Funct

ionsofFi nancialInsti
tut
ions
Fi
nanciali
nsti
tutionsinclude
i
. banks
i
i. credi
tuni ons
i
ii
. assetmanagementf i
rms
i
v. bui l
dingsoci eti
es,and
v. stockbroker ages,amongot her
s.

Theseinsti
tuti
onsar eresponsibl
efordistr
ibuti
ngf i
nancialresour
cesinapl annedwayt othe
potenti
alusers.Ther eareanumberofi nsti
tuti
onst hatcol l
ectandpr ov
idef undsforthe
necessarysectorsorindi
vi
duals.Ontheotherhand, t
herear esever
ali
nsti
tuti
onsthatactasthe
middlemenandj ointhedefi
citandsur pl
usuni t
s.Investingmoneyonbehal fofthecli
entis
anotherofthev ar
iet
yoffuncti
onsoffinanci
al i
nsti
tut
ions.

Fi
nanci
ali
nst
it
uti
onscanbecat
egor
izedasf
oll
ows:

 Deposi
tTaki
ngI nstit
uti
ons
 Fi
nanceandInsur anceInsti
tut
ions
 I
nvestmentI
nsti
t uti
ons
 Pensi
onProvi
dingI nsti
tuti
ons
 Ri
skManagementI nsti
tuti
ons

Atthesamet i
me,ther
eareseveralgovernmentalf
inanci
ali
nsti
tuti
onsassi
gnedwit
hr egulat
ory
andsuper
visoryf
uncti
ons.Theseinsti
tut
ionshaveplayedadist
inctrol
einf
ulf
il
li
ngthefinanci
al
andmanagementneedsofdi f
ferenti
ndustri
es,andhav eal
soshapedt henati
onaleconomi c
scene.

Deposi
tstaki
ngfi
nancialor
gani
zati
onsareknownascommer
cialbanks,
mut
ualsav
ingsbanks,
savi
ngsassoci
ati
ons,andloanassoci
ati
ons.

Theprimar yf
uncti
onsoff i
nanci
ali
nst
it
uti
onsoft
hisnat
urear
easf
oll
ows:
a.AcceptingDeposi
ts
b.Provi
dingCommer ci
alLoans
c.Provi
dingRealEstateLoans
d.Provi
dingMor t
gageLoans
e.I
ssuingShareCertifi
cat
es

Fi
nancecompaniesprovi
deloans,businessinventor
yf i
nancingandi ndi r
ectconsumerloans.
Thesecompaniesgetthei
rfundsbyi ssuingbondsandot herobl
igations.Thesecompani es
operat
einanumberofcount r
ies.Ont heot herhand,t herearei nsurancecompaniest hat
provi
decover
ageforavari
etyofri
skfactorsandt heyalsopr ovi
desev eralinv
est
mentopt i
ons.
I
nsurancecompani
esprovi
deloansforanumberofpur posesandcreat einvestmentpr
oducts.

Thef uncti
onsoff i
nancialinstit
utions,suchasst ockexchanges,commodi tymar ket
s,futures,
currency,andoptionsexchangesar ev er
yimportantf ortheeconomy .Thesei nstit
uti
onsar e
i
nv olvedincreat
ingandpr ovidi
ngowner shi
pf orfinanci
alclaims.Thesei nst
it
utionsar ealso
responsibl
eformai nt
ainingliquidi
tyi nthemarketandmanagi ngpricechangerisks.Aspar tof
theirvari
ousservi
ces,thesei nstit
utionsprov
ideinvestmentoppor tuni
ti
esandhel pbusi nesses
togener at
efundsforvariouspur poses.
1|Page
Thef uncti
onsoff i
nanci
alinst
it
uti
onsli
keinvestmentbanksarealsov it
alandrel
atedtothe
i
nvestmentsect or
.Thesecompaniesareinvolv
edi nanumberoff inanci
alact
ivi
ti
es,suchas
underwrit
ingsecuri
ti
es,sel
l
ingsecuri
ti
estoinvestor
s,provi
dingbr
okerageservi
ces,andfund
rai
singadv i
ce.

A.Pri
mar yFunctionsofBanks
Thepr i
maryf uncti
onsofbanksar ealsoknownasbanki
ngf
unct
ions.Twooft
hepr
imar
y
funct
ionsofbanksar eexpl
ainedbel
ow.

1.Accept
ingDeposit
s
Bankscol
lectdeposi
tsf
rom t
hepubl
i
c.Thesedeposi
tscanbeofdi
ff
erentt
ypes,
suchas

i. Savi
ngDeposits
i
i. Fi
xedDeposits
i
i
i. Curr
entDeposit
s
i
v. Recurr
ingDeposi
ts

i
.Sav i
ngDeposit
s
Thistypeofdeposi
tsencouragessavi
nghabitamongthepubli
c.Ther at
eofinter
estislow.At
presenti
tisabout4%p.a.Wi thdr
awalsofdeposi
tsareal
l
owedsubj ecttocert
ainrestr
ict
ions.
Thisaccounti
ssuit
abl
et osalaryandwageearner
s.Thi
saccountcanbeopenedi nsingl
ename
orinjoi
ntnames.

i
i.FixedDeposi
ts
Lumpsum amounti sdeposi
tedatonet
imeforaspecif
icper
iod.Hi
gherr
ateofi
nter
esti
spaid,
whichv ar
ieswi
ththeperi
odofdeposit
.Withdr
awalsarenotall
owedbefor
etheexpir
yofthe
peri
od.Thosewhohavesurplusf
undsgoforfi
xeddeposi
t.

i
ii.Curr
entDeposit
s
Thistypeofaccounti
soper
atedbybusi
nessmen.Wit
hdrawalsar
efr
eel
yall
owed.Noint
erestis
paid.Infact
,ther
eareserv
icechar
ges.Theaccountholder
scangetthebenef
itofoverdr
aft
facil
i
ty.

i
v.RecurringDeposit
s
Thi
sty peofaccountisoperatedbysalar
iedpersonsandpet
tytr
ader
s.Acer
tai
nsum ofmoney
i
speriodicall
ydeposi
tedintothebank.Withdr
awalsar
epermit
tedonl
yaf
tert
heexpi
ryofcer
tai
n
per
iod.Ahi gherr
ateofinter
estispai
d.

2.Granti
ngofLoansandAdv ances
Banksadv anceloanstothebusinesscommunit
yandothermembersofthepubli
c.Therate
chargedishigherthanwhatitpaysondeposi
ts.Thedi
ffer
encei
ntheint
erestr
ates(l
ending
rat
eandt hedepositrat
e)i
sit
sprofit
.

Thety
pesofbankl
oansandadv
ancesar
e:-
i
. Overdr
aft

i
i. CashCr edi
ts
i
i
i. Loans
i
v. Discounti
ngofBi
l
lofExchange

2|Page
i
.Ov erdraft
These t ypes ofadv ances are gi
ven to curr
entaccounthol ders.No separat
e accountis
maintained.Allentri
esar emadei nthecur r
entaccount.Acer tai
namounti ssancti
onedas
overdraftwhichcanbewi thdrawnwithi
nacer t
ainperi
odoft imesayt hr
eemont hsorso.
Int
eresti schargedonact ualamountwi thdrawn.Anov er
draftfaci
l
ityi
sgr ant
edagai nsta
coll
ateralsecuri
ty.I
tissanctionedt
obusinessmanandf ir
ms.

i
i.CashCr edi t
s
Theclientisallowedcashcr edi
tupt oaspeci
ficli
mitfixedinadvance.Itcanbegiventocurrent
accounthol dersaswel last oot herswhodonothav eanaccountwi thbank.Separatecash
credi
taccounti smaintained.I
nteresti
schargedont heamountwi thdrawninexcessofl i
mi t
.
Thecashcr editi
sgi v
enagai nstt hesecur
ityoft angibl
eassetsand/orguar antees.The
advancei sgi venforal ongerper i
odandal argeramountofl oani ssancti
onedt hanthatof
overdr
aft.

i
ii.Loans
I
ti snormall
yforshortter
m sayaper iodofoney earormedium ter
m sayaper i
odoffiv
ey ears.
Now- a-
days,banksdol endmoneyf orlongter
m.Repay mentofmoneycanbei nt
hef orm of
i
nst al
mentsspreadov eraperiodoft i
meori nal umpsum amount .I
nteresti
schargedont he
actualamountsancti
oned, whetherwithdrawnornot .Ther
ateofint
erestmaybesli
ght l
ylower
thanwhati schargedonov erdraft
sandcashcr edit
s.Loansarenor mall
ysecur
edagai nst
tangibl
eassetsofthecompany .

i
v.Discounti
ngofbillofexchange
Bankscanadv ancemoneybydi scounti
ngorbypur chasingbill
sofexchangebothdomest i
c
andforei
gnbi l
l
s.Thebankpay sthebillamounttothedr awerort hebenef
iciar
yofthebil
lby
deducti
ngusualdiscountcharges.Onmat ur
it
y,thebilli
spr esent
edt ot
hedr aweeoraccept
or
ofthebil
landtheamounti scoll
ected.

B.SecondaryFunctionsofBanks
Banksperf
orm anumberofsecondar yf
uncti
ons,
alsocal
ledasnon-
banki
ngf
unct
ions.
Theseimportantsecondar
yfunct
ionsofbanksar
eexplai
nedbel
ow.

1.AgencyFunct
ions
Banksactasanagentofi
tscust
omer
s.Someoft
heseagencyf
unct
ionsi
ncl
ude:
-

i. TransferofFunds
i
i. Coll
ectionofCheques
i
i
i. Peri
odicPay ments
i
v. Portf
olioManagement
v. Peri
odicCollect
ions
v
i. OtherAgencyFunctions

i
.TransferofFunds
Banktransf
erfundsfr
om onebr
ancht
oanot
herorf
rom onepl
acet
oanot
her
.

i
i.Coll
ecti
onofCheques
Bankscollectt
hemoneyofthechequesthroughcl
ear
ingsect
ionofi
tscust
omer
s.Thebank
alsocol
lectsmoneyoft
hebi
l
lsofexchange.

3|Page
i
ii
.Peri
odi
cPay ment
s
Onstandi
nginstr
uct
ionsoft
hecl
i
ent
,bankmakesper
iodi
cpay
ment
sinr
espectofel
ect
ri
cit
y
bi
ll
s,r
ent,
etc.

i
v.Portf
olioManagement
Banksalsoundertaketopurchaseandsellt
hesharesanddebenturesonbehal
fofthecli
ents
andaccordingl
ydebit
sorcredit
stheaccount
.Thi
sfacil
it
yiscal
ledportf
oli
omanagement
.
v.Per
iodicColl
ecti
ons
Bankscollectsal
ary,pensi
on,divi
dendandsuchot herper
iodiccoll
ecti
onsonbehal
foft he
cli
ent
.

vi.OtherAgencyFuncti
ons
Theyactast r
ustees,
execut
ors,
adv
iser
sandadmi nist
rat
orsonbehal
fofi
tscl
i
ent
s.Theyactas
represent
ati
vesofcli
entst
odealwi
thotherbanksandinst
it
uti
ons.

Money
Moneyisanyassetthati
sacceptabl
easamedi um ofexchangeinpaymentfor
goodsandservi
ces.Moneyisamedi um ofexchangewhi chensuresthesuccessofexchange
bybeingtheoneitem onoff
erthatisalwaysacceptable.Moneyisnecessarybecausehuman
bei
ngs
mustexchangetoliv
etoget
herinpeace,andtoprosper.Thisconnotesthei
mpor t
ancei
nt he
di
scoveryoft
heideaofmoney

MoneyandCapi talMarket
Businessunit
shav etorai
seshort-
ter
m aswellaslong-
ter
mf unds t
omeett heirworki
ngand
fi
xedcapitalr
equir
ementsfrom t
imetoti
me.Surpl
usmoneyflowsfrom t
heinvestorsorl
enders
tothe busi
nessmenf ort
hepurposeofproduct
ionorsaleofgoodsandser vices.So,wefind
two dif
fer
entgroups,onewhoi nvestmoneyorlendmoneyandt heothers,whobor row or
use 
t hemoney

Fi
nanci
alMar
ket
Financialmar ketist hemar ketthatfacil
i
tat
est ransferoffundsbetweeni nvestor
s/l
endersand
borrower s/users.Fi nancial 
mar ketmaybedef inedas‘ at r
ansmissionmechani sm between
i
nv estors( orl ender s)and  the borrowers( oruser s)through which transferoff unds is
facil
itat
ed’.Itconsist sofindividual
 i
nvestor
s,financi
al i
nst
itut
ionsandotheri nt
ermedi
arieswho
arelinkedbyaf ormalt rading rul
esandcommuni cat
ionnetworkfortr
adingt hevari
ousfinancial
asset sandcr edit 
inst r
ument s.Itdealsinfinanciali
nstrument s(l
i
kebi l
l
sofexchange,shar es,
debent ur
es, bonds, etc).

Mai
nfunct
ionsoff
inanci
almar
ket
(a) I tprovi
desfacili
ti
esforint
eractionbetweent heinvestorsandtheborr
owers.
(b) I tprovi
despricinginf
ormationresult
ingfrom theinteracti
onbetweenbuyer
sand
sel
ler
s i
nthemar ketwhent heytradet hefi
nanci
al assets.
(c) I tprovi
dessecur i
tytodeal
ingsi nfi
nanci
al assets.
(d) I tensuresl
iquidit
ybyprovidingamechani sm forani nvestort
osellt
hefi
nanci
alasset
s.
(e) I tensuresl
owcostoft r
ansactionsandinformat i
on.

Cl
assi
fi
cat
ionofFi
nanci
alMar
ket

4|Page
 Afi
nanci
almar
ketconsi
stsoftwomaj orsegment
s:
(
a)MoneyMarket
i
. CallMoney .
i
i
. Treasur
yBi l
l.
ii
i
. Commer cialPaper
.
iv
. Certi
fi
cateofDeposit.
v
. Tradebil
l.

(
b)Capit
al 
Market
.
1. Securi
ti
esMar ket
i. PrimaryMar ket: I
POs, Pr
ivatePl
acements.
i
i. SecondaryMar ket:Equit
yMar ket,DebtMarket
,Commodi t
yMar ket
,
Fut
uresandOpt ionsMar ket.(SecondaryMar ketcanbebasical
l
ydiv i
dedi ntotwo
–spotmar ketandf orwar dmar ket
.Forwardmar kethastwodivi
sions–f utures
andopti
ons/deri
vati
ves.Again, therear
et wotypesofopti
ons–putopt ionandcal l
opt
ion)

2. Non-
Securi
ti
esMar ket
i
. MutualFunds.
i
i. Fi
xedDeposits,
Sav
ingsDeposi
ts,
PostOf
fi
cesav
ings.
i
ii
. I nsurance.

Whi
lethemoneymarketdeal
sinshor
t-
ter
m cr
edi
t,t
hecapi
talmar
kethandl
es 
themedi
um
t
erm andl
ong-
ter
m cr
edit
.

MoneyMar ket
Themoneymar ketistheglobalfi
nanci
almar ketforshor
t-t
erm borr
owingandl
endi
ng.I
t
prov
idesshort-
terml i
qui
df undi
ngf ort
heglobal f
inanci
alsyst
em.Themoneymar keti
sa
sect
orofthecapi t
almar ketwhereshort-
ter
m obligati
onssuchasTr easur
ybi
ll
s,
commer ci
alpaperandbanker s'accept
ancesar eboughtandsol d.

Tr
easur
yBi
ll(
T-bi
ll
):Tr
easur
yBi
l
lsar
eshor
t-
ter
m secur
it
iesi
ssuedbyt
heUni
tedSt
ates
gov ernmentwhichtypicall
yhav emat urit
iesof13weeks( quar
teryear)
,26weeks( half
year )
,or52weeks( oney ear)
.Tr easuryBi l
lsarenor mallysol
din$10,000denominat
ions
anddonothav eastatedi nterestrateofr eturn.Insteadtheyaresoldatadiscountin
whicht hef ul
lamountcanber edeemedatmat uri
ty.Thisisknownassel l
ingona
discountbasis.Riskassoci atedwi thTr easur yBill
si ssol ow t
hatinsomef i
nancial
calculati
onstheT-
billi
sconsi deredar iskl
essi nvestment.

Commer
cialPaper
:Commer
cialPaperi
snot
hingmor
ethanapr
omi
ssor
ynot
esol
dbya
l
argeor ganizati
onwiththemi nimum sizeusuall
ysetat$100, 000.Themat ur
it
yof
Commer cialPaperi
sany wherebetween1and270day s(9mont hs)
.Longermat ur
iti
es
mustber egister
edwiththeSecuri
ti
esandExchangeCommi ssi
on(SEC).Linesofcredit
fr
om largebanksensur ethatthereisplentyofcashavai
labletopayof fCommer cial
Paperreducingther
isktakenonbyt hei
rholder
s

Cer
ti
fi
cat
es of Deposi
t(CDs)
:Cer
ti
fi
cat
es of Deposi
t ar
e secur
it
ies i
ssued by
commer
cialbankst
orai
secashf
orl
oansandot
herpur
poses.Maturi
ti
esusual
lyrange
fr
om 6 monthsto5y ear
s.Unl
i
ke Tr
easur
yBil
l
s,CDsar e sol
d atface v
alue and
5|Page
 accumulat
einterestataf
ixedr
atewi
ththepr
inci
pal(facev
alue)andint
erestpaidat
maturi
ty.Negoti
ableCDshavef
aceval
uesof$100,000ormor eandcanbet radedin
Capit
alMarkets.

Banker
s’Accept
ances:Banker
s’Accept
ancesar
eshor
t-
ter
mloansmadet
oimpor
ter
s
and expor
tersand hel
p withi nt
ernat
ionaltradebyal l
owing acust
omert o payfor
product
swi t
ht heacceptance.Theaccept ancemayei t
herbehelduntilmaturi
tyor
cashedinatadi scount.SinceaBanker s’Acceptanceisat wo-
part
yobl i
gat
ion( t
he
customerandthebank),
ther i
skislow.Acceptancesusual
lyhav
eamat ur
it
yof180day s
andareredeemablebyanyholder.

Capi
talMar
ket
CapitalMarketisani nsti
tuti
onalar
rangementforborrowi
ngmedi um andlong-ter
mf undsand
whichpr ovi
desfacili
ti
esf ormarket
ingandt r
adi
ngofsecur i
ti
es.Soitconsti
tutesalll
ong-t
erm
borrowingsfrom banksandf i
nanci
alinst
it
uti
ons,borr
owingsfrom f
orei
gnmar ket
sandr ai
sing
ofcapitalbyissui
ngv ar
ioussecuri
ti
essuchasshar es,debentur
es,bonds,etc.Thesecuri
ties
markethast wodifferentsegmentsnamelyprimaryandsecondarymarket.

PrimaryMar ketv s SecondaryMar ket:The pr i

marymar ketconsists ofar rangement sf or
procurementofl ong-
termf undsbycompani esbyfreshissueofshar esanddebent ures.The
secondarymar ketorstockexchangepr ovi
desar eadymar ketf orexi
sti
ngl ongterm securit
ies.
Stockexchangei sthesecondarymar ket,whichprovi
desapl aceforregularsaleandpur chase
ofdiff
erenttypesofsecur i
tiesl
ikeshares,debentur
es,bondsandgov ernmentsecur it
ies.I
ti s
an organized marketwher e al
lt r
ansactions areregul
at ed byt he rules and laws oft he
concernedstockexchanges.

Stockexchangesar etopr ovi

dereadyandcont i
nuousmar ketforsecur i
ties,inf
ormationabout
pri
cesandsal es,safetytodeali
ngsandi nvest
ment ,helpsmobi li
zati
onofsav i
ngsandcapi tal
format i
on.Itactsasabar ometerofeconomi candbusi nesscondi t
ionsandhel psi nbett
er
all
ocat i
onoff unds.St ockexchangesprovidemanybenef itstocompani es,invest
orsandt he
societyas a whol e.Butt heyalso suff
erf r
om limitati
ons l i
ke exclusi v
e speculati
on and
fl
uctuationinpr i
cesduet orumoursandunpr edi
ctableev ents.SEChasi ni
tiat
edanumberof
reformsi nthepr i
mar yandsecondarymar kettoregulatet hestockmar ket.Document aryand
procedur al
requir
ement sforli
sti
ngandt r
adinghavebeenmadest ri
cterandf ool
prooftoprot
ect
i
nv estors’i
nter
est.

Thesecondarymarkethasfurt
hertwocomponents. 
Fir
st,
thespotmar
ketwher
esecur
iti
esare
tr
adedforimmediatedeli
veryandpayment.
 Theotherisfor
wardmarketwher
ethesecuri
ti
es
aret
radedforfut
uredel
iver
yand payment
.

For
wardMar ket/ Cont
ract
Aforwardcontractrepresentsacontractt
obuyorsel lanunderl
yi
ngassetonaspecifieddate
i
nthefutur
ei.e.itisanagr eementbetweentwoparti
esi nwhichonepart
y;thebuy
er,agreesto
buyfr
om theotherpar ty;t
hesell
er,anunderly
ingassetorotherder
ivat
iveatafut
uredat eand
atapri
ceestablishmentatt hest
artofthecontr
act
.

Part
iest
oafor
war
dcont
ract
Ther
earetwopar
ti
estoaforwar
dcont
ract
,namel
y;l
ongandshor
t.Thel
ongposi
ti
oni
na
6|Page
 for
ward cont
ractrepr
esentsbuy i
ng an assetorotherderiv
at i
veinst
ruments.BUY ist he
commonestterm usedforal ongposit
ioninthecashmar ket
.Theshor tposi
tionr
epresents
sel
li
nganunderly
ingasset.SELListhecommonestwor dusedf orashortposi
ti
oninthecash
market
.

Longposi
ti
on
i
. Thelongposi t
ionmakesprofi
twhenthepr
iceofunder
lyi
ngassetgoesupint hef
utureti
me
i
.e.theinvestorswouldbebuy i
ngatacheaperpri
cecomparedt othehigherpri
cei nthe
fut
uresmar ket.
i
i
. Thelongposi t
ionmakeslosswhenthepri
ceofunderl
yi
ngassethecommi ttedtobuygoes
downint hefutureti
mei.e.hewoul
dbebuy i
ngatahighercommi t
tedpr
icecompar edtoa
l
owerf ut
urespr i
ce.

Shor
tposi
ti
on
i
. Theshor tmakespr ofitwhent hepr
iceoftheunderl
yingassethecommi tt
edtosellgoes
downi nt hefutur
etimei.e.hewoul dbesell
ingatahighercommi t
tedpri
cecomparedtoa
l
owerf uturepri
ce.
i
i
. Theshor tpositi
onmakesl osswhent hepr
iceoftheunderlyi
ngassethecommitt
edt osel
l
goesupi nt hefut
ureti
mei .
e.hewouldbeselli
ngatcheapercommitt
edpri
cecomparedtoa
hi
gherf utur
et i
mepr i
ce.
Summar y
Posit
ion Increasei
ntheFP Decreasei
ntheFP
Long Gain Loss
Short Loss Gain

Thi
sf orwardmar keti
sfurtherdivi
dedintoFuturesandOpt i
onsMar ket(Deri
vat
ives 
Mar kets)
. I
n
fut
uresmar ket,t hesecurit
iesar etraded forcondit
ionalfuturedeliver
ywher easi n opt
ion
market,twot ypesofopt ionsar etraded.Aputopt i
ongi vesrightbutnotan obli
gationt othe
ownertosell asecur i
tyt
ot hewr i
teroftheoptionatapredetermined 
pri
cebeforeacer tai
ndat e,
whil
eacal loptiongi v
esrightbutnotanobl igati
onto 
thebuy ertopurchaseasecur i
tyfrom the
wri
teroftheopt ionatapar ti
cularpri
ce bef
oreacertai
ndat e.

FuturesMar ket
Afuturesmar ket/contr
actisacont r
actt
obuyorsel
lbetweentwocount
erpar
ties,oneknown
asabuy er(long)andt heotherknownasasell
er(short
)atapri
cedetermi
nedt odayona
parti
cularunder l
yingassetbutt obeimpl
ement
edinthefutur
e.I
nsummar y
,afuturescontr
act
shouldhav ethef oll
owingv ar
iabl
es;
 Longposi tion
 Shor tposit i
on
 Under lyingasset
 Agr eedpr ice(futurepr
ice)
 Ti met omat ur
ity

Char
act
eri
sti
csofaFut
uresCont
ract
Thef
ollowi
ngarethechar
act
eri
sti
csoffut
uresmarket
:
a.Standar
disat
ion:Allasset
st raded i
nf ut
ures mar
ket ar
e st
andar
dised i
n nat
ure.
7|Page
 Standar disationcancomei nt hef orm ofqual it
yoft heasset ,quantityoft heasset ,dateof
deliveryet c.
b.Or ganisedExchange:Al lt hei nst rument st r
adedi nf uturescont r
actar eexecut edont he
fl
ooroft heexchange.Fut ur esmar ketisanor ganisedmar ketwher ebot hbuy er
sandsel lers
meetont hef loort oexecut ethei rtransactions.Fut urescont r
actisnev eranOTCcont ract.
c.Del iv
eryDat eorPer i
od:Inf uturesmar ket,deliverydat esar eusual l
yst andardisedt oev ery3
mont hs.Though,t hi
smi ghtbet rueinal lcases,t herei sar angeofdel iverydat esi nt he
futuresmar ket .
d.Set tl
ement :Set t
lementi nf utur escont ractisusual l
ydoneev eryday .Thepur poseoft hi
si s
toal l
owpr ofitorl osstobeascer tainedbyt het raders.Settlementi sal way sregulatedbyt he
clearinghouset hatensur est hatt hedef aultriskonbot hsidesi sel i
mi nated.
e.Close- out:Unl ikeanyot hercont r
act ,f
uturescont ractisusual lyclosedoutpr iortomat urity
.
Ther ei snophy sicaldeliveryoft heasseti nt hecaseoff inancialasset .Thesel ler(short
posi ti
on)aut omat i
call
y becomes buy er( long)i n ordert o close- out,whi l
et he buy er
aut omat i
cal l
ybecomest hesel l
eri nordert ocl ose-out.

AdvantagesofFutur
esMarket
 Liquidi
ty:Onepri
mar
yreasonwhyi
nvest
orsusef
utur
escont
racti
sit
sli
qui
dit
y.Mostoft
he
i
nst
rument
str
adedont
heexchangecanbeeasi
l
ytur
nedi
ntocashori
tsequi
val
ent
.

 CreditRisk:Thecredi
tri
ski
nthefutur
escontr
actst
artsi
mmedi
atel
ythecont
racti
sini
ti
ated
butitiseli
minatedbythepr
esenceofthecl
eari
nghouse.

 Def ault
:Becauset hereisacleari
nghouset hatguaranteesperformance,thedefaultbyone
partyi sel
iminatedcompl et
ely.Buyer
sandsel l
ersdonotset t
lethemselvesphysicall
y,the
clearinghouset hatserv
esasi nt
ermediar
ybet weenthem doest hesett
lement.
 Standar di
sation:Mostinstr
ument str
adedont hefutur
escont r
actarestandardandofhi gh
grade.Lowgr adeassetsintermsofqual i
ty,deli
verydate,quanti
tycannotbetradedont he
futuresmar ketbecauseallt
heseelementsmusthav ebeenspeci f
iedoutinthecontract.

Di
sadvantagesofFut ur
esMarket
 Infl
exibi
li
ty ofthe contr
actterm:Because al
lthe ter
ms int
he fut
ures cont
ractare
standardi
sed,thereisnor oom foramendingthetermsofthecontr
act.Termsoft he
contracti
ncludethedel
iv
erydat
e,thequant
it
y,t
hequali
tyet
c.

 Avail
abil
it
yoftheclear
inghouse:Ever
yfutur
esmarketmusthaveaclear
inghouse.The
costofsetti
ngupofacl ear
inghousei
shighandnofutur
esmarketcanworkwit
houtthe
presenceofacl
ear
inghouse.

 TransactionCost:Thereisalsoat r
ansacti
oncostattachedt
oev er
ycontr
actonaf ut
ures
contr
act.Asidethefinanci
alasset,t
het r
ansact
ioncostofholdi
ngaphy si
calasseti
svery
hi
ghe. g.stor
agecost,i
nsurance,
theftanddeter
ior
ati
on.

TheRol
eofCl
ear
ingHousei
nFut
uresCont
ract
Everyfuturesexchangemusthav eacl eari
nghouset hatperformssev eralfuncti
ons.Oneoft he
functi
onsi stoguaranteethatthetwopar t
iestothetransactionwi l
lperfor
m.Whenani nv
estor
takesaposi ti
onont hef ut
uresmarket,theclear
inghouset akesposi t
ionandagr eedtosati
sfy
thetermssetf ort
hint hecontr
ast.Because,theclear
inghouseser vesasi ntermediarybet
ween
thebuyerandt hesell
er ,
thebuyerneedsnott oknowt hesellerandthesel l
erneedsnott oknow
thebuy er.Theinvestorsneednotwor r
yaboutt hef i
nancialstrengthandt heintegr
it
yofthe
8|Page
partytakingsideofthecontract.Aftertheinit
ialexecuti
onofanor der,
therelat
ionshipbetween
thebuy erandt hesell
erends.Thecl eari
nghousei nter
posesit
selfast hebuyerf orever
ysal e
andt hesel lerforeverypur chase.Thusi nvestorisfreet oli
quidat
et hei
rposi ti
onwi thout
i
nvolvingt heotherpart
yint heor i
ginalcontractandwi thoutworr
yingthattheot herpart
ymay
default.Besidethisguaranteef uncti
on,thecl earinghousemakesi tsimplef orparti
est oa
fut
urescont racttounwindtheirpositi
onpriortot hesett
lementdate.

Simil
arl
y,thefuncti
onofadj ust
ingthemargi
naccountisper
formedbythecl
eari
nghouseto
ascert
ainthepr of
itandlossont hemargi
naccount.Theprocessofadj
ust
ingthemar gi
n
accounti edmar
scal
l ket
-t
o-the-market
.

I
nsummary,clear
inghouseper f
ormst
hef
oll
owi
ngf
unct
ions;
 Guaranteefuncti
on
 Set
tlementf unct
ion
 Markingthemar ginaccount

Margi
nofFuturesMarket
I
nf ut
uresmarketcont
ract
,thepersontaki
ngeit
heralongposi
ti
onorashortposi
ti
onmust
maint
ainamar gi
naccountwiththestockbroki
ngfi
rm.Thefol
lowi
ngar
et heter
minol
ogi
es
usedinthemargi
naccount
.

 Ini
ti
alMar gi
n:Whenaposi ti
oni sfi
rstt
akeninthefut
urescontract
,thei
nvest
ormust
depositaminimum amountoffundasspeci
fi
edbytheexchange.Thi
sfundi
scaledi
l niti
al
margin/f
und.Ini
ti
almargi
ncanequallybedefi
nedasanamountofmoneyi nthemargi
n
accountonthedayoftr
ansact
ionorwhenthemargi
ncal
lwasmade

 Mai
ntenanceMar gi
nRequi r
ement :Amai ntenancemar gi
nr equirementistheamountof
moneyint hemar gin accounton anydayot hert han when t hei ni
ti
almar gi
n appl
ies.
Mai
ntenancemarginr equir
ementcanequal l
ybedef inedasami nimum lev
elspecif
iedby
t
heexchanget owhicht hemar gi
naccountmayf al
ltoasar esultofanunf avour
ablepri
ce
movementbelowwhi chtheinvest
orisr
equiredtodeposi tadditi
onal money.

 Vari
ati
onMargi
n:Thi
sisthedi
fferencebetweenthebal
ancei
nthemarginaccountandt
he
i
nit
ialmargi
norsimplyput,av ariat
ionmarginistheamountofmoneyt hatmustbe
deposi
tedi
ntot
hemargi
naccountt obringt
hebal
ancetother
equi
redl
evel
.

Mai
ntenanceMar
ginf
oraLongPosi
ti
onandaShor
tPosi
ti
on
ForLong:
MMcall=I
P–(
IM –MM)
ForShor
t:
MMcall=I
P+(
IM –MM)
Wher
e;
I
P =I
nit
ial
Pri
ce
I
M =I
nit
ial
Margin
MM =Maint
enanceMar
gin

ForLong:Al
ongwi
l
lrecei
veaMM cal
lwhent
hef
utur
espr
icei
sfal
l
ingbutwi
l
lmakepr
ofi
t
whenthef
utur
espri
ceisri
sing.However
,al
ongposi
ti
oncanwi t
hdr
awf r
om t
hemar
ginaccount
i
ftheamounti
ntheaccounthasnotgonebel
owtheMM requi
rement.

9|Page
ForShor
t:I
nvest
ort
aki
ngashor
tposi
ti
onwi
l
lreal
i
sepr
ofi
tift
hef
utur
epr
icei
sfal
l
ingori
ncur
l
ossifthefutur
epri
cei
sri
sing.However
,ashortposit
iont
radercanonl
ywit
hdr
aw fr
om t
he
margi
n accountift
hefut
urepriceisfal
li
ng and t
hebalanceinthemaint
enancemargi
n
r
equir
ement.

Posi
ti
oni
nfut
uresmar
ket

Long Shor
t

I
ncrease Decrease I
ncrease Decrease
i
npr i
ce inprice i
npr i
ce inprice

Makespr
ofi
t Makesl
oss Makespr
ofi
t Makesl
oss

Canwi t
hdraw Cannotwit
hdraw Cannotwi
thdraw Canwithdr
aw
from account f
rom account fr
om account f
rom
account

Mar ki
ngdownt otheMar ket
Assumi nganinvestorhastakenalongposi
ti
oninbuyi
ngasi mpl
eequit
y.Thei
nit
ialpri
ceis
N1,000whent hetransacti
onopened(day0).Theini
ti
almargi
nwasN50andt hemar gi
n
maintenancer
equirementwasN30.Assumingthei
nvest
ortookaposi
ti
oni
n100contract
s.

I
ll
ust
rat
ion,
usi
ngt
het
abl
ebel
ow;

1.Atwhatpri
cewastheinv
estorwillbecal
ledupontobeefuphisaccount
?
2.Adj
ustthemargi
naccounttorefl
ectthechangesint
hefutur
espri
ce
3.Cal
cul
atetheover
all
prof
itandlossfrom themargi
n
Day O/
ba Fund Fut
urepr
ice Changei
nfut
ure Gai
n/Loss C/
bal
l deposi
ted pr
ice
0 1000
1 992
2 960
3 1010
4 1035
5 1030
6 1040
7 1020

Sol
uti
on
(Tut
ori
alnot
e)
Thepersoni
nvol
vedwasal
ongposi
ti
ont
rader
.Hi
sai
m wast
omakepr
ofi
tinant
ici
pat
iont
hat

10|Page
pri
cewil
lgoup.Hewascal ledupontobeefuphisaccountwhenthefutur
espr
icewasgoing
down;t
heref
ore,
thepri
ceatwhichhedidnotall
owfurthercr
ashbef
orethel
ongposi
ti
ont
rader
wascal
ledupontobeefuphisaccountcanbecal
cul
atedasf ol
l
ows
Si
nce I
P-(IM -MM)
1000-(50-30)
=1000-20
=N980

LONGPOSI
TION
Day O/
bal Fund Fut
ures Δi
nfut
ures Gai
n/Loss C/
bal

deposi
ted pr
ice pr
ice

0 - (
50x100) 1000 - - 5000

5000

1 5000 - 992 -
8 -
800 4200

2 4200 - 960 -
32 -
3200 1000

3 1000 4000 1010 50 5000 10000

4 10000 - 1035 25 2500 12500

5 12500 - 1030 -
5 -
500 12000

6 12000 - 1040 10 1000 13000

7 13000 - 1020 -
20 -
2000 11000

Pr
ofi
t 2000

Onday1,t heinvestorhadN4200i nhi saccount,thisdoesnotwar r

antacallbecausethe
amountwashi ghert hanthemar ginmai nt
enancer equirementofN3000( 30x100).Howev er
,
onday2, ther
ewasav ar
iati
onofN2000i .
e.thedif
ferencebet weenthebalanceint
heaccount
andmar ginmaintenance,theinv
estorwascal leduponaf terthe2nddayi.
e.day3tobeefuphi s
accountbyN4000.Bet weenday s4–7, t
hebal ancesintheaccountdi dnotgobelowthemar gin
maintenanceofN3000andt hustheinvestorwasnotr equir
edtobr i
ngadditi
onalmoney.The
tot
algainfrom t
histransacti
onwasN2000.Thegai ncanbef oundinthreedif
fer
entways

i
.

i
i
.

11|Page
i
i
i.

12|Page
Opti
onMar ket
Anopti
oni sacontractualagreementt hatgi
vestheoptionbuy
erther i
ghtbutnottheobl
igati
on
tobuy(i
nthecaseofacal loption)ortosell(i
nthecaseofaputoption)aspecif
iedinst
rument
ataspecifi
edprice(exerci
sepr ice)atanytimet heopt
ionbuyerchoosestoexercisehi
sr i
ght.
Thefol
l
owi ngaretheessent i
alingredi
entsthatconst
it
uteaval
idoption.
1.Exerci
sepr i
ce
2.Opti
onpr emium
3.Thet i
met omat ur
it
y
4.Thepr i
ceoftheunder ly
ing

Therearetwotypesofopti
on,namelyacal
lopti
onandaputopt i
on.
 CALLOPTI ON:Acallopti
ongivestheopti
onholdertheri
ghttobuyanassetatanagreed
pri
ceonacer t
aindat
einthefutur
e
 PUTOPTI ON:Aputoptiongiv
estheopti
onholdertheri
ghtt
osellanassetonacer
tai
ndate
foracert
ainpri
ce.

Hol
der
i
. Anoptionholderisthebuy
erofanopti
onincaseofacallopti
onandhei
sasel
l
eri
n
caseofaputoption.
i
i
. Opti
onholderistheper
sonthatpay
spr
emium t
otheopt
ionwri
ter.

Wr
it
er
i
. Anoptionwri
teristhesel
lerofanopti
onincaseofacal
lopt
ionandheisthebuy
eri
n
caseofputopti
on
i
i
. Opt i
onwr i
teri
sthepersont
hatrecei
vespr
emi
um f
rom t
heopti
onhol
der.

OPTI
ON

Cal
l Put

Opt
ionhol
der Opti
onwrit
er Opt
ionhol
der Opti
onwrit
er
Ri
ght Obli
gat
ion Ri
ght Obli
gat
ion

Buy Sel
l Sel
l Buy

Paypr
emi
um Recei
vepr
emi
um Pay
spr
emi
um Recei
ves
pr
emi
um

Opti
onPosi
ti
ons
Ther
eareonl
yfouropt
ionposi
ti
onsandt
heyar
e:Longcal
l
,Shor
tcal
l
,Longput
,andShor
tput
.

LongCal
lPosi
ti
on
Ahol
derofalongcall
posit
ionanti
cipatesani
ncreaseinthepri
ceoftheunderly
ingasseti
nthe
f
utur
e.Hi
saimi st
omakepr ofi
tfr
om suchani ncreasei
nt hepr
iceoftheunderl
yi
ngasset.I
na
l
ongcal
lposi
ti
on,thewri
terisobl
i
gat edtodel
i
v erorsel
ltheasseti
fthelongcal
lhol
der

13|Page
choosest
oexer
cisehi
sri
ghtt
obuy
.

Thef
ollowi
ngarethesummar yofhi
sposi
ti
on.
LongCall
Payoff=max( O,ST–X)
Profi
t=max( O,ST–X)–Co
Maximum loss=Co
Maximum profi
t=
Break-
even=X+Co

Shor
tCal
lPosi
ti
on
Ahol derofashor tcallposi
ti
onantici
pat
esadecreasei
nt hepr
iceoft
heunder
lyi
ngasset
.Ina
shortcall,
thewr i
terisobli
gatedtobuytheunder
lyi
ngassetatt
hestri
kepr
icei
ftheshor
tcall
holderchoosest oexer ci
sehisri
ghttosel
l.
Thef oll
owingaret hesummar yofhisposit
ion
ShortCall
Payof f=-max( O,ST–X)
Profi
t=-max( O,ST–X)+Co
Maxi mum profi
t=Co
Maxi mum loss=
Break-even=X+Co

I
ll
ust
rat
ion1
i
. Considerast ocksell
ingforN39,al ongcal lposit
ionholderhasent
eredi
ntoanagreement
tobuythest ockf orN48in30day sti
me.I nor dertoguarant
eeperf
ormance,apr
emium of
N4waspai d.Atexpi r
ati
ont hecashmar ketpriceofthestockisnowN50
a)Whatistheopt ionpayoff?
b)Whatistheopt ionprofi
t?
c)Whatistheopt ionbreakeven
d)Whatistheopt ionmaximum pr ofi
t?
e)Whatistheopt ionmaximum l oss?
Assumet hattheopt i
onisanAmer i
canoption

Sol
uti
on1
Thi
sisalongcal
lposi
ti
on
a)Thepayoff=Max(O,S–X)

b)Pr
ofi
t =Max(
O,S–X)-Co
=VT–Co

c)Br
eakev
en=X+Co
=

14|Page
 d)Maxi
mum pr
ofi
t=α

e)Maxi
mum l
oss=

MoneyMar
ketandCapi
tal
Mar
ket:
Acompar
ison
Point of Moneymar ket Capitalmar ket
di
stinct
ion
Time TheMoneyMar ketsareusedf or Capitalmar ket
s ar e used fort he
peri
od/Ter therai
singofshor tt
ermf i
nance, rai
singofl ongt er
mf i
nance,suchas
m sometimes for loans that are thepur chaseofshar es,orforloans
expected t
o be pai d back as t hatarenotexpect edt obef ul
lypaid
overni
ght backf oratleastay ear.

I
nst
rument Deal sin securi
tiesli
ke t
reasury Dealsinsecuriti
eslike
sDeal
tIn bi l
l
s,commer ci
alpaper,bil
ls of shares,debentures,bondsand
exchange,certi
fi
cateofdeposits governmentsecur it
ies
etc
Par
ti
cipant Commer cial
banks. Stockbrokers,underwr i
ter
s,
s mut ualfunds,i ndivi
dualinvest
ors,
fi
nanciali
nstit
utions

Regul
ator
y CBN SEC (
Secur
it
ies and Exchange
body Commi
ssi
on)

Assi
stance Fundsbor r
owedf r hemoney Whenacompanybor
om t rowsf rom t he
markets aret y
pical
ly used for pri
mar y capitalmar kets,of t
en t he
generaloperati
ng expenses,t o purpose ist oi nvesti n addit
ional
coverbriefperi
odsofi ll
iqui
dit
y. physicalcapitalgoods,whi chwi l
lbe
For example a company may usedt ohel pi ncreasei tsincome.I t
have inbound pay ments from can t ake many mont hs or y ears
customers that have not y et before the i nv estment gener ates
cl
eared, but may wi sh t o suffi
cientreturnt opaybacki tscost,
i
mmedi atel
ypayoutcashf orits andhencet hef i
nancei slongt er
m
payrol
l.

15|Page
 TYPESOFBANKS
Bankscomewi t
hav ar
iet
yofnames,andonebankcanf
unct
ionassev
eraldi
ff
erentt
ypesof
banks.Someofthemostcommontypesofbanksar
e:

Retai
lbanks,
Commer
cial
banks,
Inv
est
mentbanks,
Cent
ral
banks,
Credi
tuni
ons,
Onl
i
nebanks,
Savi
ngs andloans

Youmaynotbeabl
etousesomeoft
hebanksabov
edependi
ngonwhoy
ouar
eandwhaty
ou
need

Type1Sav i
ngBanks
Savi
ngbanksar eestabli
shedtocr eat
esav i
nghabitamongthepeople.Thesebanksarehelpful
forsalari
ed people and low i
ncome gr oups.The deposi
tscollect
ed from cust
omersar e
i
nvestedinbonds,securiti
es,etc.Atpresentmostofthecommer albanksc
ci ar
rythefunct
ions
ofsavingsbanks.Postaldepar
tmentalsoper f
ormsthefunct
ionsofsavingbank

Type2Commer ci
alBanks
Commer cialbanksareestabli
shedwithanobj ect
ivetohel
pbusinessmen.Thesebankscol
lect
moneyf rom generalpubl
icandgiv eshort
-t
erml oanstobusi
nessmenbywayofcashcr edit
s,
overdr
afts,etc.Commer cialbankspr ovi
dev ari
ousservi
ceslikecoll
ecti
ngcheques,bil
lof
exchange,remit
tancemoneyf rom oneplacetoanotherpl
ace.

Type3.Indust
ri
alBanks/Devel
opmentBanks
Indust
ri
al/Devel
opmentbankscol
lectcashbyi
ssuingshar
es&debent
uresandprovi
dingl
ong-
termloanstoindust
ri
es.Themainobjecti
veofthesebanksi
stoprovi
delong-
termloansfor
expansi
onandmoder ni
sat
ionofi
ndustri
es.

Type4.LandMort
gage/LandDev elopmentBanks
LandMor t
gageorLandDev el
opmentbanksar ealsoknownasAgri
cult
uralBanksbecause
thesear
eformedt
ofinanceagr
icul
tural
sect
or.Theyal
sohel
pinl
anddev
elopment.

Type5.I ndigenousBanks
I
ndigenousbanksmeansMoneyLender sandSahukars.Theycol
lectdeposi
tsfrom general
publi
candgr antloanstotheneedypersonsoutofthei
rownfundsaswel lasfr
om deposits.
Thesei ndigenousbanksar epopularinv i
l
lagesandsmalltowns.Theyperfor
m combi ned
funct
ionsoft radi
ngandbankingact
ivi
ti
es.

Type6.Cent r
al/Federal/Nat i
onal Bank
Everycountryoft heworldhasacent r
albank.I nNigeri
a,CentralBankofNi geria,InIndia,
Reser v
eBankofI ndi
a,i
nU. S.A,FederalReservea ndinU.K,BankofEngland.The secent ralbanks
aret hebankersoft heotherbanks.Theypr ov i
despeciali
sedfunctionsi .
e.i ssueofpaper
currency,wor
kingasbanker sofgov ernment ,supervi
singandcont rol
li
ngf oreignexchange.A
centralbanki
sanon- prof
itmaki nginstit
ution.Itdoesnotdealwi t
ht hepubl i
cbuti tdealswith
otherbanks.Thepr i
nci
palr esponsibil
it
yofCent ralBankisthoroughcont roloncur rencyofa
count r
y.

Type7.Co-oper
ativ
eBanks
Co-oper
ati
ve banks ar
eregi
ster
ed undert
he Co-
oper
ati
ve Soci
eti
es Actoft
he count
ry
16|Page
concerned.Theygeneral
lygi
vecredi
tfaci
li
ti
estosmallfarmers,sal
ari
edemploy
ees,small
-
scaleindust
ri
es,et
c.Co-oper
ati
veBanksareavai
l
ableinruralaswellasinur
banareas.The
functi
onsofthesebanksarej
ustsi
mil
artocommerci
albanks.

Type8.ExchangeBanks
St
andardCharter
edBankisanexampleofFor
eignBankwor
kingi
nNi
ger
ia.Thesebanksar
e
mainl
yconcernedwi
thfi
nanci
ngf
orei
gntr
ade.

Thef
oll
owi
ngar
ethev
ari
ousf
unct
ionsofExchangeBanks:
-

1. Remi tt
ingmoneyfrom onecountr
ytoanot
hercount
ry,
2. Discountingoffor
eignbi
ll
s,
3. BuyingandSel l
i
ngGol dandSi
lver
,and
4. HelpingImportandExportTr
ade.

Type9.Consumer sBanks
Consumersbanki sanewaddi ti
ontotheexi
sti
ngt y
peofbanks.Suchbanksareusuall
yfound
onl
yinadv ancedcountri
esli
keU.S.A.andGermany.Themai nobj
ect
iveofthi
sbankistogive
l
oanst o consumersf orpurchaseoft hedurabl
esl i
keMot orcar
,tel
evisi
on set
,washing
machine,
furnit
ure,
etc.Theconsumershavetorepaytheloansi
neasyi
nstal
ments

Thef ocusofbanki ngisv ari

ed,theneedsdi verseandmet hodsdifferent
.Thus,weneed
dist
inctive kinds ofbanks t o cat
ert ot he above-ment
ioned compl exi
ti
es.Deposit
-t
aking
i
nstituti
onst akethef orm ofcommer ci
albanks,whichacceptdepositsandmakecommer ci
al,
realestate,andot herloans.Therearealsomut ualsavi
ngsbanks,whi chacceptdeposit
sand
makemor t
gageandot hertypesofloans.Anothertypeiscredi
tunions,whicharecooperati
ve
organizati
onst hatissuesharecert
if
icat
esandmakemember( consumer )andotherl
oans.

Thebankingi
ndustr
ycanbedivi
dedi
ntof
oll
owi
ngsect
ors,basedont
hecl
i
ent
eleser
vedand
product
sandser
vicesof
fer
ed:

1.Retai
lBanks
2.Commer ci
albanks
3.Cooperat
ivebanks
4.I
nvestmentBanks
5.Speci
ali
zedbanks
6.Centr
albanks

RetailBanks:
Retai
lbankspr ovi
debasicbankingservi
cestoindivi
dualconsumers.Examplesincl
udesavi
ngs
banks,savingsandloanassociati
ons,andrecurri
ngandf i
xeddeposits.Product
sandservi
ces
i
ncludesaf edepositboxes,checkingandsav ingsaccounting,cer
ti
ficat
esofdeposit(CDs)
,
mor t
gages, per
sonal
,consumerandcarloans.

Commer cialBanks:
Bankingmeansaccept ingdeposit
sofmoneyf rom t
hepubl i
cforthepurposeofl endi
ngor
i
nvestment .CommercialBanksprovi
definanci
alserv
icestobusinesses,i
ncludi
ngcredi
tand
debitcards,bankaccounts,deposi
tsandl oans,andsecuredandunsecur edloans.Dueto
deregul
ation,commercialbanksarealsocompet i
ngmor ewi t
hinvestmentbanksi nmoney
17|Page
marketoperat
ions,bond underwri
ting,and fi
nancialadv i
sorywor k.Commer ci
albanks in
moderncapit
ali
stsociet
iesactasfinanciali
nter
medi ar
ies,rai
singfundsfrom deposi
torsand
l
endingthesamef undstoborrowers.Thedepositor
s’claimsagai nstt
hebank,theirdeposi
ts,
ar
eliqui
d,meaningbanksareexpect
edt oredeem depositsondemand, inst
ant
ly.

Banks’cl
aimsagai nstt
hei
rborr
owersaremuchl essl
iqui
d,gi
vingbor
rowersamuchl onger
spanofti
met orepaymoneyowedbanks.Becauseabankcannoti
mmediatel
yrecl
aim money
l
enttobor rowers,itmayfacebankr
uptcyifalli
tsdeposi
tor
sshow uponagi vendayt o
wit
hdrawallthei
rmoney.

Ther
ear
etwot
ypesofcommer
cial
banks,
publ
i
csect
orandpr
ivat
esect
orbanks.

Publi
cSect
orBanks:
Publ
icsect
orsbanksar
ethoseinwhi chthegov
ernmenthasamaj
orst
akeandt
heyusual
l
y
needtoemphasi
zeonsoci
alobj
ect
ivesthanonpr
ofi
tabi
l
ity
. 

Pri
vatesect
orbanks:
Pri
vatesect
orbanksar
eowned,managedandcont
rol
l
edbypr
ivat
epr
omot
ersandt
heyar
efr
ee
tooperat
easpermarketf
orces.

Inv
est mentBanks:
An investmentbank i saf i
nanci
alinsti
tut
ion thatassi stsi ndi
vi
duals,cor por
ati
ons and
governmentsinr ai
sing capi
talbyunder wri
ti
ng and/ oracting ast heclient'
sagenti nt he
i
ssuanceofsecur i
ti
es.Aninvestmentbankmayal soassi stcompaniesinvolvedinmergersand
acquisi
ti
ons,andprovideanci
ll
aryserv
icessuchasmar ketmaking,t
radingofder i
vat
ives,
fixed
i
ncomei nstr
uments,forei
gnexchange,commodi t
ies,andequi t
ysecuriti
es.

I
nvestmentbanksai
dcompaniesinacqui
ri
ngfundsandtheyprovi
deadvi
ceforawider
angeof
tr
ansact
ions.Thesebanksalso of
ferfi
nanci
alconsul
ti
ngser v
icesto compani
esandgive
advi
ceonmer ger
sandacqui
sit
ionsandmanagementofpubli
cassets.

Cooperat
iveBanks:
Cooper
ativeBanksar egovernedbythepr ov
isi
onsofStateCooper
ati
veSoci
eti
esActand
meantessenti
all
yforprov
idi
ngcheapcredi
ttothei
rmembers.I
tisani
mport
antsour
ceofr
ural
cr
editi
.e.
,agr
icul
tur
alfi
nanci
ngi nI
ndi
a.

Speci
ali
zedBanks:
Speci
ali
zedbanksaref orei
gnexchangebanks,industri
albanks,devel
opmentbanks,export
-
i
mpor tbankscateri
ng to speci
fi
cneedsoft hese uni
que acti
vit
ies.These bankspr
ovide
fi
nanci
alai
dtoindustr
ies,
heavyturnkeypr
oject
sandforeigntr
ade.

CentralBanks:
Centralbanksar ebanker
s’banks,andthesebankst racet hei
rhist
oryfrom t
heBankofEngl and.
Theyguar anteestablemonetaryandf inanci
alpol i
cyf rom count r
yt ocountryandpl ayan
i
mpor tantr ol
eintheeconomyoft hecountry.Typicalfuncti
onsincludeimplementi
ngmonet ary
poli
cy,managi ng f
orei
gnexchangeand gol dr eserv
es,maki ng decisi
onsr egardi
ng off
ici
al
i
nterestr ates,acti
ng as bankertothe gov ernmentand ot herbanks,and r egul
ati
ng and
supervisi
ngt hebankingi
ndustr
y.

18|Page
19|Page
 DEMAND, SUPPLY,ANDEQUI LIBRI
UM INTHEMONEYMARKET
1. TheDemandf orMoney
I
ndecidi
nghow muchmoneyt ohol d,peoplemakeachoi ceabouthow toholdthei
rwealth.
Howmuchweal t
hshallbehel
dasmoneyandhowmuchasot herasset
s?Foragivenamount
ofweal
th,theanswertothi
squesti
onwi lldependontherel
ati
vecostsandbenefi
tsofhol
ding
moneyversusotherasset
s.Thedemandf ormoneyistherel
ati
onshipbetweent
hequanti
tyof
moneypeoplewanttoholdandthefactor
st hatdet
ermi
nethatquanti
ty.

Tosi mpli
fyouranal ysi
s,wewi llassumet hereareonl ytwoway st
ohol dwealth:asmoneyi na
checkingaccount ,
orasf undsinabondmar ketmut ual f
undthatpurchaseslong-t
erm bondson
behalfofit
ssubscr i
bers.Abondf undisnotmoney .Somemoneydeposi t
searninter
est,butt
he
ret
urnont heseaccount sisgener al
lyl
owert hanwhatcoul dbeobt ai
nedinabondf und.The
advantageofchecki ngaccount sisthattheyar ehighlyliqui
dandcant husbespenteasi l
y.We
wil
l t
hinkofthedemandf ormoneyasacur vethatrepresentstheoutcomesofchoi cesbetween
thegr eat
erliqui
dityofmoneydeposi t
sandt hehigheri nt
erestratesthatcanbeear nedby
holdi
ngabondf und.Thedi ff
erencebet weent heinterestrat
espaidonmoneydeposi tsandthe
i
nterestret
urnav ai
lablefrom bondsisthecostofhol dingmoney .

a.Mot i
vesforHoldingMoney
Onereasonpeopl ehol dt
heirassetsasmoneyi ssothattheycanpurchasegoodsandser vices.
Themoneyhel dforthepurchaseofgoodsandser vi
cesmaybef orev er
ydaytr
ansactionssuch
asbuy i
nggr oceri
esorpay ingt her ent,oritmaybekeptonhandf orconti
ngenciessuchas
havi
ngt hefundsavailabl
etopayt ohav ethecarfi
xedortopayforatriptothedoctor.
Thetransacti
onsdemandf ormoneyi smoneypeopl eholdtopayforgoodsandser vi
cest hey
ant
ici
pat ebuying.Wheny oucar rymoneyi nyourpurseorwal l
ett obuyamov i
et i
cketor
maintai
nachecki ngaccountbal ancesoy oucanpurchasegrocer
ieslateri
nthemont h,youar e
hol
dingt hemoneyaspar tofy ourtransactionsdemandformoney.

Themoneypeopl ehol dforcontingenciesr

epresentstheirpr
ecauti
onarydemandformoney.
Moneyheldf orpr ecaut
ionarypur posesmayi ncludechecking accountbal
anceskeptfor
possi
blehomer epairsorhealth-
careneeds.Peopledonotknow pr ecisel
ywhentheneedfor
suchexpendit
ureswi l
loccur,buttheycanpr epareforthem byholdingmoneysothatthey
’l
l
havei
tavail
ablewhent heneedarises.

Peoplealsoholdmoneyf orspeculati
vepurposes.Bondpricesfluctuat
econstant
ly.Asaresult,
holdersofbondsnotonl year ninterestbutexperi
encegai nsorl ossesinthevalueoft hei
r
assets.Bondholder
senjoygai nswhenbondpr i
cesriseandsufferlosseswhenbondpr i
cesf al
l
.
Becauseoft hi
s,expect
ationsplayani mportantrol
easadet erminantofthedemandf orbonds.
Holdingbondsisoneal ternat
ivetohol di
ngmoney ,sothesesameexpect at
ionscanaffectthe
demandf ormoney .

John May nard Keynes,who was an enor mouslysuccessfulspecul

atori n bond markets
suggestedt hatbondholder
swhoant i
cipat
eadr opinbondpr i
ceswillt
ryt osellthei
rbonds
aheadoft hepricedropi nor dertoav oi
dt hi
slossinassetv al
ue.Selli
ngabondmeans
convert
ingi ttomoney .Keynesr ef
err
edt othespecul
ati
vedemandf ormoneyast hemoney
hel
di nresponset oconcernt hatbondpr i
cesandt hepri
cesofotherfinancialasset
smi ght
change.

20|Page
Ofcourse,moneyismoney .Onecannotsortt hroughsomeone’ scheckingaccountandlocate
whichfundsar ehel
df ortr
ansacti
onsandwhi chf undsar ether ebecausetheowneroft he
accountisworri
edaboutadropi nbondpri
cesori stakingapr ecaut
ion.Wedisti
nguishmoney
hel
df ordif
fer
entmoti
vesinor dertounder
standhowt hequant i
tyofmoneydemandedwi llbe
aff
ectedbyakeydeterminantofthedemandf ormoney :thei
nterestr
ate.

b.Int
erestRat esandt heDemandf orMoney
Thequant i
tyofmoneypeopl eholdtopayf ort r
ansact
ionsandt osati
sfyprecauti
onaryand
speculati
v edemandi sli
kelytovarywit
ht heinter
estrat
estheycanearnfrom al
ternat
iveasset
s
suchasbonds.Wheni nterestratesri
ser el
ativ
et otheratesthatcanbeear nedonmoney
deposits,peopleholdlessmoney .Wheninterestrat
esfall
,peopl
eholdmor emoney .Thelogi
c
oftheseconcl usionsaboutt hemoneypeopl ehol dandint
erestr
atesdependsont hepeople’
s
mot i
vesf orholdi
ngmoney .

Thequant i
tyofmoneyhousehol dswantt ohol dv ar
iesaccor di
ngt ot hei
rincomeandt he
i
nterestrate;differ
entav eragequant i
ti
esofmoneyhel dcansat isf
yt heirtransacti
onsand
precaut
ionarydemandsf ormoney .Toseewhy ,supposeahousehol dear nsandspendsN3, 000
permont h.Itspendsanequalamountofmoneyeachday .Foramont hwi th30day s,thatis
N100perday .Onewayt hehousehol dcouldmanaget hisspendingwouldbet oleavethemoney
i
nachecki ngaccount ,whichwewi llassumepay szer oint
erest.Thehousehol dwoul dt hus
haveN3,000i nthechecki ngaccountwhent hemont hbegins,N2,900att heendoft hefi
rstday,
N1,500halfwayt hroughthemont h,andzer oatt heendoft helastdayoft hemont h.Averaging
thedail
ybal ances,wef i
ndt hatthequantit
yofmoneyt hehouseholddemandsequal sN1, 500.
Thisapproacht omoneymanagement ,
whichwewi llcallt
he“cashappr oach,”hast hevirt
ueof
simpli
cit
y,butthehousehol dwill
earnnoi nterestonitsfunds.

Consideran al t
ernativ
e moneymanagementappr oach t hatper mitsthe same pat tern of
spending.Att hebegi nning oft hemont h,thehousehol d depositsN1, 000 ini tschecki ng
accountandt heot herN2, 000i nabondf und.Assumet hebondf undpay s1% i nter
estper
mont h,oranannuali nterestrateof12. 7%.Af t
er10days,themoneyi nthechecki ngaccounti s
exhausted,andt hehousehol dwi thdrawsanot herN1,
000f rom thebondf undf orthenext10
days.Ont he20t hday ,t
hef i
nalN1, 000from thebondfundgoesi ntothecheckingaccount .With
thi
sst rat
egy,thehousehol dhasanav er
agedai l
ybalanceofN500,whi chi st hequant it
yof
moneyi tdemands.Letuscal l t
hismoneymanagementst rategythe“ bondfundappr oach.”
Remembert hatbot happroachesal l
owt hehouseholdt
ospendN3, 000permont h,N100perday .
Thecashappr oachr equir
esaquant i
tyofmoneydemandedofN1, 500,whi let hebondf und
approachlower st hi
squant i
tytoN500.

Thebondf undappr oachgener atessomei nter

esti ncome.Thehousehol dhasN1, 000i nt he
fundf or10days(1/3ofamont h)andN1, 000for20day s(2/3ofamonth).Withaninterestrate
of1% permont h,thehousehol dear nsN10i ni nt
eresteachmont h([N1,000×0. 01×1/ 3]+
[
N1, 000×0. 01×2/ 3]).Thedisadv antageoft hebondf und,ofcour
se,isthatitr
equiresmor e
attenti
on N1,000mustbet r
ansf err
edf rom t
hef undt wiceeachmonth.Theremayal sobef ees
associ at
edwiththetransfer
s.

Ofcour se,thebondf undst r

ategywehav eexami nedher
eisjustoneofmany .Thehousehold
couldbegi neachmont hwi t
hN1, 500inthechecki ngaccountandN1, 500int hebondf und,
transferr
ingN1,500tot hecheckingaccountmidwayt hr
oughthemont h.Thisstrat
egyrequir
es
onel esst r
ansfer
,butitalsogeneratesl
essinterestofN7.50i.e.(
=N1,500×0. 01×1/2).Wi t
h
thisstrategy,t
hehousehol ddemandsaquant ityofmoneyofN750.Thehousehol dcouldalso
21|Page
maint
ainamuchsmal l
eraveragequanti
tyofmoneyinitschecki
ngaccountandkeepmorei
n
i
tsbondfund.Forsimpl
ici
ty,wecanthinkofanystrat
egythatinvol
vest
ransf
erri
ngmoneyi
n
andoutofabondfundoranotheri
nter
est-
earni
ngassetasabondfundstr
ategy.

Whichapproachshouldthehouseholduse?Thatisachoiceeachhouseholdmustmake—i ti
sa
questi
onofweighingtheinterestabondfundstr
ategycreat
esagainstthehassleandpossi
ble
feesassoci
atedwiththetransfer
sitr
equi
res.Ourexampledoesnoty i
eldaclear-
cutchoi
cefor
anyonehousehold,butwecanmakesomegener ali
zat
ionsabouti
tsimplicat
ions.

Fir
st ,ahousehol dismor el
ikel
yt oadoptabondfundstr
ategywhentheinter
estrateishigher
.
Atl owi nterestrates,
ahouseholddoesnotsacri
fi
cemuchi ncomebypursui
ngt hesimplercash
strategy .Ast heinter
estrat
er i
ses,abondfundstr
ategybecomesmor eatt
racti
ve.Thatmeans
thatt hehi ghertheinter
estr
ate,thelowert
hequanti
tyofmoneydemanded.

Second, peoplearemoreli
kelytouseabondf undst
rat
egywhenthecostoftransfer
ringfunds
i
slower .Thecr eat
ionofsavi
ngsplans,whi
chbeganinthe1970sand1980s,thatall
owedeasy
tr
ansferoff undsbetweenint
erest
-ear
ningasset
sandcheckabl
edeposi
tstendedtor educethe
demandf ormoney.

Somemoneydeposi t
s,suchassav i
ngsaccount sandmoneymar ketdeposi
taccount s,pay
i
nterest.I
nev al
uati
ngt hechoi cebetweenhol di
ngasset sassomef or
m ofmoneyori nother
for
mssuchasbonds, householdswilll
ookatt hediff
erentialbetweenwhatthosef undspayand
whatt heycouldearnint hebondmar ket.Ahigherinterestrateint hebondmar ketisli
kelyto
i
ncreaset hi
sdiff
erenti
al;alowerinter
estr atewil
lreducei t.Anincreaseinthespreadbet ween
rat
esonmoneydeposi t
sandt heint
erestr at
einthebondmar ketr
educesthequant i
tyofmoney
demanded; areducti
oni nthespreadincreasesthequant it
yofmoneydemanded.

Fi
rms,too,mustdetermi nehowt omanaget heirearningsandexpendi tures.Howev er,inst
ead
ofwor r
yingaboutN3, 000permont h,evenar el
ati
v elysmallfir
m maybeconcer nedabout
N3,
000,000permont h.Rat herthanf aci
ngt hedi f
ferenceofN10v er susN7. 50ini nt
erest
ear
ningsusedinourhousehol dexample,thi
ssmal lfirm woul
df aceadi fferenceofN2, 500per
month(N10,000versusN7, 500).Forverylar
gef ir
mssuchasToy ota,i
nt erestrat
edifferenti
als
amongv ari
ousfor
msofhol dingthei
rfi
nancialassetstransl
ateintomi l
l
ionsofdol lar
sperday .

How isthespeculat
ivedemandf ormoneyr el
atedtointerestrates?Whenf inanci
alinv
est
ors
bel
ievethatt
hepr i
cesofbondsandot herassetswillf
all
,theirspeculati
vedemandf ormoney
goesup.Thespecul at
ivedemand formoneyt husdependsonexpect ati
onsaboutf ut
ure
changesinassetpri
ces.Wil
lthi
sdemandalsobeaf fect
edbypr esentinterestrates?

I
finterestr atesar el ow,bondpr i
cesarehi gh.I
tseemsl i
kelythati fbondpr i
cesarehi gh,
fi
nancialinvest orswillbecomeconcernedthatbondpricesmightfal
l.Thatsuggeststhathigh
bondpr ices—l ow interestrat
es—wouldincreasethequanti
tyofmoneyhel dforspeculativ
e
purposes.Conv er
sely,ifbondpri
cesarealreadyrel
ati
velyl
ow,itislikel
ythatfewerfinancial
i
nvestorswi l
lexpectt hem tofallst
il
lfurt
her.Theywi l
lholdsmal l
erspeculativ
ebalances.
Economi ststhusexpectt hatt
hequantit
yofmoneydemandedf orspeculati
vereasonswillv
ar y
negati
velywi t
ht heint
erestrat
e.

c.TheDemandCur v
ef orMoney
Wehav eseenthatthet r
ansacti
ons,precaut
ionary
,andspecul
ati
vedemandsformoneyvary
negat
ivel
ywit
htheinterestr
ate.Putt
ingthosethreesour
cesofdemandtoget
her,wecandr
aw
22|Page
ademandcur veformoneytoshow how t heint
erestrat
eaff
ectsthetot
alquant
it
yofmoney
peoplehold.Thedemandcur vef ormoneyshowst hequant
it
yofmoneydemandedateach
i
nterestrat
e,al
lotherthi
ngsunchanged.Suchacur vei
sshowninFigur
e1" TheDemandCur
ve
forMoney ".Ani ncr
easeinthei nt
erestrat
er educesthequanti
tyofmoneydemanded.A
reducti
onintheinter
estr
atei
ncreasesthequanti
tyofmoneydemanded.

23|Page
Fi
gur
e1:TheDemandCur
vef
orMoney

Thedemandcurveformoneyshowsthequanti
tyofmoneydemandedateachi
nter
estr
ate.I
ts
downwardsl
opeexpressest
henegat
iver
elat
ionshi
pbet
weenthequant
it
yofmoneydemanded
andthei
nter
estr
ate.

Ther el
ati
onshipbetweeninter estrat
esandt hequanti
tyofmoneydemandedi sanapplicat
ion
ofthelawofdemand.I fwet hi
nkoft healt
ernati
vetoholdingmoneyashol
dingbonds,t
hent he
i
nterestrate—orthediff
erent i
albetweenthei nt
erestrat
ei nt
hebondmarketandt heinter
est
pai
donmoneydeposi t
s—r epresentsthepri
ceofhol di
ngmoney .Asist
hecasewi t
hallgoods
andservices,ani
ncreaseinpr i
cer educest
hequant i
tydemanded.

d.OtherDet erminantsoftheDemandf orMoney

Wedr awt hedemandcur vef ormoneyt oshowthequant
it
yofmoneypeoplewillholdateach
i
nterestrate,allotherdeterminant
sofmoneydemandunchanged.Achangei nt hose“other
determinants”willshif
tthedemandf ormoney.Amongthemostimpor
tantvari
ablesthatcan
shi
ftthedemandf ormoneyar ethelevelofi
ncomeandrealGDP,t
hepr
icelevel
,expectat
ions,
tr
ansfercost s,
andpr efer
ences.

i
.Real
GDP
Ahousehol
dwi
thani
ncomeofN10,
000permont
hisl
i
kel
ytodemandal
argerquant
it
yof
24|Page
moneyt hanahousehol dwi thanincomeofN1, 000permont h.Thatrel
ati
onshipsuggeststhat
moneyi sanor malgood:asi ncomeincreases,peopledemandmor emoneyateachi nt
erest
rate,andasi ncomef all
s,theydemandl ess.Ani ncr
easei nrealGDP increasesincomes
throughouttheeconomy .Thedemandf ormoneyi ntheeconomyi sthereforeli
kel
yt obe
greaterwhenr ealGDPisgreater.
i
i.ThePr iceLevel
Thehi gherthepr i
celevel
,themor emoneyi srequir
edt opurchaseagivenquant i
tyofgoods
andser vi
ces.Allothert
hingsunchanged,thehigherthepri
celevel,t
hegreaterthedemandf or
money .

i
ii.Expect
ati
ons
Thespeculati
vedemandformoneyisbasedonexpect ati
onsaboutbondpr
ices.Al
lothert
hings
unchanged,ifpeopl
eexpectbondpri
cest ofal
l
,t heywil
lincr
easethei
rdemandf ormoney .I
f
theyexpectbondpri
cestori
se,t
heywil
lreducetheirdemandformoney.

Theexpectat
ionsthatbondpri
cesareabouttochangeactuall
ycausesbondpr i
cestochange.
I
fpeopleexpectbondpr i
cestofal
l
, f
orexample,
theywi
llsel
ltheirbonds,exchangingt
hem for
money.Thatwi l
lshif
tthesupplycurveforbondstother i
ght,thusloweringthei
rpri
ce.The
i
mportanceofexpectati
onsinmovingmarket
scanleadtoaself-f
ulfi
l
li
ngpr ophecy.

Expectati
onsaboutfuturepri
celevelsal
soaffectthedemandf ormoney.Theexpect
ati
onofa
higherpri
celevelmeanst hatpeopleexpectt
hemoneyt heyar
ehol
dingtofalli
nval
ue.Gi
ven
thatexpectat
ion,
theyareli
kelyt
ohol dl
essofitinanti
cipati
onofaj
umpi npri
ces.

Expectat
ionsaboutf uturepri
cel ev
elsplayapar t
icul
arl
yi mportantroledur i
ngper i
odsof
hyperi
nfl
ati
on.Ifpri
cesr i
severyr
apidlyandpeopleexpectt hem tocontinuer i
sing,peopleare
l
ikel
ytotrytoreducetheamountofmoneyt heyhold,knowi
ngt hati
twi l
lfalli
nvalueasi tsit
sin
thei
rwallet
sort hei
rbankaccounts.Towardt heendoft hegreatGer manhy perinfl
ati
onoft he
earl
y1920s,pr i
ceswer edoubl
ingasof t
enast hreet i
mesaday .Undert hoseci r
cumst ances,
peopletr
iednott oholdmoneyev enforafewmi nutes;wit
hint hespaceofei ghthour smoney
wouldlosehalfi
tsvalue.

i
v.TransferCost s
Foragi venl evelofexpendi
tures,reduci
ngt hequanti
tyofmoneydemandedr equiresmor e
fr
equentt r
ansfersbetweennonmoneyandmoneydeposi ts.Asthecostofsucht ransf
ersrises,
someconsumer swil
lchoosetomakef ewerofthem.Theywi l
lthereforeincr
easet hequantit
y
ofmoneyt heydemand.I ngeneral,thedemandf ormoneywi llincreaseasi tbecomesmor e
expensi
v etot r
ansferbet
weenmoneyandnonmoneyaccount s.Thedemandf ormoneywi llf
all
i
ft r
ansfercost sdecli
ne.Inrecentyears,t
ransfercost
shav efallen,leadi
ngt oadecr easein
moneydemand.

v.Preferences
Preferencesalsoplayar ol
eindet er
mi ni
ngt hedemandf ormoney .Somepeopl eplaceahigh
valueon hav ing aconsiderableamountofmoneyon hand.Forot hers,thismaynotbe
i
mpor tant.
Househol datt
itudestowardriskareanotheraspectofpr eferencesthataf f
ectmoneydemand.
Aswehav eseen,bondspayhi gheri nt
erestratesthanmoneydeposi ts,butholdingbonds
entail
sar iskthatbondpr i
cesmi ghtfall
.Thereisalsoachancet hatthei ssuerofabondwi l
l
default,t
hatis,willnotpayt heamountspeci fiedont hebondt obondhol ders;i
ndeed,bond
i
ssuer smayenduppay i
ngnot hi
ngatal l.Amoneydeposi t,suchasasav i
ngsdeposit,mi
ght
25|Page
earnalowery iel
d,buti
tisasaf
eyiel
d.People’
satt
it
udesaboutt
hetrade-
offbet
weenr i
skand
yi
eldsaff
ectt hedegreetowhi
chtheyhol
dt hei
rwealt
hasmoney .Hei
ghtenedconcer
nsabout
ri
skinthelasthalfof2008l
edmanyhouseholdstoi
ncreaset
hei
rdemandf ormoney.

Fi
gur
e2"
AnI
ncr
easei
nMoneyDemand"showsani
ncr
easei
nthedemandf
ormoney
.Suchan
i
ncr
easecoul
dr esul
tfrom ahi
gherrealGDP,ahi gherpr
icel
evel
,achangei
nexpect
ati
ons,an
i
ncr
easei
ntransfercosts,
orachangeinpref
erences.

Fi
gur
e2:AnI
ncr
easei
nMoneyDemand

Anincreasei
nrealGDP,thepr
icelev
el,ort
ransfercosts,f
orexample,wil
lincreasethequant
it
y
ofmoneydemandedatanyi nt
erestr er
at ,i
ncreasingthedemandf ormoneyf rom D1toD2.The
quanti
tyofmoneydemandedati nt
erestr
aterr isesfrom M toM′.Ther ev
erseofanysuch
event
swoul dreducethequantityofmoneydemandedatev er
yi nter
estr ate,shif
ti
ngthe
demandcur v
etothelef
t.

2. TheSuppl
yofMoney

26|Page
Thesuppl ycur veofmoneyshowst her el
at i
onshipbetweent hequant i
tyofmoneysuppl i
edand
themar keti nt
erestrat
e,al lot herdeter
mi nantsofsuppl yunchanged.Wehav elearnedthatthe
CBN,t hroughi tsopen- mar ketoper at
ions,det er
mi nest het ot
alquant i
tyofr eservesint he
banki
ngsy stem.Weshal lassumet hatbanksi ncreasethemoneysuppl yinf i
xedpr opor
ti
ont o
thei
rreserv es.Becauset hequant i
tyofr eser
v esisdet erminedbyCBN pol icy,wedr aw the
supplycurveofmoneyi nFi gur e3"TheSuppl yCur veofMoney"asaver t
icall
ine,determi
nedby
theCBN’ smonet arypoli
ci es.I ndrawingt hesuppl ycurveofmoneyasav erti
calli
ne,wear e
assumingt hemoneysuppl ydoesnotdependont heinterestrate.Changingt hequantit
yof
reser
vesandhencet hemoneysuppl yisanexampl eofmonet arypoli
cy.

Fi
gur
e3:TheSuppl
yCur
veofMoney

Weassumet hatt
hequantit
yofmoneysuppl i
edi
nt heeconomyisdeter
minedasaf i
xed
mul
ti
pleoft
hequanti
tyofbankreser
ves,whi
chi
sdet
erminedbytheCBN.Thesuppl
ycur
veof
moneyisav
erti
cal
li
neatthatquant
it
y.

a.Equi
li
bri
um i
ntheMar
ketf
orMoney

27|Page
Themoneymar keti
sthei nt
eracti
onamongi nst
it
uti
onsthroughwhichmoneyi ssuppli
edt o
i
ndividuals,fi
rms,andotherinsti
tut
ionsthatdemandmoney .Moneymar ketequi
li
bri
um occurs
atthei nter
estrateatwhichthequant i
tyofmoneydemandedi sequaltothequanti
tyofmoney
supplied.Figur
e4" MoneyMar ketEquili
bri
um"combi nesdemandandsuppl ycur
vesformoney
toill
ust r
ateequili
bri
um i
nt hemar ketformoney .Withastockofmoney( M),t
heequil
ibri
um
i
nterestr at
eisr.

Fi
gur
e4:MoneyMar
ketEqui
li
bri
um

Themar ketf
ormoneyisinequi
li
bri
um ift
hequanti
tyofmoneydemandedi
sequalt
othe
quant
it
yofmoneysuppl
i
ed.Her
e,equi
li
bri
um occur
sati
nter
estr
ater
.

28|Page
b.Ef
fect
sofChangesi
ntheMoneyMar ket
Ashif
tinmoneydemandorsupplywil
lleadt
oachangei
ntheequi
l
ibr
ium i
nter
estr
ate.Let
’s
l
ookattheef
fect
sofsuchchangesont
heeconomy
.

c.Changesi nMoneyDemand
Supposet hatthemoneymar ketisi nit
ial
lyinequi l
ibrum atr
i 1wi t
hsuppl ycurveSandademand
curveD1asshowni nPanel (a)ofFi gur e5" ADecr easei ntheDemandf orMoney "
.Nowsuppose
thatthereisadecr easei nmoneydemand,al lotherthingsunchanged.Adecr easei nmoney
demandcoul dresultfrom adecr easei nthecostoft ransfer
ringbetweenmoneyandnonmoney
deposits,f
rom achangei nexpect ations,orf rom achangei npr efer
ences.Her e,
wear elooking
onlyatchangest hator i
ginatei nf inancialmar ketstoseet heirimpactonaggr egatedemand
andaggr egatesuppl y.Changesi nt hepr i
cel evelandi nrealGDPal soshi f
tthemoneydemand
curve,butthesechangesar et her esultofchangesi naggr egatedemandoraggr egatesuppl y
.
Panel( a)showst hatt hemoneydemandcur veshiftstot helefttoD2.Wecanseet hatthe
i
nterestratewi l
lfall
tor 2.Toseewhyi nterestratefall
s, werecallt
hatifpeoplewantt ohol dless
money ,thent heywi llwantt ohol dmor ebonds.Thus,Panel( b)showst hatthedemandf or
bondsi ncreases.Thehi gherpr i
ceofbondsmeansl oweri nt
erestrates;l
oweri nterestrates
rest
oreequi l
ibri
um int hemoneymar ket.

Fi
gur
e5:ADecr
easei
ntheDemandf
orMoney

Adecr easei nt hedemandf ormoneyduet oachangei nt r

ansactionscost s,pref
erences,or
expectati
ons,asshowni nPanel( a),wil
lbeaccompani edbyani ncreaseint hedemandf or
bondsasshowni nPanel(b),andaf alli
ntheinter estrate.Thefalli
nt heinterestrat
ewillcause
ar i
ght
war dshifti
nt heaggregatedemandcur v
ef om AD1 t
r oAD2,asshowni nPanel(c).Asa
resul
t,realGDPandt hepricelevelr
ise.
Lowerint erestrat
esinturnincreasethequant
ityofi nvestment.Theyal sostimulatenetexports,
asloweri nterestrat
esleadtoal owerexchanger ate.Theaggr egatedemandcur v
eshift
st othe
ri
ghtasshowni nPanel(c)f om AD1 t
r oAD2.Giv ent heshor t-
runaggr egatesupplycurveSRAS,
theeconomymov est oahigherrealGDPandahi gherpr i
celevel
.

Ani ncr
easei nmoneydemandduet oachangei nexpectati
ons,pref
erences,ortransactions
coststhatmakepeopl ewantt oholdmor emoneyateachi nter
estratewillhavetheopposi te
eff
ect.Themoneydemandcur vewil
lshif
ttot heri
ghtandthedemandf orbondswi l
lshif
ttot he
l
eft.Ther esul
ti
nghi gheri
nterestr
atewi l
lleadtoal owerquanti
tyofinvestment.Also,higher
i
nterestrateswil
lleadt oahigherexchanger at
eanddepressnetexpor t
s.Thus,theaggr egate
29|Page
demandcur
vewi
l
lshi
ftt
othel
eft
.Al
lot
hert
hingsunchanged,r
ealGDPandt
hepr
icel
evelwi
l
l
fal
l
.

d.Changesi nt heMoneySuppl y
Nowsupposet hemar ketf ormoneyi si nequil
ibri
um andt heCBNchangest hemoneysuppl y
.
Allothert hingsunchanged,how wi l
lthischangei nthemoneysuppl yaf f
ectt heequi l
i
bri
um
i
nterestr ateandaggr egat edemand,r ealGDP,andt hepr icelevel?Supposet heCBNconduct s
open-mar ketoper ationsi nwhichi tbuy sbonds.Thi sisanexampl eofexpansi onarymonet ary
poli
cy .Thei mpactofCBNbondpur chasesi sill
ustr
atedi nPanel( a)ofFigur e6" AnI ncreasein
theMoneySuppl y".TheCBN’ spurchaseofbondsshi ftsthedemandcur veforbondst ot heri
ght,
b
rai
singbondpr i
cest oP2.Aswel ear ned,whent heCBN buy sbonds,t hesuppl yofmoney
i
ncreases.Panel( b)ofFi gure6" AnI ncreaseint heMoneySuppl y"showsaneconomywi t
ha
moneysuppl yofM,whi chi sinequi li
brium atani nterestrateofr 1.Now supposet hebond
purchasesbyt heCBNasshowni nPanel( a)resul
tinani ncreasei nthemoneysuppl ytoM′ ;
thatpol i
cychangeshi ft
st hesupplycur veformoneyt other i
ghtt oS2.Att heor i
ginalinter
est
rater 1,peopledonotwi sht oholdt henewl ysuppl i
edmoney ;t heywoul dpr efert ohold
nonmoneyasset s.Tor eest abl
ishequili
brium inthemoneymar ket,theinterestratemustf al
lto
i
ncreaset hequant it
yofmoneydemanded.I ntheeconomyshown, theinterestratemustf al
lto
r2toincreaset hequant i
tyofmoneydemandedt oM′ .

Fi
gur
e6:AnI
ncr
easei
ntheMoneySuppl
y

TheCBN i ncr
easest hemoneysuppl ybybuy ingbonds,i
ncreasi
ngthedemandf orbondsin
b
Panel(a)from D1 t
oD2 andthepriceofbondst oP2.Thi
scor r
espondst
oani ncreaseint
he
moneysuppl ytoM′i nPanel(b).Theinterestrat
emustf al
ltor2toachi
eveequili
bri
um.The
l
oweri nter
estratel eadsto an i
ncreasei ninvest
mentand netexports,which shi
ft
sthe
aggregat
edemandcur vef
rom AD1toAD2i nPanel(c)
.Real
GDPandt hepri
celev
el r
ise.

Thereducti
onininterestrat
esr equi
redtorestor eequi
li
brium t
ot hemarketformoneyafteran
i
ncreaseinthemoneysuppl yisachievedint hebondmar ket.Theincreasei
nbondpr ices
l
owersinter
estrates,whichwillincr
easethequant it
yofmoneypeopl edemand.Loweri nterest
rat
eswi l
lsti
mulateinvestmentandnetexpor ts,viachangesi ntheforei
gnexchangemar ket
,
andcausetheaggr egatedemandcur v
etoshiftt otheright,
asshowni nPanel(c),
from AD1 to
AD2.Giv
entheshor t
-runaggregatesupplycureSRAS,
v theeconomymov estoahigherr
eal GDP
andahigherpri
celevel.

30|Page
Open- mar
ketoperat
ionsinwhichtheCBNsellsbonds,thatis,acontr
actionarymonetarypoli
cy
willhavet
heoppositeeffect
.WhentheCBNsel l
sbonds, t
hesuppl ycurveofbondsshiftstothe
ri
ghtandt hepriceofbondsf all
s.Thebondsal esleadtoar educti
oni nthemoneysuppl y,
causingthemoneysuppl ycur
vetoshifttotheleftandr aisi
ngtheequi l
ibri
um i
nterestrate.
Higherint
erestr
atesleadtoashif
tintheaggr
egatedemandcur vetotheleft
.

Aswehav eseeninlookingatbothchangesindemandforandinsuppl
yofmoney,t
heprocess
ofachievi
ng equi
li
bri
um i nthemoneymar ketwor
ksi ntandem wi
ththeachi
evementof
equi
li
bri
um inthebondmar ket.Theint
erestrat
edet
erminedbymoneymarketequil
i
bri
um is
consi
stentwi
ththeint
erestrateachi
evedinthebondmarket
.

e.TheMoneyMarket
WhenMargieear
nsanincome,sheal
way
sdeposi
tsherpay
checki
ntoachecki
ngaccountat
31|Page
thebank.Shechoosest okeepsomeofhermoneyi nherchecki ngaccountatall
times,andshe
evenkeepsal it
tlei
nt hef orm ofcashi nsi
deherpur se.Sheal sotr
ansfer
ssomeoft hismoney
tohersav i
ngsaccount .Thisi swhateconomi stscallthe' demandf ormoney '
.Atthesamet ime,
alt
houghMar giemaynotr ealizei
t,thecentr
al bankiscont r
olli
nghowmuchmoneyi savail
able-
whateconomi stscal
l t
he' supplyofmoney '.
Wheny oulookatbot hoft hesetwoper spectivestoget her,wecallitthemoneymar ket
.John
May nardKeynesdev elopedt hetheoryofliquidit
ypr eference,whichsay sthattheequil
ibr
ium
'
price'ofmoneyisthei nterestrat
ewher emoneysuppl yintersectsmoneydemand.

Agr aphrepresenti
ngthedownwar dslopeofthedemand
curve
Themoneymar ketisaneconomicmodeldescribingt
hesupplyanddemandf ormoneyina
nat
ion.Consumersandbusinesseshaveademandf ormoney,i
ncl
udingcashandchecki
ngand
sav
ingsaccounts,andt heyusefinanci
ali
nst
it
utionsforthi
spurpose.Economist
sill
ustr
ate
moneydemandusi ngademandcur ve,j
ustl
i
ketheydointhemarketforpr
oductsandserv
ices.

MoneyDemandandMoneySuppl yCur ves

Thedemandcur veformoneyi ll
ustrat
est hequantityofmoneydemandedatagi v
eni nterest
rat
e.Noticet hatthedemandcur v
ef ormoneyi sdownwardslopi
ng,whi chmeanst hatpeopl e
wanttoholdl essoftheirwealt
hint hef or
m ofmoneyt hehigherthatinter
estratesonbonds
andotheralternati
veinvestmentsare.
Thecentralbankcont rol
sthesupplyofmoney ,andtheyi
nter
actwit
hot herfi
nanciali
nst i
tut
ions.
Thisi
nter
act i
oni spartofthemoneymar ket,andwecani l
l
ustr
atei
tusingasuppl ycur ve.

Thesupplycur
vef ormoneyil
lustr
atesthequant i
tyofmoneysuppli
edatagi v
eni nt
erestr
ate,
andhere'
swhatthatlooksl
ike.Noticethatunli
keat ypi
calsuppl
ycur
veintheproductmarket,
thesuppl
ycurv
ef ormoneyisv er
ti
cal,becauseitdoesnotdependonint
erestr
ates.I
tdepends
enti
rel
yondeci
sionsmadebyt hecentralbank.

Equi
li
bri
um i
ntheMoneyMar
ket

32|Page
Equi l
i
brium i
sr eachedwhensupplyanddemandar ethe
same.
Equili
bri
um inthemoneymar kett
akesplacewhent hequanti
tyofmoneydemandedisequalto
thequant i
tysuppli
ed.Here'
swhatthisequil
i
br i
um looksli
ke.Nowthatwehaveamodel t
owor k
with,wecanbegi ntovi
suali
zewhathappenswhenmoneydemandi ncr
easesordecr
eases,or
whent hemoneysuppl yi
sincreasedordecr easedbyt heCBNReserve.Letusl
ookfir
statan
exampl eofmoneydemandchangi ngandt henseewhathappenswhent hesupplyofmoney
changesi nst
ead.

Supposet hattheeconomyisdoingv erywell,

andrealGDPincreasesthisyearby5%.Mar gi
eis
selli
ngmor ecakesthisyearthanlasty ear
.Ever
ythi
ngishappyandpr osperousinthelandof
Ceelo-andi ntownsacrossthenation.Ahighereconomicoutputleadstohigherincomes.The
higherthatincomeis,t
hemor eoftheirwealthpeoplechoosetoholdint heform ofmoney,so
thisleadstoanincr
easeinthedemandf ormoney.

Asy oucanseeher e,whenmoneydemandi ncr

eases,thedemandcur veformoneyshi f
tstothe
ri
ght,whichchangest heequi l
i
br i
um inthemoneymar ket.Whathappenstothenomi nali
nter
est
rat
e?Itri
ses, f
rom r1t or2.Ont heotherhand,i
ftheeconomyexper i
encesar ecession,i
ncomes
couldfal
lbelowt heirprevi
ouslev elf
rom aprev
iousyear.Adecreaseinincomest hroughoutthe
economywoul dcauseal eftwardshifti
nthemoneydemandcur ve,andresul
tinal owerinter
est
rat
e,from r
1t or2,asy oucanseeher e.

A decr
ease i
nincomes cr
eat
es a l
eft
war
d shi
fti
nthe
demandcur
ve.

33|Page