
a. Allow for transfer of credit risk between two parties
Correct. Answer is correct as credit risk is transferred from one party
to another whereby the party facing the risk pays periodic payments to
the other party and other party will compensate for any losses occurred
because of the occurrence of credit event
b. Are traded on derivatives exchanges

Incorrect. Answer is wrong as these contracts are over-the-counter contracts
and not traded on exchanges
c. Are only options

Incorrect. Answer is wrong as credit derivatives need not be only options
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d. Are similar to insurance contracts

Incorrect. Answer is wrong. Even though credit derivatives are structured
like insurance contract, insurance contracts provide protection against
known events.
9. A swap transaction
a. Allows one of the parties to receive the cash flow desired
Incorrect. Answer is wrong as swap allows both parties to exchange cash
flows desired
b. Allows both parties to exchange cash flows based on pre-agreed formula

Correct. Answer is correct as a swap allows both parties to exchange cash
flows based on a pre-agreed formula
c. Allows one party to exchange cash flow by paying the other party a premium
Incorrect. Answer is wrong as there is no premium to be paid to either party
to enter into a swap transaction
d. Allows both parties to exchange cash flows only at the time contract is
entered into
Incorrect. Answer is wrong as cash flow is exchanged throughout the life
of the option as predetermined intervals and not at the time of contract is
entered into.
10. Difference between interest rate swap and currency swap is

a. Only interest payments are swapped in currency swap while interest and
principal are swapped in interest rate swap
Incorrect. Answer is wrong as interest payments only are swapped in interest
rate swap while both interest and principal amount are swapped in currency
swap
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b. Only interest payments are swapped in interest rate swap while principal
and interest payments are swapped at the exchange rate prevailing at the
time of each exchange in a currency swap
Incorrect. Answer is wrong because principal at end of the swap is not
swapped at the exchange rate prevailing at the end of the swap but at the
exchange rate prevailing at the beginning of the swap
c. Only interest payments are swapped in interest rate swap while principal
payments are swapped at the exchange rate prevailing at the time contract is
entered into both at the start and the end of the swap in a currency swap
Correct. Answer is correct as principal at end of the swap is swapped at the
exchange rate prevailing at the beginning of the swap
d. Interest rate swap is used to hedge interest rate risk in one currency while
currency swaps are used to hedge interest rate risk in two currencies
Incorrect. Answer is wrong because currency swap is used to hedge currency
risk and not interest rate risk.
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Study
Unit
FIN301
Learning Outcomes
• Analyse how the international monetary system has evolved over time
• Examine the characteristics of foreign exchange market
• Describe how currencies are traded in the foreign exchange market
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Overview
With increased globalisation, trade and capital movements across countries have been
increasing. This has resulted in an organised market to trade currencies. In Chapter 11,
we will first discuss the history of international monetary arrangements and then discuss
how the foreign exchange market operates.
Read
Edition, (2015).
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Chapter 11: Foreign Exchange Market
Understanding how foreign exchange market functions is important because of increased

globalisation of trade and capital movement. Currencies are traded in the foreign
exchange market where one sells one currency and buys another currency. The rate at
which a currency can be exchanged for another is known as the exchange rate between
the two currencies.
Foreign exchange market has evolved over time and during this period, exchange rates
have been determined based on many criteria. The history of international monetary
system is discussed next.
11.1 History of International Monetary System

International Monetary System has evolved over different stages over time and can be
classified as:
a. Bimetallism prior to 1875

b. Classical gold standard 1875 – 1914
c. Inter-war period 1914 – 1944
d. Bretton Woods system 1945 – 1972
e. Flexible exchange rate system from 1973
11.1.1 Bimetallism prior to 1875

Before the 1870s, many countries followed bimetallism, that is, free coinage maintained
for both gold and silver. In Great Britain, bimetallism was maintained till 1816 when the
Parliament passed a law abolishing free coinage of silver and maintaining coinage of gold
only. In the United Sates, bimetallism started in 1792 and remained legal until 1873 when
Congress dropped silver dollar from minting. France maintained bimetallism till 1878.
Countries such as China, India and Germany were on silver standard.
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During this period, gold and silver were both used for international payment and
exchange rates among currencies were determined by either gold or silver contents. The
exchange rate between British pound which was on gold standard and French franc which
was on bimetallic standard was determined based on the gold content of these currencies.
Exchange rate between French franc and German mark was based on the silver content of
those currencies. The exchange rate between German mark and British pound was based
on their exchange rates against the French franc.
11.1.2 Classical Gold Standard

First full-fledged gold standard was established in 1821 in Great Britain when the Bank of
England announced that notes were redeemable into gold. France adopted gold standard
in 1878. Germany adopted gold standard in 1875 followed by USA in 1879 and Russia
and Japan in 1897. Gold standard continued to exist in 1914 until the war broke out, when
many countries got out of the gold standard.
Under the gold standard, gold alone is assured of unrestricted coinage, there is a two-way
convertibility between gold and national currencies in a stable ratio and gold can be freely
exported or imported. In order to support unrestricted convertibility into gold, bank notes
need to be backed by gold reserve of a minimum stated ratio. The domestic money stock
would rise and fall as gold flows in and out of the country.
In gold standard, the exchange rate between two currencies will be determined by the
gold content. If the pound is pegged to gold at six pounds per ounce and the US dollar is
pegged to gold at twelve dollars per ounce, the exchange rate between pound and dollar
will be 1 pound = 2 US dollars. As long as the pound and dollar remain pegged to the
gold at given prices, the exchange rate will remain stable. Under the stable exchange rate,
international trade and investment grew.
Any misalignment of exchange rate will be automatically corrected by cross-border

flows of gold. Suppose 1 punt is trading at 1.90 US dollars. This means that pound is
undervalued and US dollar is overvalued. This would mean that investors would buy
pounds using US dollars. They can buy gold from Bank of London, ship it to the US and
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sell the gold for US dollars. For example, if an investor needs USD 1,000, it would cost
1000/1.9 = 526.32 pounds. Instead, they can buy 1000/12 ounces of gold from Bank of
London for 500 pounds and ship the gold to New York and sell it to the Federal Reserve
for USD 1,000. Thus, one can save 26.32 pounds. Since everyone would be buying pounds
at exchange rate of USD 1.90, pound would appreciate to its fair value of USD 2.00.
In gold standard, international imbalance of payment will also be corrected automatically.

Suppose Britain exported more to USA than imports. This imbalance will not persist under
the gold standard because any imbalance will be accompanied by flow of gold. Since
Britain has a trade surplus, there will be an outflow of gold from USA to Britain. This will
lead to a lower price level in the USA and a higher price level in Britain. This will result in
lower export from Britain to USA and higher import from USA to Britain. This adjustment
mechanism is called price-specie-flow mechanism.
In spite of this advantage of gold standard, there are shortcomings associated with it.
Since supply of newly minted gold is restricted, growth in investment and trade can be
hampered for lack of sufficient monetary reserves. Further, a government may find it
necessary politically to preserve national objectives that are inconsistent with maintaining
the gold standard.
11.1.3 Interwar Period 1915 – 1944

In August 1914, Britain, France, Germany and Russia suspended redemption of bank notes
in gold and placed restrictions on gold exports. After the war in 1918, many countries
forced hyperinflation. During this period, countries used depreciation of their currencies
to gain advantages in export market.
United States has replaced Britain as the dominant financial power by this time and started
taking steps to restore the gold standard. US returned to gold standard in 1919 and Britain
in 1925. France, Switzerland and Scandinavian countries restored gold standard by 1925.
The Great Depression and accompanying financial crisis during 1929 till 1934 signified a
death knell for gold standard. Many banks in Austria, Germany and United States suffered
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sharp declines in their portfolio values resulting in bank runs. Britain experienced a
massive outflow of gold resulting from balance-of-payment deficit and lack of confidence
in pound-sterling. British gold reserves began to fall in spite of coordinated efforts, and in
September 1921, British government suspended gold payments and let the pound float.
Countries such as Canada, Sweden, Austria and Japan followed by the end of 1931. US got
off gold standard in April 1933 after a spate of bank failures and outflow of gold. France
abandoned gold standard in 1936. Paper standards came into being when gold standard
was abandoned.
No coherent international monetary system prevailed during the inter-war period.
11.1.4 Bretton Woods System

In July 1945, representatives of 44 nations met at Bretton Woods in USA to discuss and
design a postwar international monetary system. This resulted in the signing of Articles
of Agreement of the International Monetary Fund (IMF), which became the case of the
Bretton Woods system. The IMF was entrusted with explicit set of rules about the conduct
of international monetary policies and was responsible for enforcing these rules. Another
institution the International Bank for Reconstruction and Development also known as the
World Bank was created for financing individual development projects.
Under this system, each country established a par value in relation to the US dollar, which
was pegged to gold at $35 an ounce. Each country was responsible for maintaining its
exchange rate within 1% of the adopted par value by buying or selling foreign exchange
as necessary. If a country faced a fundamental disequilibrium, it may be allowed to make
change in the par value. US dollar was the only currency convertible to be sold. Other
countries held US dollars as well as gold as reserves and used to make international
payments. Due to these arrangements, Bretton Woods system can be described as a dollar-
based gold-exchange standard. A country on the gold-exchange standard holds most of
its reserves in the form of currency of a country that is really on the gold standard.
For the gold-exchange standard to work, the US had to run balance-of-payments deficits
continuously. However, if US have a perennial balance-of-payments deficit, it would result
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in a low confidence in US dollar causing a run on the dollar. This dilemma is known as
the Triffin Paradox and was responsible for the collapse of the gold-exchange standard.
US began to experience trade deficits with the rest of the world in 1950s and the problem
persisted into the 60s. By the early 60s, the total value of US gold stock when valued as $35
per ounce fell short of foreign dollar holdings, creating concern about the viability of the
dollar-based system. Against this backdrop, President Charles de Gaulle advised the Bank
of France to buy gold from US Treasury, unloading its dollar holdings. Efforts to remedy
the problem centred on a series of dollar defence measures taken by the US government
and creation of new reserve asset called the Special Drawing Rights (SDRs) by the IMF.
To partially alleviate the pressure on the dollar as the Central Reserve currency, the
IMF created an artificial international reserve called the SR in 1970. The SDR is a basket
currency comprising of major individual currencies, which was allotted to the members
of the IM who could then use it for transactions among themselves or with the IMF. In
addition to gold and foreign exchanges, countries could use the SDR to make international
payments.
Initially, SDR was designed to be the weighted average of 16 currencies of those currencies
whose shares in world export exceeded 1%. The percentage share of each currency in
SDR was about the same as the country’s share in world export. In 1981, however, SDR
was greatly simplified to comprise only five major currencies, namely, US dollar, German
Mark, Japanese Yen, British Pound and French Frank. The weight for each currency is
updated periodically reflecting the relative importance of each country in the World trade
of goods and services.
SDR is used not only as a reserve asset but also as a denomination currency for
international transactions. Since SDR is a portfolio of currencies, its value tends to be more
stable than the value of any individual currency included in SDR. The portfolio nature
of SDR makes it an attractive denomination currency for international commercial and
financial contracts under exchange rate uncertainty.
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The efforts to support dollar-based gold-exchange standard turned out to be ineffective

because of the expansionary monetary policy and rising inflation in the United States
which were related to the financing of Vietnam War. In the early 1970s, it became clear
that the dollar was overvalued, especially relative to the German Mark and Japanese Yen.
As a result, the German and Japanese Central Banks had to make massive interventions
in the foreign exchange market to maintain their par values. The repeated intervention by
the Central Banks of other countries could not solve the underlying disparity. In August
1971, President Nixon suspended the convertibility of the dollar into gold and imposed a
10% import surcharge.
In order to save the Bretton Woods system, 10 major countries, known as the Group of
Ten, met at the Smithsonian Institution in Washington D.C. in December 1971 and reached
the Smithsonian Agreement. Under this agreement:
a. Price of gold was raised to $38 per ounce

b. Each of the countries revalued its currency against the US dollar by up to 10%
and
c. The band within which the exchange rates were allowed to move was expanded
from 1% to 2.25% in either direction.
The Smithsonian Agreement lasted for about a year and it came under attack again. The
devaluation of the US dollar was not sufficient to stabilise the situation. In February 1973,
the dollar came under heavy selling pressure prompting central banks around the world
to buy dollars. The price of gold was further revised from $38 to $42 per ounce. By March
1973, European and Japanese currencies were allowed to float freely completing the failure
of Bretton Woods system.
11.1.5 Flexible Exchange Rate Regime: 1973 onwards

The flexible exchange rate regime that followed the demise of the Bretton Woods system
was ratified in January 1976 when IMF members met in Jamaica and agreed on a new set
of rules for international monetary system. The key elements of Jamaica agreement are:
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a. Flexible exchange rates were declared acceptable to IMF members and central
banks were allowed to intervene in the exchange markets to decrease volatility.
b. Gold was officially abandoned as an international reserve asset. Half of IMF’s
gold holdings were returned to the members and the other half were sold with
proceeds to be used to help poor nations.
c. Non-oil-exporting countries and less developed contrived were given greater
access to IMF funding.
11.1.6 Current Exchange Rate Agreements

IMF classifies exchange rate regimens into the following categories:
a. Exchange arrangements with no separate legal tender

b. Currency-based or fixed-peg arrangements
c. Other conventional fixed peg arrangements
d. Pegged exchange rates with horizontal bands
e. Crawling pegs
f. Exchange rates with crawling bands
g. Managed floating with no pre-arranged path for exchange rate
h. Independent floating
11.1.7 Fixed or Pegged Exchange Rate Systems

In a fixed exchange rate system, government sets exchange rates and tries to enforce their
acceptance on buyers and sellers. If they can be maintained, fixed rate systems reduce
foreign exchange risk for companies with cross-border trade.
Exchange rate changes in a fixed rate system are called devaluations when one currency
falls in relation to another and revaluation when one currency raises in relation to another
currency. There are two major setbacks in a fixed rate system. Fixed rate forges a direct
link between domestic and foreign inflation and employment. If one country has higher
inflation, its goods will become more expensive and hence consumers of the other country
will shift their purchases away which will push employment towards low inflation
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country. This will cause wages to fall in high inflation country and wages to rise in low
inflation country. Thus fixed exchange rate system links cross-country inflation differences
to wage levels and employment conditions.
Another problem in fixed rate system is the difficulty of sustaining fixed rates when they
diverge from market rates. The governments are standing ready to buy or sell currencies
at official exchange rates and thus attempt to fulfil the functions of the foreign exchange
market. If the official rate is different from the market rate, government will suffer a loss of
value as counter party buys the undervalued currency and sells the overvalued currency.
If the government refuses to buy or sell at the official rate, it will impede the cross border
flow of goods, services and capital.
The governments in general are adamant about maintaining fixed rates when fixed rate
systems are under pressure. Devaluation typically comes on the heel of claims that
governments have full confidence in the value of their currency and will maintain the
fixed rate system at all costs. This will only encourage currency speculators to bet against
the currency. When fixed rate system collapses, government officials are quick to blame
currency speculators for participating in the collapse.
Many governments attempt to peg or manage their currency values in relation to another
currency such as US dollar or to a Composite Index. For example, Denmark attempts to
peg the value of Krone within a band around the value of Euro. Saudi Arabia tried to peg
the value of Riyal to the US dollar. Singapore pegs the value of its dollar to a basket of
currencies.
The problem in pegging the value of a currency to another is that the economic
performance such as inflation and unemployment will have to be similar in the two
countries. In case the country that has pegged its currency suffers a higher inflation than
the country whose currency is used as the peg, the currency value would be overvalued
and can create problems.
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11.1.8 Floating Rate System

Floating rate system allows currency values to fluctuate to market supply and demand
without direct interference by the government. In these systems, there are no official
bounds on currency values. However, government intervention in the foreign exchange
markets can have an impact on currency values, especially in the short-term. An increase
in a currency value under a floating rate system is called appreciation and a fall in a
currency value is called depreciation.
The major advantage of floating rate system is that changes in inflation, wage levels and
unemployment in one country are not forced on another country through currency values
as exchange rate automatically adjusts for the inflation differentials between countries.
The major disadvantage of freely floating system is the volatility in exchange rate that
causes exchange rate risk.
11.1.9 Exchange Arrangements with No Separate Legal Tender

Some countries do not have a national currency of their own. The members of European
Monetary Union are the most prominent countries that follow this system. In 1999,
European Monetary Union countries adopted a common currency called the Euro, which
is the legal tender in all member countries.
11.2 European Union and Development of Euro

In 1971, the band of exchange rate movements was expanded from original plus or
minus 1% to plus or minus 2.25% under the Smithsonian Agreement. However, members
of European Economic Community (EEC) decided on a narrower band of 1.125% for
their currencies. This version was known as snake. EEC countries adopted the snake
because they felt that stable exchange rates among the EEC countries were essential for
promoting intra-EEC trade and deepening economic integration. The snake arrangement
was replaced by European Monetary System (EMS) in 1979. The chief objectives of EMS
were:
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a. To establish a zone of monetary stability in Europe

b. To coordinate exchange rate policies against non-EMS currencies
c. To pave the way for eventual European Monetary Union
All EEC member countries except United Kingdom and Greece joined EMS. The two
main instruments of EMS were the European currency unit (ECU) and the exchange rate
mechanism (ERM).
European currency unit is a basket currency constructed as a weighted average of the

currencies of member countries of the European Union. The weights were based on each
country’s relative GNP and share in intra-EU trade. The ECU served as the accounting unit
of the EMS and played an important role in the workings of the exchange rate mechanism.
The exchange rate mechanism (ERM) refers to the procedure by which EMS member
countries collectively manage their exchange rates. The ERM was based on a parity grid
system, which is a system of par values among ERM currencies. The par values in the
parity grid were computed by first defining the par values of EMS currencies in terms
of the ECU. These par values were called the ECU central rates. Based on the par values
against ECU, exchange rates among currencies were determined.
When ERM was established in 1979, a currency was allowed to deviate from parities with
other currencies by a maximum of + or –2.25% based on the comparison of ECU central
rate and market value of ECU. If currency’s ECU market rate deviated from the central
rate by the maximum allowable limit, the country is required to adjust its macroeconomic
policies to maintain its par values relative to other currencies.
As members of EMS were not fully committed to coordinating economic policies, EMS
went through a series of realignments. Italian lira deviated by 6% in July 1985 and again
by 2.7% in 1990. In September 1992, Italy and United Kingdom palled out of ERM as high
interest rates in Germany induced massive capital flows into Germany. Italy rejoined the
ERM in December 1996.
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European Union members met at Maastricht in December 1991 and signed Maastricht
Treaty. The Treaty established the following convergence criteria for EMU entry to ensure
relatively homogenous economic and monetary conditions in EMU countries:
a. Inflation rates within 1.5% of the three best performing EU countries

b. Long-term interest rates within 2% of the three best performing EU countries
c. Exchange rate stability within ERM for at least 2 years
d. Budget deficits no higher than 3% of GDP
e. Government debt less than 60% of GDP
By the end of 1997, there was convergence in inflation, interest rates and budget deficits
in participating EMU countries. There was less convergence in the amount of public debt
outstanding. Greece did not meet any of the treaty’s convergence criteria and was unable
to join until 2001.
On January 1, 1999, the Euro replaced the ECU in the European exchange rate mechanism,
becoming unit of account, but not yet a physical currency. The exchange rates of
participating countries were pegged to the euro at that time. On January 1, 2002, Euro
began public circulation alongside national currencies. On July 1, 2002, Euro formally
replaced the currencies of participating countries.
Voters in Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,

Netherlands, Portugal and Spain ratified Maastricht Treaty. Voters in Denmark, Sweden
and United Kingdom failed to ratify the treaty, but retained the option of joining EMU at
a later date.
Under the EMU, European Central Bank (ECB) was created in Brussels and ECB is
responsible for maintaining the value of Euro against other currencies. Euro is a freely
floating currency and is also used as a reserve currency in many countries.
11.3 IMF and Currency Crisis

The mission of the IMF is to make short-term loans to countries with temporary fund
shortages. IMF has aided many countries in times of stress. However, IMF has not had
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great deal of success in keeping its involvement in short-term. A number of currency crises
have evolved in the 1990s, which were triggered by a fixed or pegged exchange rate system
that overvalued the local currency and/or a large amount of foreign currency debt. In each
case, the government depleted its foreign currency reserves in defence of the currency and
was unable to maintain the fixed exchange rate.
11.3.1 Mexican Peso Crisis of 1995

During December 1994 and January 1995, the Mexican peso lost 40% of its value against
the US dollar. The Mexican stock market also fell 50% in local Peso terms during this time.
The combined effect of peso depreciation and stock market crash was a 70% drop in the
dollar value of equity investments in Mexico.
Peso came under increasing pressure in late 1994 as Mexico’s foreign exchange reserves
were depleted. Eventually, the Mexican government concluded that the exchange rate
could not be sustained. On December 1994, the government announced a 30% devaluation
of the peso. The market value of Peso continued to fall by 50% against the US dollar.
To assist Mexico in meeting short-term obligations, United States and IMF assembled a
standby credit of $40 billion. With liquidity ensured, Mexican economy started to recover
in 1995. The Mexican stock market and value of Peso became stable and Mexico paid off
IMF loan in 2000.
11.3.2 Asian Financial Crisis of 1997

In May 1997, the Thai baht came under pressure as speculators bet against the currency,
which was pegged to a currency basket that included the US dollar. Foreign currency
reserves were severely depleted as the Bank of Thailand defended the currency falling
from nearly $40 billion in December 1996 to less than $10 billion by July 1997. On July 2,
1997, Thailand allowed the Baht to float. By the end of 1997, the Baht had lost nearly 50%
of its value against the dollar.
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Thailand suffered from several problems at the time of its crisis including a current
account deficit that was 8% of GDP, massive short-term foreign currency borrowings
used to support speculative property ventures in Thailand and declining competitiveness
brought on by rising wages. With lack of investor confidence, property and stock markets
fell and stock market had lost more than 50% of its value by the end of the year.
Asian contagion soon spread to Indonesia. Indonesia also had a pegged exchange rate, a
large current account deficit, massive short-term foreign currency debt used to support
speculative property ventures and declining competitiveness. The rupiah fell steadily
throughout the second half of 1997. By the end of January 1998, rupiah had lost more than
75% of its value against the dollar.
South Korea’s won was the next to fall. South Korea’s economic situation was also
undermined by a pegged exchange rate, a large current account deficit and large short-
term foreign currency obligations. Despite the competitiveness of the Korean economy,
won lost nearly one-half of its value during the last several months of 1997.
IMF came to the rescue of these economies. With the support of USA, Europe and Japan,
the IMF assembled standby credit arrangements of $58 billion for Korea, $43 billion for
Indonesia and $17 billion for Thailand.
11.3.3 Russian Ruble Crisis

Russia embarked on a painful transition towards a market-based economy after the
breaking of the Soviet Union in 1991. The difficulties during this transition included
hyperinflation, an undeveloped banking system, widespread tax avoidance, corruption
and huge budget deficits. GDP fell from $804 billion in 1991 to only $282 billion in 1998
with a budget deficit of nearly 10% of GDP.
In July 1993, Russia placed the ruble in a crawling peg. This stabilised the value of ruble
against the dollar and reduced inflation from 1700% in 1992 to 15% by 1997. It also resulted
in high real ruble interest rates. Faced with declining tax revenues, the government
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financed its fiscal deficit by borrowing in the capital markets. In 1997, Russia began rolling
over its ruble-denominated debt into dollar-denominated Eurobonds.
In 1998, ruble came under speculative pressure as investors reassessed the viability of
emerging market investments following the Asian crisis of 1997. By July 1998, Russia was
finding it difficult to refinance its dollar debt as it matured. IMF arranged a $23 billion
loan package, but this was not enough to support the rouble. On August 17, 1998, Russia
was forced to abandon the exchange rate peg and defaulted on more than $40 billion of
debt. By April 1999, Russia owed IMF nearly $13 billion.
11.3.4 Reminbi Controversy

The problem with managed exchange rate arises because the country may purposely
undervalue its currency in order to gain competitive advantage. This is the case with
Chinese reminbi where countries such as USA and Europe accuse China of keeping the
reminbi at an artificially low value in order to compete in the international market.
11.4 Problems with Freely Floating Currencies

When currencies are freely floating, the volatility of exchange rate would increase due
to frequent trading of currencies. In addition, a particular currency may show consistent
appreciation or depreciation creating imbalance in the competitiveness of the countries.
For example, during the mid-80s, the US dollar rose in value relative to other currencies.
During this time, foreign governments complained that high value of US dollar was
causing inflation in their economies because of the high price of imports denominated in
US dollars. The US government complained of widening trade deficit due to poor position
of high priced US goods. In September 1985, the Group of Ten met at the Plaza Hotel in
New York and agreed to cooperate in controlling volatility in exchange rates. A principal
objective of the Plaza Accord was to bring down the value of the US dollar. By February
1987, the dollar had fallen to what many believed to be equilibrium. At that time, the
Group of Five (France, Germany, Japan, United Kingdom and United States) met in France
and agreed in Louvre Accord to promote stability in the currency market. Since 2000,
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dollar has been increasing as well as decreasing in value, with governments intervening
in the market to stabilise its value.
11.4.1 Greek Issue

The year 2010 saw turmoil in Europe with Greece almost at bankruptcy, as it was not able
to repay the national debt it had accumulated. Since Greece was using Euro instead of
national currency, it could not print its own currency to pay off the debt and had to rely
on bail out by other members of the Europe Monetary Union.
11.5 Foreign Exchange Markets

Foreign exchange market is essential for international trade because it permits the transfer
of purchasing power from one currency to another at a point in time. The currency
market also allows speculators to bet on the direction of changes in currency values.
Currency speculation by international banks, hedge funds and wealthy individuals
ensures that foreign exchange rates represent a consensus of market participants and
provides additional liquidity to the foreign exchange market.
Foreign exchange market also provides a means to hedge against currency risk. Currency
risk or foreign exchange risk is the risk of unexpected changes in foreign currency
exchange rates.
Foreign exchange market facilitates international capital flow and provides investors
with opportunities for international portfolio diversification. Financial institutions,
corporations, investment funds and individuals undertake this.
11.5.1 Structure of Foreign Exchange Market

The structure of the foreign exchange market is an outgrowth of one of the primary
functions of a commercial banker: to assist clients in the conduct of international
commerce. For example, a corporate client desiring to import merchandise from abroad
would need a source for foreign exchange if the import was invoiced in the exporter’s
home currency. Assisting in foreign exchange transactions of this type is one of the services
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that commercial banks provide for their clients and one of the services that bank customers
expect from the bank.
The spot and forward market is an over-the-counter market; that is, trading does not
take place in a central market place where buyers and sellers congregate. The foreign
exchange market is a worldwide linkage of bank currency traders; non-bank dealers and
foreign exchange brokers who assist in trades connected to one another via a network
of telephones, telex, computers and automated dealing systems. Reuters, Telerate and
Bloomberg are the largest vendors of quote screen monitors used in trading currencies.
Twenty-four-hour-a-day currency trading follows the sun around the globe. There are
three major market segments: Australasia, Europe and North America. Australasia
includes trading centres of Sydney, Tokyo, Hong Kong, Singapore and Bahrain. Europe
includes Zurich, Frankfurt, Paris, Brussels, Amsterdam and London. North America
includes New York, Montreal, Toronto, Chicago, San Francisco and Los Angeles. Most
trading rooms operate over a 9 to 12 hour working day, although some banks have
experimented with operating three 8-hour shifts in order to trade around the clock. Active
trading takes place when the trading overlaps in the three markets.
The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market and the other tier is the retail or client market. The foreign
exchange market participants can be categorised into five groups: international banks,
bank customers, non-bank dealers, foreign exchange brokers and central banks.
International banks provide the core of the foreign exchange market. Approximately 700
banks worldwide actively make a market in foreign exchange, that is, they are willing
to buy or sell a foreign currency. These international banks serve their retail clients, the
bank customers in conducting foreign commerce or in making international investment
in assets that require foreign exchange. Bank customers include MNCs, money managers
and private speculators. Non-bank dealers are large non-bank financial institutions such
as investment banks who maintain their own trading room to trade directly in the
interbank market for their transaction needs.
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Part of the interbank trading among international banks involves adjusting the inventory
position they hold in various foreign currencies. However, most interbank trades are
speculative or arbitrage transactions where market participants attempt to correctly judge
the future direction of price movements in one currency versus another or attempt to profit
from temporary price discrepancies in currencies between competing dealers.
Foreign exchange brokers match dealer orders to buy and sell currencies for a fee but do
not take a position themselves. Brokers have knowledge of the quotes offered by many
dealers in the market. Interbank traders will use these brokers primarily to disseminate
as quickly as possible, a currency quote to many other dealers. However, use of brokers
has decreased because of the introduction of automated trading systems.
Central banks participate in the foreign exchange market through intervention.

Intervention is the process of using foreign currency reserves to buy one’s own currency
in order to decrease its supply and thus to increase its value or sell one’s own currency
for foreign currency in order to increase its supply and lower its value. Central banks
frequently intervene in the foreign exchange market to influence the value of their
currency relative to a trading partner.
The interbank market is a network of correspondent banking relationships with large

commercial banks maintaining demand deposit accounts with one another, called
correspondent banking accounts. This account network allows for the efficient functioning
of the foreign exchange market. The Society for Worldwide Interbank Financial
Telecommunication (SWIFT) allows international commercial banks to communicate
instructions of transfer of money to one another. SWIFT is a private non-profit message
transfer system with headquarters in Brussels with intercontinental switching centres
in Netherlands and Virginia. The Clearinghouse Interbank Payment System (CHIPS)
in cooperation with the US Federal Reserve Bank System provides a clearinghouse for
interbank settlement of US dollar payments between international banks.
Exchange Clearing House Limited (ECHO) is a multilateral netting system that on each
settlement date nets a client’s payments and receipts in each currency regardless of
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whether they are due to or from multiple counterparties. Multilateral netting eliminates
the risk and inefficiencies of individual settlement.
11.5.2 Spot Market

Spot Market involves the immediate purchase or sale of foreign exchange. Usually, cash
settlement is made in two business days, excluding holidays of either the buyer or seller,
after the transaction for trades.
Typically, the common practice among currency traders worldwide to price and quote
currencies is against the US dollar. Spot rate quotation can be either a direct quotation
or an indirect one. If the currency quote in any country is stated as the number of local
currency units per US dollar, the quote is an indirect quote and if the quote is stated as the
number of US dollar units per one unit of local currency, the quote is a direct quote. Direct
quote is used in UK, Australia, New Zealand and Ireland while indirect quote is used in
other countries. In Singapore, the quote is always given as the units of Singapore dollars
per unit of foreign currency such as USD 1 = SGD 1.2825 or AUD 1 = SGD 1.3156.
In interbank market, the standard size trade among large banks in the major currencies is
for the US dollar equivalent of $10 million. Dealers quote both the bid and asked, willing
to either buy or sell up to $10 million at quoted prices. Spot quotations are good for only
a few seconds. If a trader cannot immediately make up his mind whether to buy or sell at
the offered prices, quotes are likely to be withdrawn.
11.5.3 Currency Derivatives

Currency options and currency futures are available for hedgers to hedge currency
risk. Currency options are traded in options exchanges as well as in the OTC market.
Currency futures are traded in the futures exchanges. The trading procedure for currency
derivatives will be discussed under derivatives market.
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Lesson Recording
Foreign Exchange Market
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a. A mortgage loan uses the asset as a collateral
b. In case the borrower defaults on the mortgage loan, lender can repossess the
asset
c. In a mortgage loan, interest payments are paid periodically and principal is
paid at maturity
d. A mortgage loan is an amortising loan
2. In an adjustable rate mortgage

a. The interest rate on the loan remains constant
b. The interest rate on the loan always increases
c. The interest rate on the loan can either increase or decrease
d. The interest rate on the loan will always decrease
3. A reverse annuity mortgage

a. Requires the borrower to pay equal monthly payments over the life of the loan
b. Requires the lender to make equal payments to the borrower over the life of
the loan
c. Is one in which the borrower will continue to own the asset at maturity of the
loan
d. Is useful for retired people as the monthly payment would be low

a. The purpose of securitisation is to remove the loans provided from the balance
sheet
b. A special purpose vehicle is used for the issue of asset-backed security
c. The asset backed securities are sold by special purpose vehicle to investors
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d. The risk faced by investors in the asset-backed securities will be based on the
credit rating of the mortgage originators

a. In a pay-through structure, Tranche 1 security holders face the largest risk
b. In a pay-through structure, Tranche 3 security holders face the largest risk
c. In a pay-through structure, payment to tranche 3 security holders can vary
over time
d. In a pay-through structure, Tranche 2 security holders are promised a higher
interest rate compared to tranche 1 security holders

a. A CDO is a security backed by underlying debt obligations
b. A CDO typically consist of different tranches with different risks
c. A CDO pays the Tranche 1 security holders first
d. There is no risk involved in the purchase of Tranche 1 securities in a CDO as
they are paid first

a. Default risk arises in CMO generally when interest rate increases
b. Prepayment risk arises in CMO generally when interest rate decreases
c. Prepayment risk arises in CMO generally when interest rate increases
d. While investing in CMO, investors should be concerned with both default risk
and prepayment risk
8. All of the following are credit enhancement activities except

a. Overcollateralization
b. Reserve funds
c. Triggered amortisation
d. Repurchase of CMO
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9. Overcollateralization occurs when

a. SPV buys $100 worth of assets and sells $120 m worth of asset-backed securities
to investors
b. SPV buys $100 worth of assets and sells $100 m worth of asset-backed securities
to investors
c. SPV buys $100 worth of assets and sells $80 m worth of asset-backed securities
to investors
d. SPV holds large amount of cash
10. Triggered amortisation means

a. SPV must redeem all CDOs issued when required to do so by investors
b. SPV must redeem all CDOs issued when certain conditions are met
c. SPV must redeem all CDOs issued when default percentage increases
d. SPV must redeem all CDOs issued when cash is not available to pay the claims
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a. A mortgage loan uses the asset as a collateral
Incorrect. Answer is wrong as the statement “A mortgage loan uses the asset
as a collateral” is correct
b. In case the borrower defaults on the mortgage loan, lender can repossess the
asset
Incorrect. Answer is wrong as the statement “In case the borrower defaults
on the mortgage loan, lender can repossess the asset” is correct
c. In a mortgage loan, interest payments are paid periodically and principal is

paid at maturity
Correct. Answer is correct as the statement “In a mortgage loan, interest
payments are paid periodically and principal is paid at maturity” is wrong.
In a mortgage loan, periodic payments include both interest for that period
as well as part of the principal amount
d. A mortgage loan is an amortising loan

Incorrect. Answer is wrong as the statement “A mortgage loan is an
amortising loan” is correct
2. In an adjustable rate mortgage

a. The interest rate on the loan remains constant
Incorrect. Answer is wrong because the interest rate on the loan can change
based on how the interest rate in the market changes
b. The interest rate on the loan always increases
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Incorrect. Answer is wrong because interest rate on the loan depends on the
market interest rate which can either increase or decrease
c. The interest rate on the loan can either increase or decrease

Correct. Answer is correct because the interest rate on the loan depends on
the market interest rate which can increase or decrease
d. The interest rate on the loan will always decrease

Incorrect. Answer is wrong because interest rate on the loan depends on the
market interest rate which can either increase or decrease
3. A reverse annuity mortgage

a. Requires the borrower to pay equal monthly payments over the life of the
loan
Incorrect. Answer is wrong as the lender will make equal payment to the
borrower over the life of the loan or until the death of the borrower and at
that time the lender will own the asset
b. Requires the lender to make equal payments to the borrower over the life of
the loan
Correct. Answer is correct as the lender will make equal payment to the
c. Is one in which the borrower will continue to own the asset at maturity of
the loan
d. Is useful for retired people as the monthly payment would be low

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that time the lender will own the asset and the borrower need not have to
make any payment

a. The purpose of securitisation is to remove the loans provided from the
balance sheet
Incorrect. Answer is wrong as the statement “The purpose of securitisation
is to remove the loans provided from the balance sheet” is correct as
securitisation removes the loans from the balance sheet
b. A special purpose vehicle is used for the issue of asset-backed security

Incorrect. Answer is wrong as the statement “A special purpose vehicle
is used for the issue of asset-backed security” is correct as asset backed
securities are issued through a special purpose vehicle
c. The asset backed securities are sold by special purpose vehicle to investors
Incorrect. Answer is wrong as the statement “The asset backed securities are
sold by special purpose vehicle to investors” is correct as the special purpose
vehicle creates the asset backed securities and sell them to the investors
d. The risk faced by investors in the asset-backed securities will be based on the
credit rating of the mortgage originators
Correct. Answer is correct as the statement “The risk faced by investors
in the asset-backed securities will be based on the credit rating of the
mortgage originators” is wrong. The risk is based on the credit worthiness
of the borrowers of mortgage loan and not of the mortgage originators

a. In a pay-through structure, Tranche 1 security holders face the largest risk
Correct. Answer is correct as the statement “In a pay-through structure,
Tranche 1 security holders face the largest risk” is wrong. Tranche 1
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security holders have priority to receive the money and hence face the least
risk
b. In a pay-through structure, Tranche 3 security holders face the largest risk

Incorrect. Answer is wrong as the statement “In a pay-through structure,
Tranche 3 security holders face the largest risk” is correct as the Tranche 3
security holders are equivalent to holding equity and they will be paid only
after Tranche 1 and Tranche 2 holders are paid
c. In a pay-through structure, payment to tranche 3 security holders can vary

over time
payment to tranche 3 security holders can vary over time” is correct. Since
the total payment from the assets can vary over time and the Tranche 1 and
Tranche 2 holders are promised a certain rate of return, the amount payable
to tranche 3 holders can vary over time
d. In a pay-through structure, Tranche 2 security holders are promised a higher

interest rate compared to tranche 1 security holders
Tranche 2 security holders are promised a higher interest rate compared
to tranche 1 security holders” is correct. Since Tranche 2 securities are
subordinate to Tranche 1 securities, the risk for Tranche 2 is higher and hence
interest rate will be higher for Tranche 2 securities

a. A CDO is a security backed by underlying debt obligations
Incorrect. Answer is wrong as the statement “A CDO is a security backed by
underlying debt obligations” is correct.
b. A CDO typically consist of different tranches with different risks
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Incorrect. Answer is wrong as the statement “A CDO typically consist of

different tranches with different risks” is correct.
c. A CDO pays the Tranche 1 security holders first

Incorrect. Answer is wrong as the statement “A CDO pays the Tranche 1
security holders first” is correct.
d. There is no risk involved in the purchase of Tranche 1 securities in a CDO

as they are paid first
Correct. Answer is correct as the statement “There is no risk involved in the
purchase of Tranche 1 securities in a CDO as they are paid first” is wrong.
Tranche 1 security also faces the risk of the borrowers of underlying loans
defaulting so that Tranche 1 security holders may not receive the promised
payments.

a. Default risk arises in CMO generally when interest rate increases
Incorrect. Answer is wrong as the statement “Default risk arises in CMO
generally when interest rate increases” is correct. When interest rate
increases, the mortgage borrowers may not be able to make payments and
hence default
b. Prepayment risk arises in CMO generally when interest rate decreases

Incorrect. Answer is wrong as the statement “Prepayment risk arises in
CMO generally when interest rate decreases” is correct. When interest rate
decreases, original mortgage borrowers are likely to refinance the loan at a
lower rate and hence are likely to pre-pay the original mortgage
c. Prepayment risk arises in CMO generally when interest rate increases

Correct. Answer is correct as the statement “Prepayment risk arises in
CMO generally when interest rate increases” is wrong. Prepayment of
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original mortgage will happen when the interest rate falls and the original
mortgage borrowers are likely to refinance the loan at a lower rate
d. While investing in CMO, investors should be concerned with both default

risk and prepayment risk
Incorrect. Answer is wrong as the statement “While investing in CMO,
investors should be concerned with both default risk and prepayment
risk” is correct because CMO holders will be affected both by default and
prepayment
8. All of the following are credit enhancement activities except

a. Overcollateralization
Incorrect. Answer is wrong as “overcollateralization” is a credit enhancement
activity
b. Reserve funds
Incorrect. Answer is wrong as “reserve funds” is a credit enhancing activity
c. Triggered amortisation
Incorrect. Answer is wrong as “triggered amortisation” is a credit enhancing
activity
d. Repurchase of CMO
Correct. Answer is correct as “repurchase of CMO” is not a credit
enhancing activity
9. Overcollateralization occurs when

a. SPV buys $100 worth of assets and sells $120 m worth of asset-backed
securities to investors
Incorrect. Answer is wrong as overcollateralization means that the value of
asset-backed securities issued is less than the value of collateral used to create
the asset-backed securities
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b. SPV buys $100 worth of assets and sells $100 m worth of asset-backed
Incorrect. Answer is wrong as overcollateralization means that the value of
asset-backed securities issued is less than the value of collateral used to create
the asset-backed securities
c. SPV buys $100 worth of assets and sells $80 m worth of asset-backed
Correct. Answer is correct as overcollateralization means that the value of
asset-backed securities issued is less than the value of collateral used to
create the asset-backed securities
d. SPV holds large amount of cash

Incorrect. Answer is wrong as overcollateralization means that the value
of asset-backed securities issued is less than the value of collateral used to
create the asset-backed securities. The amount of cash is not considered in
overcollateralization
10. Triggered amortisation means

a. SPV must redeem all CDOs issued when required to do so by investors
Incorrect. Answer is wrong as triggered amortisation occurs when the SPV
must redeem all CDOs when the conditions stated occur
b. SPV must redeem all CDOs issued when certain conditions are met
Correct. Answer is correct as triggered amortisation occurs when the SPV
c. SPV must redeem all CDOs issued when default percentage increases
d. SPV must redeem all CDOs issued when cash is not available to pay the
claims
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SU6-34

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Course Development Team

Head of Programme : Dr Tan Chong Hui

© 2020 Singapore University of Social Sciences. All rights reserved.

Educational Technology & Production

How to cite this Study Guide (APA):

(study guide). Singapore: Singapore University of Social Sciences.

Build S1.0.5, T1.5.21

2. Course Description and Aims............................................................................ CG-3

3. Learning Outcomes.............................................................................................. CG-4

4. Learning Material................................................................................................. CG-5

5. Assessment Overview.......................................................................................... CG-6

Chapter 1: The Financial System........................................................................... SU1-4

Chapter 2: Characteristics & Regulation of Financial Markets and

Chapter 3: Efficient Market Hypothesis............................................................. SU1-23

Formative Assessment.......................................................................................... SU1-28

Chapter 4: Financial Institutions........................................................................... SU2-4

Formative Assessment.......................................................................................... SU2-80

Chapter 5: Money Market and Money Market Instruments............................. SU3-4

Chapter 6: Bond Markets and Instruments....................................................... SU3-25

Formative Assessment.......................................................................................... SU3-50

Chapter 7: Equity Markets..................................................................................... SU4-4

Chapter 8: Stock Index Related Securities......................................................... SU4-24

Formative Assessment.......................................................................................... SU4-32

Chapter 9: Derivatives Market and Instruments................................................ SU5-4

Chapter 10: Options, Credit Derivatives and Swaps....................................... SU5-28

Formative Assessment.......................................................................................... SU5-56

Chapter 11: Foreign Exchange Market................................................................. SU6-4

Formative Assessment.......................................................................................... SU6-23

List of Lesson Recordings

The Financial System................................................................................................. SU1-14

Characteristics and Regulations............................................................................... SU1-22

Efficient Market Hypothesis..................................................................................... SU1-27

Financial Institutions (Commercial Banks)............................................................. SU2-79

Financial Institutions (Investment Banks and Mutual Funds)............................. SU2-79

Financial Institutions (Insurance Companies and Pension Funds)..................... SU2-79

Money Market and Money Market Instruments................................................... SU3-24

Bond Markets and Instruments................................................................................ SU3-49

Equity Markets............................................................................................................ SU4-23

Equity Related Securities........................................................................................... SU4-31

Derivatives Markets and Instruments..................................................................... SU5-27

Credit Derivatives and Swaps.................................................................................. SU5-55

Foreign Exchange Market.......................................................................................... SU6-22

Financial Instruments, Institutions

2. Course Description and Aims

Knowledge & Understanding (Theory Component)

1. Explain the significance and functioning of financial markets in the economy

Key Skills (Practical Component)

Assessment Description Weight

Assignment 1 Pre-Class Quiz 1 2%

Assignment 2 Group-Based Assignment / GBA 38%

Class Participation Class Participation 6%

Examination Written Examination 50%

Assessment Description Weight

Assignment 1 Pre-Course Quiz 2 2%

Assignment 2 Group-Based Assignment / GBA 38%

Class Participation Class Participation 6%

Assessment Description Weight

Examination Written Examination 50%

SUSS’s assessment strategy consists of two components, Overall Continuous Assessment

At the end of this unit, you are expected to:

• Analyse the components of a financial system

Chapter 1 provides an introduction to the course on financial institutions, instruments

In Chapter 2, we will discuss the characteristics of and functions served by financial