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FIN3703 Notes

Financial Markets (National University of Singapore)

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FIN3703 – FINANCIAL MARKETS NOTES

WEEK 1 – INTRODUCTION TO FINANCIAL MARKETS

Financial Assets:
 Asset: Any possession that has value in an exchange
 Can be tangible or intangible

Tangible Assets Intangible Assets

Value of a tangible asset is a function of its Value of intangible assets is a legal claim to
physical properties their future benefits (cash flows)
Examples: Land, buildings, machineries, Example: Financial assets like stocks,
vehicles certificates, corporate bonds, derivatives

Derivatives:
 Are structured assets, where the value of the asset is derived from the value of the
underlying financial asset.
 Eg: Futures, Options
o An options contract gives an investor the right, but not the obligation, to
buy/sell shares at a specific time, as long as the contract is in effect, while
o A futures contracts requires a buyer to purchase shares, and a seller to sell
them on a specific future date, unless the holder’s position is closed before the
expiration date.
 For a stock option, the value of the option depends on the value of its underlying
stock value
 For index futures, the futures contract value is a function of the underlying index
value.

Real Assets Financial Assets

Used to produce goods and services Claims to the income generated by the real
assets or on income from the government.
Does not directly contribute to the
productive capacity of the economy.
Difficult & expensive to store, costly Easy to store & transfer
maintenance
Value is stable, relatively insensitive to Sensitive to market conditions, such as
exchange rate fluctuation and political risk exchange rate, inflation & political
instability
Eg: Land, equipment, Intellectual property Eg: Cash, bond, stock, derivatives,
retirement savings account
 Cash is an IOU from the government
 financial asset
Role of Financial Assets:
 Facilitate the transfer of funds from surplus units to deficit units
 Relocation of scare resources from non-productive to productive use

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 Pulling of funds, as well as risk pooling and risk sharing

10 Properties of Financial Assets:

1. Moneyness
o Money: Financial assets which acts as a medium of exchange
o Eg: Cash, demand deposit, current account
o Near money instruments: Assets that are not money, but can be transformed
into money fast at little costs
o Eg of near money instruments: Saving deposits, fixed/time deposits, T-bills

2. Divisibility and Denomination

o the minimum amount or size in which assets can be traded
o Eg: US bonds are generally sold in $ 1,000 denominations, commercial paper
in $25,000 units and deposits are infinitely divisible.
o Divisibility is desirable for investors

3. Reversibility / round trip costs (bid-ask spread)

o Refer to all the costs incurred in a securities or other financial transaction
o Include commissions, exchange fees, bid-ask spreads, market impact costs,
brokerage fees, stamp fees/duty, loadings (other transaction fees) and
occasionally taxes.
 Stamp fee/duty: mostly relevant to international transactions
 Loadings: Common with mutual fund investments

Bid-ask spread:
 Reflects the difference between the price at which the market/market maker is willing
to buy and sell
 Varies with the riskiness of the market (volatility of the price and the type of security)
& the thickness of the market (liquidity)
o In a thin market  trading is infrequent  pricing is difficult  higher
uncertainty concerning the price of future transaction  market maker charges
a higher bid-ask spread

4. Term to maturity (Time period for payment)

o Demand instruments: Assets with the shortest term to maturity
o Infinite maturity: Bonds issued by the British government, as well as stocks,
have infinite maturity.

5. Liquidity (thickness of the market)

o Refers to the transferability into cash without significant loss
o An asset in a thick market (heavy trading) is considered to be a liquid asset 
losses can be mitigated in thick markets as immediate liquidation at low costs
is possible.
 Investments in stocks are very liquid, but stocks on SGX are less liquid
than NYSE (need to see trading volume to see the liquidity)
 Liquidity of US markets are generally better

6. Convertibility

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o Some financial assets can be converted into other types of financial assets

7. Currency
o Foreign denomination exposes the investor to exchange rate risk
o Example: US$, €, £, ¥, S$

8. Cash-flow and return predictability

o Riskiness of the asset is related to the predictability of the cash flows
(payments) to which the asset gives right
o Potential measure of risk is the volatility of the asset price

9. Complexity
o Complex assets combine 2 or more simpler assets
o Eg: Convertible bond

10. Tax status

o Taxability at (local), state, and federal level
o Tax implications are complicated with double taxation, domicile, citizenship
etc

Financial Market:

 Government can either be borrowers or lenders.

 Financial markets are arranged groups or institutions that facilitates the transfer of
funds between entities.
 Financial intermediaries
o Identify potential surplus units to match deficit units
o Assists in efficient allocation of wealth throughout the system
 Allocates funds to best, most efficient, most productive use, not
necessarily most profitable use
o Supporting greater efficiency for the economy

Role of Financial Markets:

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1. The informational Role

 Capital flows to companies with best prospects
 Prospects of the company  reflected in their stock prices
 Market optimism/pessimism captured in prices
 Stock prices provide information about the potential of a company

2. Consumption Smoothing
 Creating a balance between spending and saving during the different phases of our
lives (high and low earnings period) to achieve a higher overall standard of living.
 Requires planning and sticking to a budget so that bills are paid when they come due.
 Can be achieved with financial assets
o Eg: Borrowing early for home/study, and paying off debt during high earner
middle age

3. Allocation of Risk
 A wide variety of securities in the market allows investors to select securities
consistent with their tastes for risk
 Benefits companies who can issue securities at the best possible price

Separation of Ownership & Management

 Owners and managers of businesses are usually different
 Agency problem: arises when managers pursue their own interest instead of
maximizing the firm’s value.
 Mitigating solutions:
o Compensation plans that tie managers’ income to firm success
o Monitoring by the board of directors
o Screening by the external security analysts, activists, Takeover threat

Corporate Governance & Corporate Ethics:

 There will only be efficient allocation of resources if market signals are accurate and
investors are acting on accurate information
 Eg. Misleading or overly optimistic company reports may lead investors to make the
wrong investment decisions. Other egs: accounting scandals, analyst scandals
 Corporate governance: system of rules, policies, and practices that dictate how a
company’s board of directors manages and oversees the operations of a company.
 Corporate governance includes principles of transparency, accountability, and
security.
 Helps to eliminate such violation of proper rules so that markets can be a more
efficient avenue for capital allocation

Different ways to classify financial markets:

By type of claim: Fixed Income (Debt) Market, Equity (Stock) market, FOREX, Derivatives

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By Primary of Secondary Market

By type of claim: Fixed dollar amount claim vs Residual or equity claim

By maturity of claim:

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Money Market:
 Assets have short term maturity
 Assets are trading close to their face value
 Examples:
o Certificates of deposits: a savings account that holds a fixed amount of
money for a fixed period of time, such as six months, one year, or five
years, and in exchange, the issuing bank pays interest. When you cash in
or redeem your CD, you receive the money you originally invested plus
any interest.
o Repurchase agreements (repos): Repos allow the borrower (normally
financial institutions) to obtain immediate funds by selling securities (for
example, T-bill) and simultaneously agreeing to repurchase the same or
similar securities (other T-bills with the same maturity) in the near future at
a higher price (the repurchase price is agreed at the start when the
borrower sells the financial asset to another financial institution short-
term)

By Retail or Wholesale Market

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 Most corporations rely on bank loans

 Bank has information advantage over some firms because they have more resources to
do research on companies
 In Singapore, some companies do not list on the stock exchange because of high cost
and disclosure
o Private companies  depends on bank loans

Financial Institution:
 Institutions/business entities which provide financial services
 Are generally financial intermediaries
 Involved in
o Maturity intermediation: Making long-term loans on funds borrowed at short-
term interest rates.
o Denomination intermediation: Allowing small investors to purchase pieces of
assets with large minimum sizes such as negotiable CDs and commercial
paper issues.
o Risk intermediation (via diversification)
o New asset creation (IBs, commercial banks)
o Asset pooling (mutual funds)

Commercial Banks Takes deposits from individuals & corporations and lends these
funds to borrowers
Investment Banks, Raises money for corporations by issuing securities
Finance Companies,
Mortgage Companies
Pension Fund Invest money set aside to pay future pensions in securities, real
estate and other assets
Charitable Foundation Invests the endowment of a non-profit organization such as a
university
Mutual Fund Pools savings from individual investors to purchase securities

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VCs and PE firms Pools money from individual investors and other financial
Fintech firms / intermediaries, generally to fund relatively small, new
Crowdfunding businesses or help in restructuring

Depositories Non-Depositories
Raise funds by attracting deposits in the Do not raise funds by attracting deposits.
wholesale and retail market, and use these The lending activities are financed with
deposits to fund new lending. equity or borrowings.
Have both securities and loans in their Do not have loan portfolios and virtually
portfolios  have option to either hold the sell off all their issued loans to fund further
loans on their balance sheets or sell them off lending activities  thus have to price their
in the capital in the form of MBS when the MBS to attract some sellers at any time.
market is optimal
Has access to short-term funds from the Fed Does not have access to short-term funds
at a low rate from the Fed at low rate
Some loans are resold as mortgage-backed Most loans are resold as MBS in the capital
securities (MBS) in the market market.
Examples: Retail banks, finance companies, Examples: Insurance companies, pension
building societies funds, unit trusts, private equity firms,
Investment Banks

Restricted Depositories:
 Operate in wholesale segment
 Examples: Offshore banks, wholesale banks and private banks

Roles of banks:
 Service providers for asset transformation and fund allocations
 Has a monitoring function
o Concept from Diamond (1984)
 Cost effective information provider  Helps to deal with information asymmetry
o Concept from Boyd and Prescott (1986)
o Since not all agents have the same information
o While banks have better access to information  thus can take over the role of
information gathering and information provision for investors and ultimately,
the monitoring of firms to align investors and management incentives
 Addresses the adverse selection problem
o Adverse selection problem: An informed agent’s financial decisions, based on
his privately held information, adversely impacts other uninformed agents.

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Diamond’s Model is set up as follows:

 The more the number of lenders, the greater the monitoring costs, as there is a liner
relationship between total costs and the number of lenders (m lenders monitoring =
mk)
 While the Borrower bears penalty costs if found cheating (unlikely), the lenders still
face default cost

Financial Intermediaries (eg. Banks)

 Without financial intermediaries, flow of fund between fund suppliers and users is
likely to be low due to high search cost and high risk.
 In indirect fund transfer, the fund suppliers can benefit from lower risk (by investing
in mutual funds, or corporate bonds instead of buying direct ownership in a
corporation and taking on responsibility for losses).
 The credit allocation efficiency can be improved as not only the supplier of the funds
but also the financial institution monitor the company in which the investor invest via
the FI.
 FIs, especially insurance companies, facilitate intergenerational wealth transfer – FIs
provide savers the ability to transfer wealth.

Roles of the Financial Intermediaries:

 Denomination intermediation, and reduction of transaction and contracting costs with
economies of scales
 Maturity intermediation – FIs can better bear the risk mismatching of the maturities of
their assets and liabilities
 Reducing monitoring costs – reduce the risk for the supplier of funds and also reduce
the risk for the borrower
 Liquidity provision and price risk reduction – by allowing supplier of funds to access
their funds more flexibly and by providing liquidity, so suppliers can trade their assets
with lower price risk and invest in different assets to diversify
 Provision of payment mechanisms (credit card services, ATMs, foreign payment
transfer, etc.), with the use of new technology, iPad banking and phone payment

Traditional banks vs w Challengers:

Banks (traditional) has advantage by Fintech challengers have the advantage

in
 Established trust, long history, large  Providing access to financial
network and financial resources solution in remote locations via
 Corporate finance, investment basic phones and smart phones
banking (Traditional banks have the  Providing access to previously
large financial resources and the underrepresented investors
knowhow to set up and manage (expanding banking accessibility as
large deals, such as large syndicated well as expanding on service, such
loans for financing of large airplanes as Stashaway which provides mutual
for Singapore Airlines for example. fund and ETF investment options
SIA also likely to have well with small denomination while
established banking relationship it is banks often have minimum ticket
easy to leverage on existing size of 1000-2000 SGD)

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relationship and likely cost  Insurance products are available on

effective) the go
 Tailored business solution, reliance  providing access to services 24/7,
on banking relationship Nice/attractive/modern interface,
 Providing traditional solutions for easy to use (for the tech savvy)
(elderly) for the nontech savvy

Causes of Failures and Issues in Financial Services Industry

 Imperfect competition
 Stakeholders do not behave as purely rational agents
 Presence of externalities
 High levels of risk – excessive risk taking without proper risk management
 High transaction costs  may deter optimal investments
 Information asymmetries
o Moral Hazard: when someone's behaviour changes based on their access to
financial services. Exists when a party to a transaction has an incentive to take
unusual business risk because he is unlikely to suffer potential consequences
o Adverse Selection: occurs when one party in a transaction possesses more
accurate information compared to the other party. Eg: People whose activities
are particularly risky, takes high interest loans/buys insurance.

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WEEK 2 – NON-DEPOSITORIES

Private Equity, Venture Capitals, Angel Investors

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WEEK 3 – DEPOSITORY FINANCIAL INSTITUTIONS

Depository institutions:
 accept deposits and make loans

Specialised Banks
 Examples: Savings & Loans associations (S&L), mutual savings banks (MSB), credit
unions (CU), building societies
 Funds primarily from savings and time deposits
 Make mortgage and consumer loans, but commercial loans are becoming more
prevalent
 MSBs, CUs issue deposits as shares and owned by their depositors, with CUs
belonging to a particular group e.g. a company’s workers

Credit Unions:
 Predominantly in the US
 Are all chartered and supervised by the National Credit Union Administration
(NCUA)
 Member must contribute to the National Credit Union Share Insurance Fund
(NCUSIF)
 Owned by the government and its members (aka mutuals)  no corporate stock
ownership
o Do not issue stock or pay dividends to outside stakeholders
o Earnings are returned to members (all who have accounts at the credit union)
in the form of lower loan rates, higher interest on deposits, lower fees, and
enhanced technology and convenience.
 Deposits are known as/called shares in CUs
 Originally, membership in a credit union was limited to people who shared a
"common bond": working in the same industry or for the same company, or living in
the same community.
o In the recent past, credit unions have loosened the restrictions on membership,
allowing the general public to join.
 Are not-for-profit organizations that are intended to provide high-quality services to
its members, not to maximize profits.
 Are actively involved in the community
 Objective: To further community development
 Example: Navy Federal Credit Union (US)

Advantages Disadvantages
Exempted from paying corporate income Smaller in size than most banks and are
tax on earnings. structured to serve a particular region,
industry, or group. Less brick-and-mortar
locations as compared to banks
Generate only enough earnings to fund daily Offers less financial services and products
operations  Have narrower operating than banks
margins than banks  CUs can pay higher
interest rates on deposits, while charging
lower fees for other services  saves
members money on loans, accounts, savings

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products

Savings and Loan Associations (S&L), Thrifts (US)

 Provide similar services to customers as commercial banks, but places stronger
emphasis on residential mortgage
 Take short term deposits and issue long term fixed mortgage loans
o Exposed to fluctuation of interest rates
 Lifting of deposit rate ceiling (Regulation Q)
 Increase risk of loan portfolio and decrease in REprices  default
 In the US they lost importance after 80’s

Building Societies (UK, Australia, Commonwealth)

 Provides banking and other financial services to their members
 Similar to credit unions and savings and loan institutions, but their members are
typically those in construction trades, real estate, or co-op housing.
 Building societies in the U.K. are also not allowed to raise more than 50% of their
funds from wholesale markets.
o VS banks which have a diverse array of funding societies from open markets
to bond issuances to investment in commercial markets.
 In Australia, the Australian Association of Permanent B

 uilding Societies (AAPBS) merged with Credit Union Industry Association (CUIA) to
form Australian Mutuals (Association of Building Societies and Credit Unions)
Universal Banks

Commercial Banks
 Fund primarily from savings and time deposits

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 Make commercial, consumer and mortgage loans

Banks in Singapore
 Banks in SG need to have a balance
o Need more banks to increase competition to offer best interest rates for
consumers but,
o If there are too many banks competing for a limited number of borrowers, it
will push down interest rates  result in banks lending to high risk consumers
at low i/r due to high competition

Local Banks – 6 Locally incorporated in name (3 effectively)

1. Development Bank of Singapore (DBS)
2. Oversea-Chinese Banking Corp (OCBC)
 Bank of Singapore (part of OCBC)
 Singapore Island Bank (part of OCBC)
3. United Overseas Bank (UOB)
 Far Eastern Bank (part of UOB)

Islamic Bank of Asia:

 Local bank established in 2007, but shut down in 2016
 Set up by DBS
 Shut down due to its inability to achieve economies of scales
o Too small of customer base
o Most restrictions when the company borrows from Islamic banks

Qualified Full Banks

 Opened only to foreign banks
 Active in retail and wholesale market
 Allowed to freely compete with local banks on all retails services  makes banking
sector more competitive

1. Bank of China Limited Singapore

2. China Construction Bank
3. Industrial and Commercial Bank of China (ICBC)
4. BNP Paribas
5. HSBC Bank (Singapore) Limited
6. ICICI Bank, State Bank of India (SBI)
7. Maybank Singapore limited
8. Standard Chartered Bank (Singapore)
9. State Bank India
10. Citibank Singapore Limited

Benefits of QFB:
 Establish up to 25 service locations, which can be either brick-and-mortar branches or
off-site ATM locations;
 Share ATMs among themselves;
 Provide debit services through an Electronic Funds Transfer at Point of Sale
(EFTPOS) network;

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 Provide Supplementary Retirement Scheme and Central Provident Fund (CPF)

Investment Scheme accounts and, from 1 July 2002, accept CPF fixed deposits.

What qualifying full banks have to do:

Give out loans in Singapore, invest in Singapore, need to have some community involvement

Full Banks
 conduct a whole range of banking business for retail and corporate clients
 cannot do investment of pension investments, ie cannot take CPF money to invest
 prohibited from engaging in non-financial activities
 license is open to local and foreign banks but the latter enjoy less flexibility than their
local counterparts in their branch and automated teller machine (ATM) networks.

20 full banks (subsidiaries of foreign banks w/o QFB license):

1. Bangkok Bank Public Co. Ltd.
2. Bank of America, NA. 13. Indian Overseas Bank
3. Bank of China Limited 14. JP Morgan Chase Bank, N.A.
4. The Bank of East Asia Ltd. 15. Malayan banking Berhad
5. Bank of India 16. Mizuho Corporate Bank, Ltd.
6. Bank of Tokyo-Mitsubishi UFJ 17. MUFG bank, Ltd
7. Citibank N.A. 18. PT Bank Negara Indonesia (Persero)
8. CIMB Bank Berhad TBK
9. Credit Agricole Corporate and Investment Bank 19. RHB Bank Berhad
10. HL Bank 20. SC bank solutions (Singapore limited)
11. HSBC 21. Sumitomo Mitsui Banking Corporation
12. Indian Bank 22. UCO Bank

Wholesale banks
 May engage in the same range of banking as full banks except that they do not carry
out Singapore dollar retail banking activities
o Can do: normal banking activities authorized by MAS, including financial
advisory services, insurance broking and capital market services.
 Can only have one main branch
 May transact any banking business with approved financial institutions, but in
individual transactions subjected to the following restrictions:
o it shall not operate savings accounts denominated in Singapore dollars, except
with the prior approval of MAS;
o it may accept fixed deposits but in respect of Singapore dollar fixed deposits,
the initial deposit shall not be less than S$250,000 and the outstanding
deposits (including interest) shall not be less than this sum at all times except
on termination of the account or the withdrawal of all deposits standing to the
credit of the depositor;
o it may operate current accounts, but in respect of current accounts
denominated in Singapore dollars where the customer is a natural person and a
resident of Singapore, the current account shall not be interest-bearing, except
with the prior approval of MAS.
 May issue, in Singapore, bonds and negotiable certificates of deposit (CDs), provided
that:
o the bonds or negotiable certificates of deposit are to be denominated in foreign
currency; or

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o where the bonds or negotiable certificates of deposit are denominated in SGD

must have maturity greater than 12 months, denomination greater than
S$200,000 and issued to sophisticated investors or their nominees.
 Banking guidelines are subject to any additional requirements that may be imposed,
including in particular, MAS Notices 619 and 757, and the Asian Currency Unit
Terms and Conditions of Operation.

Offshore banks (Singapore)

 Can engage in the same activities as full and wholesale banks for businesses
transacted through their Asian Currency Units (ACUs).
 ACUs: used to book all foreign currency transactions conducted in the Asian Dollar
Market (ADM).
 The banks' Singapore dollar transactions are separately booked in the Domestic
Banking Unit (DBU).
 The scope of business transacted in offshore’s bank DBU has slightly more
restrictions on dealing with residents compared to wholesale banks
 Offshore banks (all foreign bank branches) have been given greater flexibility in
Singapore dollar wholesale business.
o Offshore banks had their Singapore dollar lending limit raised to S$500
million.
o They are now allowed to engage in Singapore dollar swaps in respect of
proceeds arising from the issue of Singapore dollar bonds managed or
arranged by them.
 First bank that was given the permission to start an ACU (Asian Currency Unit) was
Bank of American in 1968
o This date is considered the separation of the national and international banking
in Singapore
o Distinction eliminated with the Banking act, revised in 2019

Financial Companies (not so depository):

 Funds from commercial paper (ST debt), stocks, bonds
 Make consumer loans for durable goods & small business loans
 In many jurisdictions, they can also engage in deposit taking:
o No checking account (aka no demand deposit)
o No unsecured personal loan (loans not backed by collateral, loans are based on
creditness)
o Restricted (Capital >$100m) dealing in foreign currency, gold or other
precious metals
o Can still take deposits
o EG: Hong Leong Finance

Digital Banking

in Singapore
 MAS announced 4 successful digital bank applicants in 2004
o Digital Full Bank (DFB) Licenses:
 A consortium comprising Grab Holding Inc. and Singapore
Telecommunications Ltd
 Sea Ltd

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o Digital Wholesale Bank (DWB) Licenses:

 A consortium comprising Greenland Financial Holdings Group Co.
Ltd, Linklogis Hong Kong Ltd, and Beijing Co-operative Equity
Investment Fund Management Co. Ltd
 Ant Group Co. Ltd
 Digital banking = Online Banking + Mobile banking

Pure Digital banks (Online Banks) globally

 Russia: Tinkoff bank since 2007
o First fully digital & online bank, operating for 12 years, with 1 million daily
users
o Lifestyle banking: All banking needs, investment advice, delivery services,
holiday booking
o AI: Chatbots, voice recognition services, AI credit scoring
o Mobile virtual network operator (MVNO): Does not own network, has
agreement with one or more MNO to provide services.
 Hungary, Granit banks for SMEs, since 2010
 Philippines: Tonik bank (CEE founders)
 Ant SME, and Infinium (by Tencent, ICBC)

Online Banks:
 Some online banks may not issue loans/credit cards to reduce risk
 Others may start small but expand into a wide range of services like online brokerage
accounts loans and credit cards
o Example: SoFi
 Traditional banks are also embracing digital, especially in Singapore with government
support, with the Singpass System

Advantages to Digital banking Disadvantages to Digital Banking

24/7 Access to banking Services Downtime: Internet access & server
downtime can adversely affect banking
needs
Low to no fee structures and higher than Learning curve: Difficult for those who are
average i/r in exchange for no in-person not tech-saavy
branch experience
More streamlined, online and mobile-only Security: Hacking of usernames and
product offering, at lower operational costs, password
potentially provide vast benefit to the  However, online banks pursue the
underbanked and unbanked communities same degree of risk-reducing
security protections, such as multi-
factor authentication like physical
banks

Key Banking Services

Short term services: Deposit taking safekeeping

 Money market accounts
o Interest-bearing account at a bank/CU

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o Generally, pay higher interest rates than regular savings accounts and often
come with debit cards and limited checkwriting privileges.
o insured by the Federal Deposit Insurance Corporation (FDIC)
o require customers to deposit a certain amount of money to open an account
and to keep their account balance above a certain level
o Limited transactions each month
o Money is used to invest in the stock market  i/r tied to how well the stock
market is performing
 Borrowing from other banks and central banks

Longer term services: Investment services

 Structured deposit investment:
o Combines a deposit with an investment product
o Return on a structured deposit depends on the performance of an underlying
financial asset, product or benchmark
 Currency linked investments:
o A dual currency investment involving a currency option,
o Bank repays the principal amount and interest at maturity in either the base or
the alternate currency, regardless of your preference.
o Interest represents the premium on the currency option.
o Subjected to foreign exchange fluctuations, which may affect the return of
your investment.
 Savings account

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Deposit service
 Singapore banks do not charge quarterly or monthly account management fees for
deposits
 Checking account
o Not used much in SGD, only in foreign currency
o Most liquid account  costly for banks to manage, they have reserves set
aside to ensure liquidity
 Savings accounts, passbook savings, limited check writing services
 Special accounts
o 360 (OCBC), multiplier account (DBS), step-up accounts (Citibank)
o No interest payment, unless special conditions are met

Loans
 Assets for the banks while liabilities for clients, HHs, other companies/other banks
 Examples:
o Reverse repos: bank give cash to another loan short term, in temporary
exchange for some treasuries/other liquid safe assets
o Short term personal loans, student loans, home loans/mortgages, car loans,
corporate loans
 Risk relevant for loan issuance:
o Interest rate risk
o Market risk
o Business risk and industry risk
o Credit/Default risk
o Currency risk
o Asset risk (if there is a collateral for the loan, that is the property for
mortgages in general)
o Liquidity risk (can the loan be resold, or can the asset be liquidated)

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Mortgage services

Mortgage: loan used to purchase or maintain a home, land, or other types of real estate. The
borrower agrees to pay the lender over time, typically in a series of regular payments that are
divided into principal and interest. The property serves as collateral to secure the loan
 Generally long term for individuals (20-30 years)
 Shorter term (5-10 years) for corporations

Mortgage types:
 Fixed rate mortgages (FRM)
o Fully amortizing mortgage, where the interest rate on the note remains the
same until maturity
o Payment amounts and the duration of the loans are fixed
o Dominant type of loan in the USA
o Local banks not giving out long term FRM because there is high interest rate
risk (won’t give out at <0.8%)
 Adjustable rate mortgages (ARM) / Variable-rate mortgage
o Interest rate on the note periodically adjusted based on an index, which
reflects the cost to the lender on borrowing on the credit markets
o Loan may be offered at the lender's standard variable rate/base rate
o May be a direct and legally defined link to the underlying index, but where the
lender offers no specific link to the underlying market of index - they can
choose to increase or decrease at their discretion.
o In Singapore, property loans are ARMS with min. 20% down payment after
the global financial crisis (2007)
o Local banks in Singapore offer low interest rate (when the market conditions
is good) for the first few years first
 Option ARM
o ARM with added flexibility that allow borrowers to change payments to better
manage household cash flows
o 4 types of payment options available
o Have an attractive first low monthly payment (A)
o After that, the payment changes annually, and a payment cap limits how much
it can increase or decrease each year

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o There is minimum payment option after the initial first year (where payment
can be set to A), but this may not be enough to pay all of the interest charged
on your loan for the previous month and the unpaid interest will be added to
the principal balance you owe (will be deferred).
 Hybrid ARM
o I/r is fixed for an initial period, thereafter the rate is periodically adjusted like
with ARMs
o Most common type of loan in Singapore, where the i/r is fixed for 1-2 years
and adjustable for the rest of the term
o Hybrid ARMs notation: 3:27 refers to a loan which is a combination of 3 year
fixed rate and a 27 year floating loan.
o Reset date: Date that a hybrid ARM shifts from a fixed-rate payment schedule
to an adjusting payment schedule
o After the reset date, a hybrid ARM floats at a margin over a specified index
just like any ordinary ARM.
 Interest only (IO) loan
o Loan in which, for a set term, the borrower pays only the interest on the
principal balance, with the principal balance unchanged
o At the end of the interest-only term the borrower may enter an interest-only
mortgage, pay the principal, or (with some lenders) convert the loan to a
principal and interest payment (or amortized) loan at his/her option.
o Most of the times, they are combined with ARM/FRM
 Loan pays only interest for initial 3-5 years, after which it becomes a
fully amortizing loan

Common Indices used for ARM In the USA

 1 year constant maturity Treasury (CMT)
 6 month Tbill rate
 6 month LIBOR, or 12-Month Treasury Average (MTA or MAT)
 Cost of Funds Index (COFI) - National
o This Index is the monthly median cost of funds: interest (dividends) paid or
accrued on deposits, FHLB (Federal Home Loan Bank) advances and on other
borrowed money during a month as a percent of balances of deposits and
borrowings at month end. The interest rate on Cost of Funds (COFI) indexed
ARM loans is usually adjusted every 6 months. Index changes on a monthly
basis and it not very volatile.
 Cost of Funds Index (COFI) - 11th District
o This index is the weighted-average interest rate paid by 11th Federal Home
Loan Bank District savings institutions for savings and checking accounts,
representing the savings institutions (savings & loan associations and savings
banks) headquartered in Arizona, California and Nevada. Since the largest part
of the Cost of Funds index is interest paid on savings accounts, this index lags
market interest rates in both uptrend and downtrend movements.
 LIBOR
o L.I.B.O.R stands for the London Interbank Offered Rate, the interest rates that
banks charge each other for overseas deposits of U.S. dollars based on survey
which was found to be “manipulated” by key banks in the U.K.
 National Average Contract Mortgage Rate (NACR)

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o This index is the national average contract mortgage rate for the purchase of
previously occupied homes by combined lenders. This index changes on a
monthly basis and it not very volatile.

Common Indices used for ARM In SG

 SIBOR – Singapore interbank offer rate
 SGD SWAP offer
o the synthetic rate for deposits in SGD, which represents the effective cost of
borrowing the SGD synthetically by borrowing USD for the same maturity,
and swap out the USD in return for the SGD.
 Board rate
o Bank owns borrowing rate
o Non transparent
 Fixed Deposit-link home loan
o The interest rate is linked to a bank’s fixed deposit account interest rate for a
specified tenor e.g. the interest rate for a 8-month fixed deposit. If those
interest rates go up, so do the home loan interest rates.

Amortization table: for a 36 month, 100,000 loan with 10% i/r

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Prime loans (aka A loans):

 Loans with borrowers >620 FICO score
o FICO score: US credit score, ranging from 300-850
o Super prime: loans with borrowers with a nearly perfect 750-850 score
o AltA loans: 600-620 score

Conventional loans
 Is any type of home buyer’s loan that is not offered or secured by a government entity
o Instead, they are available through private lenders, such as banks, credit
unions, and mortgage companies.
o However, some loans made in the conventional market and could be
securitized by Government sponsored Enterprises (GSEs)
 The Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac)
 Conventional loan interest rates tend to be higher than those of government-backed
mortgages, such as FHA loans
 Loans are generally <$450,000 for a single-family home as of 2015
 There are also established guidelines for borrower credit scores (generally above 620),
income requirements and minimum down-payments (generally minimum 5-20%)

Jumbo Loans:
 A type of financing where the loan amount is higher than the conforming loan limits
set by the Federal Housing Finance Agency (FHFA)

Banks tend to be overexposed to mortgage assets

 Solution: Creation of GSEs, to support secondary mortgage market
 Resale off the mortgages from the bank balance sheets

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Mortgage Backed Securities (MBS):

 Are variations of asset-backed securities that are formed by pooling together
mortgages exclusively.
 The investor who buys a mortgage-backed security is essentially lending money to
home buyers
 Is an investment similar to a bond that is made up of a bundle of home loans bought
from the banks that issued them
 Investors in MBS receive periodic payments similar to bond coupon payments.

Figure 1Securitization

 In SG: local banks directly issue bonds (aka green bonds) backed by mortgages
without government guarantee, so called covered bonds (MBS effectively)

Mortgage terms:
 Front-end debt ratio aka mortgage to income ratio
o Projected monthly mortgage payment / total gross income
o Limit: 28% for conventional loans
 Back-end ratio
o Takes into account all debt obligations relative to income
o Limit: 36% for conventional loans

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 Singapore mortgage lending rules: monthly home loan instalment is part of the Total
Debt Servicing Ratio (TDSR) introduced in 2013.
o TDSR restricts that an individual can borrow only up to a maximum of 60% of
his or her gross monthly income - including your housing loan, and all other
outstanding debts like personal loans, car loans and credit card debt.
o Minimum down payment is 25% (increased from 20% in July 2018), so the
home buyer can borrow only 75% of the home value on the first home (second
home, actually require 55% down payment).

Mortgage Calculations:
 Mortgage value (loan balance) is the PV of all future payments
 Annuity, where the payments are made monthly

r: annual interest rate (quoted as APR)

APR = Period rate * the number of periods per year
n: mortgage maturity in months

EXAMPLE (ARM/Hyrbid ARM also same method):

Yvonne finds the current market interest rates attractive and decides to take a Adjustable Rate
Mortgage (ARM) for $500,000. The contract is based on the 6 month T-Bill (which is
currently 0.5%) with a 1.5% margin. The loan term is 30 years.
A) What is the initial monthly payment?
B) What will be the monthly payment 1 year from now (At the first adjustment date),
if the T-Bill rate is 1.75% a year from now?

A) To calculate PMT:
PV=500,000
N=360
FV=0 (unless otherwise stated the loans are assumed to be fully amortizing loans, the future
value is 0).
I/Y= 2%/12=0.16666% (you do not need to enter the % sign in the financial calculator)
PMT= 1,848.10
B) Based on the information: FV=0, I/Y=2/12, N=348, PMT=1.848.1 then OLB=PV of
remaining 348 payments is 487,711.28

PV=487771.28
N=348
I/Y = (1.75+1.5)/12=0.270833
FV=0
Compute PMT= 2,166.18 (about 318 payment increase)

EXAMPLE (IO Loans):

Yeong borrowed $500,000 with a 30year IO loan. What is his payment if the interest is 4% on
the loan?

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500000 * 0.04 = 20000 (yearly interest)

Monthly interest = 20000/12 = 1666.67

Governments and Fintech

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WEEK 4 – BANKING AND BANK MANAGEMENT

Role of Financial Intermediaries (Recap)

 Middleman institutions that allocate funds from investors to borrowers
indirectly
 Anglo-American financial systems are more market-oriented
 Continental European and other systems are more bank-oriented

Address and manages:

1. Transaction costs
 FIs reduce transaction costs in fund allocation
o They develop expertise and economies of scale
o Provide customers with
 Liquidity services: bank deposits are liquid assets that earn
interest but can be converted into goods and services
anytime
 Diversification services: FIs buy a range of assets, pool
them, and sell right to the diversified pool
2. Risk sharing
 FIs act as a systematic ‘risk buffer’ by allowing investors to limit their
risk exposure
o Asset transformation
 Create and sell assets with lesser risk to investors
 Buy assets with greater risk from borrowers
o Risks that FIs deal with:
 Maturity risk (taking ST deposits, giving LT loans)
 Credit risk
 Currency risk
 Liquidity risk
 Macroeconomic risk

3. Asymmetric information
 Key impediment to fund allocation is asymmetric information
o Before transaction: Adverse selection problem
 Investor cannot distinguish good and bad borrowers 
hence they only pay an average of good and bad values
 Good securities  undervalued, won’t be issued
 Bad securities  overvalued, too many issued
o After transaction: Moral hazard (Agency theory)
 FIs have a cost advantage in producing information and monitoring
contracts over atomistic investors (individuals) that invest directly
o Cost reduced by expertise and economies of scales and scope

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 Anglo-American market-oriented systems: strong disclosure and investor

rights  investors to cut off the middle man
 Bank oriented systems elsewhere: weaker disclosure and investor rights
deter investors from investing directly

Bank Management – Balance sheet

 Companies generally do not hold cash because they don’t generate returns  there is
an opportunity cost as they can get interest from loans

Bank liabilities

Transaction accounts:
 Depositor has right to withdraw anytime
 Non-interest earning checking accounts and demand deposits

Non transaction Deposits:

 the overall primary source of bank liabilities (74%) and are accounts from which the
depositor cannot write checks; examples include savings accounts and time deposits
(also known as CDs or certificates of deposit)
 are generally a bank’s highest cost funds because banks want deposits which are more
stable and predictable and will pay more to the depositors (funds suppliers) in order to
achieve such attributes
 Depositor cannot immediately withdraw  stable funding, less liquid

Borrowings:
 banks obtain funds by borrowing from the Federal Reserve System, other banks, and
corporations; these borrowings are called:
o discount loans/advances (from the Fed),

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o fed funds (from other banks),

 Overnight borrowings between banks and other entities
o interbank offshore dollar deposits (from other banks),
o repurchase agreements (a.k.a., “repos” from other banks and companies)
 ST (overnight) sale of government securities with the agreement to buy
them back
o commercial paper and notes (from companies and institutional investors)

More on repos:

Figure 2 Overnight 10mil repo at 2%, with 1% haircut

Trading account liabilities:

 Short positions, revaluation losses on foreign exchange, stock & commodity trades

Other borrowed funds, commercial papers, bonds, subordinated debt:

 Deposits as funding sources significantly declined

Contingent convertible bonds/Coco bonds:

 Preparedness for loss absorption  converts to equity if bank equity hits a certain low

Bank Capital:
 Source of funds supplied by the bank owners, either directly through purchase of
ownership shares or indirectly through retention of earnings (NI – dividends)
 This Is the shock absorber

Bank Assets
 Cash and balances due from depository institutions
o cash items in process of collection (7%)
 checks deposited at a bank, funds that have not yet been transferred
from another bank, the bank own cash, and own deposits placed at
other banks
o Reserves (or Balances at the Fed, Central Bank (CB)
 required reserves (in Europe defines as% of deposits)
 any further reserves are excess reserves

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 Generally does not receive interest

 Main assets are Loans
o Corporate loans, leases
o Personal Loans, individual mortgages, car loans, business loans
 Banks can also have some investments assets, stocks, bonds, property, funds etc.

Bank management – Major concerns

Reserve (liquidity) management

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Capital adequacy management

 ROE = Net Income/Assets * Assets/Equity = ROA * EM

 Higher bank capital (equity)  lower EM  lower ROE
 Hence, banks don’t want to hold a lot of capital due to profitability concern

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Strategies for managing capital

 if too much capital
o increase dividends to reduce retained earnings
o repurchase stock
o increase asset growth via debt (like CDs)
 if too little capital
o decrease dividends to increase retained earnings
o issue stock
o slow asset growth (retire debt)

Asset management

Liability management

Other liquidity management

 liquidity is the bank’s ability to fund increases in assets and meet obligations as they
come due, without incurring unacceptable losses.

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 Effective liquidity risk management helps to ensure a bank’s ability to meet cash flow
obligations, which are uncertain as they are affected by external events and agents’
behaviour.
 Liquidity risk management is of paramount importance because a liquidity shortfall at
a single institution can have system-wide repercussions.

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Interest rate (IR) risk

 When interest rate increases  existing current bond holding value decline, loan
values decline in the secondary market as well, because in the high interest rate
market the bank could issue loans with higher rates
 Financial Institutions incur interest rate risk when the maturities of the assets and the
liabilities are mismatched, and the interest rate is volatile
 Gap position used to measure i/r risk
 Gap position = Interest rate sensitive assets (RSA) – interest rate sensitive liabilities
(RSL)

Case 1: Matched gap (no interest rate risk)

Bank X has $1m in 3-mth fixed-rate (10%) corporate loan and $1m of 3-mth (5%) fixed
deposit
 Interest income = 5% (unaffected in the one-month horizon)

 Notice that the maturity of asset and liabilities are matched – thus no interest rate risk,
the GAP1month = RSA- RSL =0

Case 2: Mismatched gap (1 month gap = -1)

Bank Y has $1m in 3-mth fixed-rate (10%) corporate loan (asset for the bank) and $1m of 1-
mth (5%) fixed deposit (this is liability for the bank).
 One month later: only the deposits mature, thus RSA – RSL = 0-1 = -1
 If interest rates decrease next month  liabilities repriced at a lower rate  interest
income increase (bank benefits)
 If interest rates increase next month  liabilities repriced at a higher rate  interest
income decrease (bank suffers) (eg: S&L crisis)

Case 3: Mismatched gap (1 month gap = +1)

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Bank Z has $1m in 1-mth fixed-rate (10%) money market loan (this is asset for the bank) and
$1m of 3-mth (5%) fixed deposit (this is liability)
 One month later, only the loan matures, thus RSA – RSL = 1 – 0 = 1
 If interest rates increase next month  interest income decreases (bank benefits)
 If interest rate decreases next month  interest income increases (bank suffers)

Net income sensitivity to interest rate = GAP * percentage interest change

 EG: If the interest increases by 1%, the net income interest income change would be
o Bank Y = -1 million * 1% = -10000 (thus a bank with negative gap loses with
interest rate increase)
o Bank Z = 1 million * 1% = 10000

Shortcomings of GAP analysis:

 Use of book values
 Disregard of time value of money
 Disregard of off-balance sheet activities
 Ignore rate-insensitive asset/liability
 Prepayments and defaults Ignore demand deposit &
passbook savings
because they don’t have
to pay i/r (depends, on
question) as rsl.

In the first bracket, we

have money/near money
instruments which can be
used in financial
transaction as mediums
of exchange and can be
converted into cash if
needed with any loss in
value.

Calculating the 1 year Rate sensitive assets:

(include the short term consumer loans, three month T-bill, and six month T-Bill, and the
floating rate (or adjustable rates) mortgages where the rates are reset every 9 months.

Calculating the 1 year Rate sensitive liabilities:

The 20 million equity capital and the 40 million demand deposits do not pay interest and
therefore, they are non-interest paying assets & are not included as rate sensitive liabilities.
The 40 million in two year time deposits generate interest expense over the next year, but the
interest is set for the next 2 years, therefore unaffected by interest rate change.

If interest rate decreases by 1%:

 CGAP (1 year) = RSA (1year) = 155-140= +15
 Asset interest rate sensitivity = CGAP/Total Assets =15/270 = 5.6%
 Expected loss by bank = 15mil * -1% = -150000

Managing Interest Rate Risks - Balance Sheet Strategies

 What to do with Positive gap:

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o Sell off short term rate sensitive loans, or securitize ARMs while issue more
fixed rate loans (asset side)
o Borrow rate sensitive funds, buy brokered deposits, issue ST debt (liabilities
side)
 What to do with Negative gap: increase assets and get rid of liabilities
o Increase RSA: Buy or issue more short term rate sensitive loans using cash
(asset side)
o Reduce the rate sensitive liabilities, refinance short term debt obligations with
long term debt (liabilities side)
 Banks need to find an optimal balance (in gap), suitable for the current market
conditions

Off-balance-sheet items

Activities not appearing on balance sheet can still involve risk, such as:
 Fee income
o Lines of credit
 Loan commitment, overdraft privileges, standby letters of credit to
underwrite credit lines and securities
o Debt guarantees
o Foreign exchange for trades for customers
o Servicing mortgage-based securities
 Trading activities and risk management techniques
o futures and options
o foreign exchange trading
o interest rate swaps
o Derivatives (now there is initial margin requirement swaps cannot be recorded
with zero value)

Examples:
 Barings Bank collapsed due to $1.3bn losses in 1995
o Nick Leeson, head derivatives trader in Singapore
o was to arbitrage Nikkei 225 futures in Osaka v Singapore, but he speculated
rather than took offsetting (hedged) positions
o Nikkei collapsed due to Kobe earthquake, 6.5 years in prison
 Societe Generale lost €4.9bn in 2006-2008
o Jerome Kerviel, junior futures trader
o was to arbitrage equity derivatives v cash equity prices, but unauthorized
directional trades on European index futures
o Jan 2008 announcement
 downgrade by Moody’s and Fitch, bank seeks €5.5bn
 5-year sentence pending appeal

Bank Regulations: Basel ‘rules’

Basel I:
 Set of International banking regulations put forth by the Basel Committee on Banking
Services (BCBS)
 Sets out the min. capital requirements of financial institutions

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Basel II:
 Expanded on the min. capital requirements established under Basel I
o Taking into consideration operational risks in addition to credit risks
associated with the risk weighted assets (RWA).
o Requires banks to maintain a min. capital adequacy requirement of 8% of its
RWA.
o Two main approaches allowed to calculate capital requirements: standardized
approach (suitable for banks w smaller volume of operations and a simpler
control structure) and internal ratings-based approach (suitable for banks
engaged in more complex operations, with more developed risk management
system).
 Provided framework for the regulatory review
o Banks obligated to assess the internal capital adequacy for covering all risks
they can potentially face in the course of their operations
 Provided set of disclosure requirements for assessment of capital adequacy
o Ensures that users of financial information receive the relevant information to
make informed trading decisions and ensure market discipline
Basel III:
 2009 international regulatory accord that introduced a set of reforms designed to
mitigate risk within the international banking sector
 Requires banks to maintain proper leverage ratios and keep certain levels of reserve
capital on hand
 Increased risk reserve, with higher equity requirement: commercial banks
(introducing CET) must hold 4.5% of total risk based assets by January 2015, then a
further capital conservation buffer of 2.5%, (resulting in a total 7% common equity
capital).
 Introduction of a regulated leverage ratio
 Introduction of counter-cyclical buffers of 0-2.5% (when growth is associated with
built up systematic risk)
 Introduction of aggregate or individual counterparty risk
 More emphasis on liquidity, with the use of short and medium-term quantitative
liquidity ratios

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Week 6 & 8 – Debt Markets

Fisher Effect: When expected inflation rises, interest rate will rise.
i = r + + r
i is nominal rate, r is real rate,  is expected rate of inflation.

r = (1+R) / (1+i) – 1
r = real rate, R = nominal rate

For approximation if nominal rate is small: r = R – inflation

Current Yield:

C = annual coupon in dollars

P = current market price

 If bond’s price is near par + has a long maturity  CY is a good approximation

 Change in the CY  signals change in the same direction as YTM

Yield to Maturity:
 Also based on the belief that investor purchases the security at the current market
price and holds it until the security has matured
 the yield which equates the present value of all the cash flows from a bond to the
price of a bond
 It is used as comparisons for potential investments at the same risk level. Where the
YTM is the discount rate of the bond. Thus a higher discount rate would result in a
lower price of the bond → more desirable
 It is better than coupon rate where the coupon rate only takes into account when the
bond was issued, while the YTM takes into account the market conditions throughout
the period of the bond and adjusts the price of the bond accordingly
 Not fixed, changes overtime
o If the credit rating of the company falls (higher risk), then YTM falls.
 YTM is only guaranteed if all the coupon rate you receive has been reinvested at the
YTM
 YTM is only guaranteed if there is no change in I/R

Relationship between YTM and bond prices:

 As interest rates increase → the bond's PV & price decreases, vice versa
o Can look in the pov of opportunity cost, which is why there is a negative
relationship
 As YTM increases → the bond prices decreases, vice versa
 Bond prices fluctuate as interest rates change, so a bond can trade above or below the
par value based on what interest rates are.
 If you hold the bond to maturity and the firm remains solvent, you are guaranteed to
get your principal back
o However, if you sell the bond before it matures, you will have to sell it at the
going rate, which may be above or below par value.

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 As interest rate increases, bond price decreases (left graph)

 The longer the maturity of the bond (steeper slope), keeping all things constant the
more price sensitive the bond is to interest rate changes (graph on the right)
o Long-term bonds have more price risk (or Interest rate risk) than short-term
bonds
 All else the same, the lower the coupon rate on a bond, the greater is its price
sensitivity to changes in interest rates.
o Low coupon rate bonds have more price risk (or interest rate risk) than high
coupon rate bonds
 All else equal, high-coupon bonds have more reinvestment rate risk than low-coupons
bonds.
 All else equal, short-term bonds have more reinvestment rate risk than long-term
bonds.
 For any bond, a given increase in i/r will cause a smaller price change than a decrease
in i/r of the same magnitude.

Commercial Paper:
 Maturity ranges up to 270 days (but on average 30 days)
 Easy and fast to issue

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 Generally not required to register with SEC

 Used to cover inventory costs and provide the necessary working capital to finance
operating expenses
 Are unsecured debt obligations  only high credit worth institutes are able to issue
them
 Commercial papers don’t pay interest or coupon payments, return is from face value –
purchase value
 Don’t have maturity risk, liquidity risk etc bc it is ST  yield on CP is much less
 Singapore is generally the only few countries that can issue bond without credit rating

Asset-backed commercial paper:

 backed by high quality collateral or credit-supported commercial paper, guaranteed by
organisation with excellent credit (bank)
 Lower credit worthy firms: issue ABCP or use bank loan for ST financing
 2 methods of issuing paper:
o Directly issued to investor
o Sell CP to a dealer, who then sells the paper in the market
 CPs are quoted on a discount basis:
o icp(dy) = [(Pf - P0)/Pf] x (360/h)
o Converted to bond equivalent yield (BEY): icp(bey) = [(Pf - P0)/P0] x (365/h)
 Often linked with structured investment vehicles (SIVs)
o SIV: special kind of conduit. A type of structured vehicle that issues ABCP
o SIVs are administered by large commercial banks/asset managers  to fund
purchases of investment grade securities and earn the spread
o In contrast to a multi-seller or securities arbitrage conduit, an SIV does not
employ credit enhancement, and the underlying SIV assets are marked-to-
market at least weekly.

Bond Indentures: the contract between the issuer and the bondholder
Includes:
 Type of issuer (corporate vs fed Government vs municipal governments)
 Term to maturity – ST (1-5 years), Intermediate (5-12 years), LT (>12 years)
o Longest bond: perpetual bond issued by UK (consol bonds)
 Price of the bond – par, discount/premium bonds
 Principal and coupon rates (Fixed or floatisng coupon rate bonds)
o Floating coupon bonds: issues where the coupon rate resets periodically (the
coupon reset date)
o Coupon reset formula: reference rate + quoted margin
 Convertibility and options (call & put provision)
 Security – Collateralized or not, or Senior versus Junior
 Covenants
 Issue location (dollar denominated bonds): Eurodollar and Asian bonds are US
corporation USD denominated bonds issued in Europe and Asia.

 If Current Price < Par Value, YTM > Coupon Rate (Discount Bond)
 If Current Price > Par Value, YTM < Coupon Rate (Premium Bond)
 If bond is at par with current price = par value, yield = coupon rate (YTM = coupon or
interest)

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Bond Interest rate determinants:

 Default free, ST, real interest rate as a base interest rate
 Risk premium determined by:
o Issuer type (Corporation versus government)
o Anticipated inflation: Price of bond lowers if anticipated inflation is high
o Term to maturity: longer term, more risky
o Default / credit risk: Price of bond will drop if issuer’s perceived credit quality
deteriorates
o For embedded options rates are higher (lower) for callable (puttable)
o Event risk, liquidity, tax status, exchange risk, country risk (sovereign risk)

Bond reinvestment risk:

 Occurs if one hold series of short bonds over long holding period
 Gain from increase in interest, lose when interest decrease
 Assumptions: Investors hold the bond till maturity, Investors can reinvest the coupons
at YTM

Bond IRR measure:

CP: coupon payment

 All else equal, when the

maturity of a bond lengthens, the duration rises as well
 All else equal, when interest rates rise, the duration of a coupon bond fall

1. The higher is the coupon rate on the bond, the shorter is the duration of the bond
2. The longer the term of the bond normally longer the duration
3. For zero coupon bond duration is maturity, as there is only one CF at the end.
4. Duration is additive: the duration of a portfolio of securities is the weighted-average
of the durations of the individual securities, with the weights equaling the proportion
of the portfolio invested in each

 The greater the duration of a security, the greater the % change in market value of the
security for a given change in interest rate.

Treasury Bills quote

To calculate price of the T-bill:
 n = number of days till maturity
 r = prevailing interest rate (yield of the asset here)
o Use bid interest rate for bid price and ask interest rate for ask price
 Assuming par value = 100

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 Price = 100 (or face value) - (n x r) / 360

 BEY of ask (or bid) yield = ask (or bid) interest rate * 365/360

Private Debt market (nontraded debt)

 Bank loans, syndicated banks
o Efficient monitoring, bank relationship can reduce adverse selection can
reduce adverse selection and information asymmetry  lower risk  lower
costs (interest rate of the borrowers)
o Large loans are given out as loan syndicates, where multiple banks are
involved and with diversification against risk  reduce cost
 Private equities financing (debt/structured debt)
 Venture Capitalist (debt/structured debt)
 Crowd financing, P2P lending, informal lending
o Crowdfunding: used to fund smaller companies or an idea by selling small
amounts of equity to many investors
 Microfinance: source of financial services for entrepreneurs and small businesses
lacking access to banking & related services
o Use various financing assets: debt, equity & deposits
o Debt comprised over one-third of the total funding of MFIs

For sub-investment grade assets (bank loans): more covenants, maturity 4-9 years, more
risk
For sub-investment grade (high-yield bonds): Nonamortizing feature with higher risk,
limited security feature, share pledge and incurrence

Syndicated Loan Bonds

Key advantages for the borrower: Key advantages for the borrower:
 Generally cheaper cost of  Large sum of new capital can be
borrowings obtained in one issuance, which
 Strong availability for non-volatile could be structured in different
liquidity currencies depending on the
 Feasible pre-payments (useful in borrowers’ cash flow generating

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case of early refinancing/disposals) ability (allow liability – asset match)

 Flexibility of documentation  Less restrictive covenants, usually
 Preserves confidentiality of financial triggered by specific occurrences 
information but usually no security for the lender
 Institutional investors have granted in case of default
access to deeper pockets of liquidity  Longer term and more ‘stable’
 Preserves banking relationships source of financing
 Minimises negotiation time/costs as  Fixed rate instrument
only needs to deal with one/few
arranger Cons:
 Expensive to issue and require full
disclosure (and potentially require
firm to get rating)

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Week 8 – Stock Markets and Efficient Financial Markets

Types of Securities:
Shares
Ordinary Shares Preferred Shares
Give ownership right with residual cash Hybrid asset: Mix of bond and equity
flow (as debt holders have priority claims) Higher priority to claim than ordinary
shareholders in dividend payment and in the
event of liquidation
Voting vs Non-voting No Voting Rights
 Cumulative voting
 Straight voting (the no. of shares
determine the total votes,
restricting minority shareholders’
power in elections)
 Special classes, Class A shares may
have no votes
Fully paid vs partially paid New developments:
A) Share which receives a fixed lump
sum on redemption and is not entitled
to any periodic dividend.
B) Auction rate preferred stocks, where a
Dutch auction is used to reset the
interest payments, or dividends,
usually every 49 days (more or less).
C) Zero dividend preference shares
- Issued by split capital investment funds:
investment trusts that are split into 2 or
more types: income shares and capital
shares
- No dividend payments

Dual Class Shares

 Most jurisdictions and market places allow multiple share classes and virtually all
accept the reliance on pyramidal or cascading shareholdings
 Mechanisms for locking in control in most jurisdictions include voting right ceiling
 Initially prohibited by most exchanges (including Singapore) but recently more and
more exchanges permit it to attract IPOs

Depository Receipts (DRs)

 Negotiable (transferable) securities which represent foreign firms publicly traded
equity or debt instruments
 Broker purchases the firm’s shares in the firm’s home market  deposits the shares in
a custodian bank  custodian bank issues depository receipts  Depository receipts
traded in the local exchanges or OTC  dividends paid in the local currency
 Allows investors in one country to invest in the securities of another country

American Depository Receipts (ADR)

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 Foreign shares re-bundled and sold on exchanges of a foreign country (NYSE,

AMEX, Nasdaq)
o Rebundling: specific number of shares per ADR so the price per ADR will be
attractive to the investors ($10-$100 per ADR)
 Trades like stock - Price depends on demand and supply, but also closely linked to
home shares & home market
 Exposed to political & forex risk

Global Depository Receipts (GDR)

 European version of ADRs, still dominated in USD

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ETF Shares
 Open-ended investment funds to track specific indices/fixed basket of stocks
 Provide access to a wide range of asset classes, markets & sectors
 Hybrid of open- and close-end funds: Trade like a stock (closed-end) and tracks NAV
and no fixed number of units (open-end)
 Less costly than index mutual funds: no loading
 More transparent - Unlike traditional funds, you can see ETF prices and trade ETFs
anytime during trading hours

REIT Shares
 Raise capital to purchase primarily real estate assets
 Allows individual investors to indirectly invest in property and share the benefits &
risks of owning a portfolio of property assets, which typically distribute income at
regular intervals
 Traded like ordinary shares, can be very liquid
 Historically less volatile than equities (less risk) and have less correlation with other
financial assets (good for hedging)
 Pays more dividends (interest) than ordinary stocks (bonds)  pass >90% of profit to
investors

Warrants / Transferable Subscription Right

 Also a type of option (on equity)
 A security that entitles the holder to buy the underlying stock of the issuing company
at a fixed exercise price until the expiry date.
 Has a fixed tenure. If not exercised  warrant becomes worthless after the expiry
date
 Similar to stock option in terms of risk and hedging options
o Call warrant: gives the holder a right to buy the underlying asset
o Put warrant: gives the holder a right to sell the underlying asset
 Frequently attached to bonds/preferred stock, allowing issuer to pay lower i/r or
dividends  enhance the yield of the bond and make them more attractive
 In the case of warrants issued with preferred stocks, stockholders may need to detach
and sell the warrant before they can receive dividend payments.

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Options Ordinary Warrants Structured Warrants

Issued by parties outside the Issued by firms Issued by a 3rd party financial
firms themselves institution, on the shares of an
unrelated company’s shares, a
basket of companies’ share or
an index
When call is exercised, no. When an ordinary  Allows one to trade more
of outstanding shares warrant is exercised, a warrants that the underlying
remains constant firm must issue new share for the same
shares. Number of shares investment
increases.  Index & Basket warrants
Exercise of an option do not Exercise of a warrant provide exposure to a
bring cash into the firm brings cash into the firm sector/market

Equity vs Debt Payoff

Raising Public Equity

Advantages Disadvantages
 Credibility by public accounting  Giving  Issuing cost and
higher bargaining power with creditor & banks regulatory compliance
 Image enhancement cost
 More freedom for the management. Unlike debt  Loss of privacy due to
holders with covenants, equity holders do not disclosure
have rights in general that allows them to restrict  Potentially dilution of
firm’s excessive risk taking. Also, retail control (threat of
investors are generally unable to accumulate takeover)
significant ownership, or restricted with dual  Pressure to pay
share classes dividends
Initial Public Offering (IPO)
 Firm commitment (Underwriting)
o Underwrite (IB) guarantees the sales
o Shares that are not sold are bought back by the underwriter
 Best effort:
o Underwriter helps in the sales

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o Underwriter sets a minimum level of sale

o If minimum level is not reached then the sale is cancelled
 Dutch auction (single strike or discriminatory auction):
o The issuing company typically reveals the maximum number of shares to be
offered and a potential price range, for which investors submit bids (including
the quantity of shares and the highest acceptable price).
o Once the equilibrium clearing price is determined, investors who bid at least
that price are allocated shares in the offering. If more shares are bid for than
shares available, allocation allotment are awarded on a pro-rata basis.
o Designed to maximize the amount of money raised by the company issuing the
shares

Direct Listing (Non-IPO)

 Company’s shares are listed on a stock exchange without a primary or secondary
underwritten offering (no IB)
 Existing security holders become free to sell shares on the stock exchange at market-
based prices
 Features in typical IPO (lockup agreements, price stabilization activities)  not
present in direct listing

Seasoned Equity Offerings

 Rights offers: Shares offered to existing shareholders
o Popular in Asia, rarely used in EU & USA
o Issued the same way as IPO – issuer negotiates with  1 IBs to market the
offer & then set the price
 Accelerated offers: Deals & Accelerated book building, where in the bought deal to
the issuing firm announces the amount of stock it wishes to sell and investment banks
bid for these shares, usually by submitting bids shortly after the market’s close. The
bank that offers the highest net price wins the deal.

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 Subscription Right: For every share an investor owns, they can subscribe to x new
shares at a preset price
 Pre-emptive rights: Allow shareholders to maintain their ownership
o EG: If Peter has 10,000 shares in a company which has 500,000 shares traded,
then he has a 2% ownership. If the company decides to issue another 500,000
shares and Peter has pre-emptive rights, then the company has to give Peter an
opportunity to purchase additional shares (from the new offering) to maintain
his ownership fraction.

Stock Exchange
 An organized and regulated financial market where securities are purchased and sold
 Role to connect savers (investors) with investment opportunity  channel funds for
best use
 To ensure that the financial information is reliable: stock prices have to be informative
 Exchange has to
o Enforce full information disclosure
o Support good corporate governance
o Promote liquidity so traders can trade on information and restrict stock market
manipulation

Over-the-Counter
 Some securities are traded in some other platform than formal exchange in a dealer
network

Exchange Trading – Order Types

 Market Order: immediate execution at best price
o Trader does not specify price
o Certainty with respect to execution but not price
o Consumes/take away liquidity
o Types (NYSE context):
 Pure market order,
 market on open: A market order executed at the opening of the market
 market on close : A market order submitted to execute as close to the
closing price as possible (cancelled if not executed)
 Limit Order: trader specifies the price to trade (limit price)
o Certainty with respect to price but not execution
o Limit price can be different from the bid price
o Price of limit buy order > offer price or limit price of sell order < bid price:
marketable limit order  functions like a market order
o Provides liquidity

Order Driven Market:

 The orders of both buyers & sellers are displayed with detailed price at which they are
willing to buy/sell a security and the amount of the security that they are will to
transact at that price
 (+ve): transparency

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Efficient Capital Market :

 One in which stock prices fully reflect available information
 Firms should expect to receive the fair value for securities that sell
 Assumptions:
o Investor Rationality
o Independence of events
o No herding, no one/group of traders can move prices
o Arbitrage eliminated mispricing

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Efficient Market Hypothesis (EMH):

Market Inefficiency & Sources of frictions:

Real:
 Cost of supplying immediacy/ order processing
 Compensation for holding inventory (market makers)
 Opportunity cost of maintaining a continuous market
 Economic rent due to market makers oligopoly
 Regulators to:
o improve the trading system/process and/or increase competition among market
makers
o Allow trading on positive and negative info
o Reduce transaction costs
Informational:
 Compensation for losses to informed traders
 Regulators to:
o Increase disclosure (reduce insiders and/or illegal trading activity)

Stock Market Index:

 Quantitative representations of the performance of a set of equities relative to a base
reference value in the past.
 Created by:
o Compiling a basket of representative stocks based on share price, where the
basket may represent an entire market (broad-based) or a market sector
(narrow-based)
o Equity prices in the basket, are combined into a single number (by adding 
arithmetic index or by multiplying  geometric index)
 Good representative of the movement of the whole stock market in that particular
country

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 Price weighted Index: sensitive to the price movement of high priced stock in the
index
o Eg: Dow Jones Industrial Average (DJIA), Nikkei 225
 Market value weighted index: less sensitive to price movements of one single stock
o Hang Seng Index (HSI), Straits times index (STI)
 A good index is: (1) comprehensive, (2) stable, (3) reproducible, (4) representative
and (5) easy to understand
 Index level= Σ(Price of stock* Number of shares)*Free float factor/ Index Divisor.
 The FFF represents the floated shares / outstanding shares rounded at 5% for
calculation purposes.

Security trading – Positions

1. Long position (buy and hold) Buy Low, sell high
 Benefits from price increase
2. Contra trading
 Buying a security and selling it before settlement
 No cash outlay: only pay loss or receive profit
 Under the old T + 5 settlement system, the contra buyer often did not have to pay up
until 10 days after - he could sell on the 5th day and pay the difference between the
purchase and sale prices after settlement of the contra sale, which was another 6 days
later
 Now, with the shorter settlement cycle, T + 3, contra trading has become less
attractive
 Brokers have responded by using other forms of financing
3. Short position  Sell high, buy low
 Benefits from price decrease
 Sell a security you don’t own
 Borrow shares from broker  Sell in the market  Post proceeds and margin as
collateral  keep it on the account until you close out the position
 In the US, Regulation T determines the 150% initial margin (the margin can be
noncash, such as Treasury)
4. Margin position  Margin = equity/total position
Long position:

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Loss of 25% = (12000-9000)/12000 = 25%

Vs cash trading
 You bought 1000 shares of United States Steel Corp (X) at $24 (total value of
24,000). If the price goes up by $3 then you make money. As of now your current
position is worth $27*1000 =27,000, you made $3000. (On the 24,000, that means
12,5% return)
 Now, if the price goes down by $3, then you lose 3000, that is again 12.5%
3000/24000=12.5%.

Short selling:

Short position is liability: how much it cost for you to buy back the assets in the market

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Week 9 – FOREX Market

Drivers of currency strength (long-term)

 Relative price levels: Inflation normally result in depreciation
 Surplus in the BOP & demand for the currency in an open market  currency will
appreciate for the floating currencies
 Trade surplus (exports > imports): strengthens the currency exchange rate
 Large, public debt encourages inflation and distress currency (depreciation)
 Political stability & economic performance

Types of Exchange Rate Regimes: Way a country manages its currency with respect to
foreign currencies and the foreign currencies and the foreign exchange market

Fixed Exchange Rate Pegged Float Floating Exchange Rate

Descriptio National currency is Currency is pegged to Currency’s value is
n fixed with a direct some band or value, allowed to fluctuate
convertibility towards either fixed or according to the foreign
another currency periodically adjusted exchange market
Eg: Oil exporters, Eg: Most developed
Kuwait countries like USD, Euro,
SGD
Benefits - Stability - Stable balance of
- No speculation payments
- Competitive - Automatic correction of
- Reduce volatility in export receipts surplus and deficits
- Absorption of economic
shocks
Drawbacks - Balance of trade not automatically adjusted - Uncertainty in exchange
- Central bank must hold high amounts of rate
foreign reserves, very expensive - Increased currency risk
for overseas investors
- Greater speculation
compared to fixed rate

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Singapore Exchange Regime

1963 1965 1967 1972 1981

Merger with Singapore’s Interchangeability SGD Basket-band-crawl
Malaysia Independence Agreement pegged System
Use of MYR Use of MYR Issuance of SGD to USD Managed Float of
pegged to Pound SGD (trade
weighted exchange
with a band)
1972: Singapore stopped pegging its currency to gold

MAS uses exchange rate instead of interest rate for monetary policy due to
 Size of economy
 Open economy (to trade & capital flows)
With the objective:
 To preserve purchasing power of SGD
 Maintain confidence in currency
 Preserve value of worker’s savings, especially CPF balances

Exchange Quotes & Cross Rates

 American Terms (direct quote, USD on the right) (1 unit of foreign currency = x units
of home currency. Foreign currency – home currency)
o AUD/USD = 0.7606 (1 AUD gives 76 USD cents) GBP/USD = 1.4847
o AUD/GBP = 0.7606/1.4847= 0.5123
 European Terms (indirect quote, dealers’ convention, USD on the left)
o USD/AUD = 1.3147 USD/GBP = 0.6735
o GBP/AUD = 1.3147/0.6735 =1.9519

Purchasing Power Parity (PPP)

 Law of one price: Identical products should sell at identical prices in different
countries otherwise arbitrage will bring the price back to parity
 Price should reflect the exchange rate if prices are stated in different currencies
 Use a baskets of goods/price indices to calculate PPP

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 Higher inflation  Exports become more expensive  BoT decreases (X<M) 

Depreciation of currencies
 Expected inflation:
E ( S t +1 ) æ1+ ö
= E çç 1
÷÷
St è1 + 2 ø

Forward Contract
 Contract between 2 parties who agree to buy or sell an underlying asset at specific
price sometime in the future
 Buyer (long position): Betting that the price of the underlying asset will go up
 Seller (short position): Betting that the price of the underlying asset will go down
 No money/assets exchange hands until the settlement date

Forward rate: Exchange rate quoted today for settlement at future date
é æ FC 9 0 öù
ê 1 + çi x 3 6 0 ÷ú
è øû
F 9 F0 C / $ = S F C /$
x ë
é æ $ 9 0 öù
ê 1 + çi x 3 6 0 ÷ú
ë è øû
F = So * (1+rforeign)t / (1+rhome)t
So is the spot rate.

Interest rate parity: difference in national interest rates for securities of similar risk &
maturity should be equal to opposite of forward rate discount/ premium for foreign currency

Covered Interest Arbitrage (CIA): invests in currency that offers higher return on covered
basis

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Factors that may make the Covered Interest Arbitrage (CIA) less than perfect, i.e. the true
forward rate may vary from the theoretical rate due to:
 Bid-ask spread
 Commission
 Borrowing rate > lending rate
 Tax structure
 Forex control or restrictions

Uncovered Interest Arbitrage (UIA): investors borrow in currencies w/ low interest rates &
convert proceeds into currencies w/ high interest rates.
 Uncovered because investor does not sell the currency forward

Example: Exploiting cheap borrow cost in Japan @ 0.4%, assuming that USDJPY rate
remains the same and that I can earn 4% in the US:

Forex Exposure
1. Translation exposure
 In the consolidation of financial statements
 If have subsidiaries in other countries, may have foreign exchange losses

2. Economic exposure
 Over-reliance on one country for exports vs relying on multiple countries for exports

3. Transaction exposure (payment)

 Buys from Germany (raw material), high exposure to Euro, while sells in the US

Forex Market Participants

 financial institutions like commercial banks, central banks, money managers and
hedge funds (arbitrageurs).
 Global corporations use forex markets to hedge currency risk from foreign
transactions.

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 Individuals (retail traders) are a very small relative portion of all forex volume, and
mainly use the market to speculate

They tend to use forex to:

 Hedge against international currency and interest rate risk
 Speculate on geopolitical events
 Diversify portfolio
 Exploit arbitrage opportunities

2 point & 3 point arbitrage

Currency Contracts:
 Spot contracts
o Outright exchange of currency
o Generally OTC contracts with commercial banks’ treasury department
 Forwards contracts
o Have forward exchange rate at which bank agrees to exchange one currency
for another at a future date, tailored contract
 Futures
o Standardized contract with notional (non-existent irl) principal 100k or so
denomination to exchange a currency for another
o Market to market, traded on derivative exchanges
 Swaps
o A series of futures of forwards
o To hedge long term exposure

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o Frequently used to manage cross country exposure (translation and

transaction)

Currency Swap:
Example
 If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British
firm wanting to finance dollar borrowing in the amount of $16,000,000.
 Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a
U.K.–based multinational.

Gain of 64,000 by swap bank: 0.4% * $16million = $64,000

Variations of Basic Swaps

 Currency swaps
o Fixed for fixed
o Fixed for floating
o Floating for floating
o Amortizing
 Interest rate swaps
o Zero for floating
o Floating for floating
 Exotics

Risks of Currency Swaps (6)

 Interest Rate risk
o Interest rates might move against the swap bank after it has only gotten half of
a swap on the books, or if it has an unhedged position
 Basis Risk
o If the floating rates of the 2 counterparties are not pegged to the same index
 Exchange rate risk

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o In the example of a currency swap given earlier, the swap bank would be
worse off if the pound appreciated.
 Credit Risk
o Risk that a counter party will default on its end of the swap
 Mismatch risk
o Hard to find a counterparty that wants to borrow the right amount of money
for the right amount of time
 Sovereign Risk
o Risk that a country will impose exchange rate restrictions that will interfere
with the performance of the swap

Forex Market Trading

 No central exchange or meeting place
 All trading is done over computer networks between traders in different parts of the
world
 Forex Market worth 5 trillion, way more than stock markets
 Spot contracts & Swaps are the 2 most common contracts

 Forex Markets: European (largest), American, Asia Pacific, Middle East

 Singapore 3rd/4th largest trading centre in the world, offering FIs
o Pro-business environment
o Excellent infrastructure
o Cost-competitive environment
o Highly skilled/cosmopolitan labour force
o Strategic location at the heart of SEA to serve fast growing markets in the Asia
Pacific region

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Week 10 – Financial Innovations

Tangible Assets
(+ve) inflation insensitive
(-ve) generally illiquid market

Property investment – Commercial

 Traditionally beyond the possibility of retail investors because of its large sum outlay
& long investment horizon
 Property automatically pays off itself in rental
o In Europe: Usually in 6-8 years, with yields ~5-8%
o In Singapore: High property prices, hence yields are lower ~ 3%

Gold, Jewellery, Wine, art

 Real Assets
 Jewellery & gold relatively liquid (exceptions of tangible assets)
o But still less liquid than treasuries
 (-ve) Style change  value change

IP rights, patents
 Can directly invest on platforms which facilitate the buying and selling of patents
 No significant traction because patents are complex  people don’t know how to
value them
 Can invest via PE and Angelfunds

SME Lending
 Credit investing on the Validus platform helps SMEs who are underserved, or
unserved by traditional bank financing, gain access to working capital from investors
 Investors can gain exposure to the SME asset class for high yield and low volatility
investing, as it is relatively uncorrelated to markets due to absolute returns earned
from repayment of loan facilities

Private (P2P) Lending

 Allows direct lending P2P lending to individuals/businesses through online platforms
 Lenders face significant default risk
 MAS regulated P2P lending, but it is not insured
 To qualify as a lender/investor, the individual must
o Be 18 years old and above
o Be a SG citizen / PR / Foreign resident with a valid employment pass,
dependent’s pass or student pass
o Have a bank account with a local or foreign qualifying full bank in Singapore

Blockchain
 Distributed and immutable ledger
o Secure transaction ledger database where data and access to the network is
encrypted and shared by all parties in a distributed network
o Great storage of information cannot be altered  improve security of the
transactions
 Allows tracking of almost anything – tangible or intangible goods

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 All (each) nodes that are running in that blockchain network have a record of every
transaction that has ever taken place
 Everyone has the same copy of that blockchain

 Each transaction, verified by the blockchain network is:

o Time-stamped
o Embedded into a ‘block’ of information
o Cryptographically secured by a hashing process that links to and incorporates
the hash of the previous block, and joins the chain as the next chronological
update
o Hashing process of a new block always includes meta-deta from the previous
block’s hash output
 Technology for most cryptocurrencies

Cryptocurrencies
 A digital asset designed to work as a medium of exchange that uses cryptography to
secure its transactions  To control the creation of additional units & to verify the
transfer of assets

 Public and permissionless

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o Anyone can see all the transactions that have ever taken place
o Anyone can register to be one of the nodes in the network
 Anytime a new transaction is made, the blockchain will get a new block

Advantages:
 Disintermediation
o Allows P2P transactions with less oversight/intermediation of a third party
o While still not exposing the system to counterparty risks
o No intermediary  transacting becomes quicker and cheaper
 Security
o Cryptographic nature makes the network more secure
o Hash values prevent any maligned user from altering the transactions
o Blocks already installed in the chain cannot be modified/destroyed
 Privacy
o Pseudonymous nature of cryptocurrencies

Crypto Coins Tokens

Built on their own Built on existing blockchain, but aren’t considered currency
blockchain, intended as a but rather, programmable assets that allow for the creation and
form of currency execution of unique smart contracts
Example: Ether (ETH) is  Contracts can establish ownership of assets outside the
the cryptocurrency based blockchain network
on the Ethereum  Tokens can represent units of value, like electricity,
blockchain money etc
Constructed within the blockchain of an existing coin like
Bitcoin or Ethereum

1. Bitcoin
 First crypto in 2009
 18.8 billion bitcoin tokens in circulation, against a capped limit of 21 million
 Designed to be independent of any government or central bank
 Traded on decentralised public ledger that contains a digital record of each bitcoin
transactiong
 Established the basic system of cryptography and consensus (P2P) verification that is
the foundation of most of crypto
 Proof of work: complex, time consuming process of verifying blocks of transactions
and generating more bitcoins
 Transactions locked permanently on the blockchain
 Cons: A lot of energy required to create bitcoin, environmental pollution

2. Ethereum
 Designed as a programmable blockchain  Wasn’t created to support a currency, but
to enable network’s users to create, publish, monetize and use applications
 Also generated using proof-of-work system
 Unlike bitcoin, there is no limit to the number of ETHs that can be created
 Helped fuel many initial coin offerings
 Behind the boom of non-fungible tokens (NFTs)

3. Cardano (ADA)

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 Relies on Proof-of-stake (Pos): PoW calculations and high electricity usage required
for mining coins like bitcoins aren’t necessary  network more efficient &
sustainable
 Cryptocurrency is called ADA
 Main applications are in identity management & traceability
 First application can be used to streamline the collection of data from multiple sources

Altcoins
 Not bitcoin = altcoin
 Most altcoins are built on the same basic framework as bitcoin, sharing the same
characteristics
 Some altcoins use a different process to produce and validate blocks of transactions

Tokens
 Created and given out through an initial coin offering, ICO, like stock offering
 Can be represented as value tokens (like bitcoins), security tokens (like stocks), utility
tokens (designated for specific uses)
 Represents value but are not exactly valuable themselves
 Tokens can be used in transactions for other things

1. Security Tokens
 A regulated offering of securities using blockchain technology
 Dividends in the form of additional coins are given to token holders each time the
issuing company of the tokens earn a profit in the market.
 If cryptocurrency passes the Howey test  deemed as a security token
 As these tokens are deemed a security, they are subjected to federal securities and
regulations in the USA

Howey Test
1. An investment of money or other forms of asset
2. In a common enterprise
3. With the expectation of profit
4. To be derived from the efforts of others

2. Utility Tokens (similar to gift cards or transportation tickets irl)

 Token has rights to utilize or own a product and to pitch or vote for particular cases or
topics
 Having utility tokens allows you decentralized storage
o Tokens provide the exchange value for the services they give
 Improves user experience by giving rewards for particular things
 Act as a currency in the blockchain
 Possible to share the utility tokens for earning certain things

Security token Utility token

 An investment contract representing the legal  To fund ICOs and create
ownership of a physical or digital asset, that an internal economy
has been verified within the blockchain & the within the project’s
token value linked to the company blockchain
 Very low chance of scam as it is highly  Highly unregulated, more

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regulated chance for scams

NFTs
 Unique, one of a kind type of collectible token
 Can be artwork, meme, video, merch, film, ranks etc
 Digital art that cannot be replaced
 Some are stored on blockchain
 Cannot be traded like bitcoin (trading one for another and getting the same in return)
 Mostly built on the Ethereum blockchain
 Can be copied as many times as one wants to


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Week 11 – Derivatives Market

Derivatives: Contract that derives its value from the performance of an underlying entity like
an asset, cryptocurrency, stocks or bonds etc
 Main use: hedging against risk or speculations to exploit favourable market
movement, with extreme leverage

Types of Derivatives:
 Swaps: i/r swaps, total return swaps and credit default swaps
 Futures
 Forwards on commodities, indices, i/r and currencies
 Options: Stock option, currency, index options
 Contract for difference (CFD)

1. Contract for difference (CFD)

 Benefit from fluctuations in the price of stocks, commodities, indices and more
without really purchasing them
 Leverage trading
 Encourage traders to trade large positions with ‘small’ cash outlay, effectively trading
on the margin
 Can choose magnification

2. Option Value
 Intrinsic value – Value of option if exercised now
 Call price = Intrinsic value + Time value of money
 “In the Money” Option: if the date of expiration would have been today, the option
holder would have exercised their option
o Call: S > X
o Put: S < X
 “At the Money” Option: if the date of expiration would have been today, the holder
would have been indifferent to exercising their option
o S=X
 “Out of the Money” Option: if the date of expiration would have been today, the
holder would have given up the right to exercise the option
o Call: S < X
o Put: S > X

Call Option:
 A security that gives its holder the right (but not the obligation) to purchase a given
asset (eg. A stock) for a predetermined price (aka exercise/strike price) on a given
date, or any time before a give date.
 European option: can be exercised only at the expiration date
 American Option: can be exercised any time before expiration
 If X <  buy stock by exercising the option at a price that is lower than the price
prevailing in the market  exercise option  Value of option =
 If X >  buy stock in the market at a price lower than the price required by
exercising the option  let option expire, don’t exercise it  Value of the option = 0
 Payoff of Call at Maturity:

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The value of a call option C must fall within

Max (S-X, 0)  C  S
* If either of these bounds are violated, there is an arbitrage opportunity

CALL Options Valuation

 Stock price increase  Value of call option increase
 Value of call option increase with both the rate of interest and the time to maturity
o The option’s price is paid today but the exercise price isn’t paid until the
option is exercised  thus, the longer the option maturity and the higher the
interest rates, the more valuable the delay in payment of the exercise price
 Value of call option increases with both the volatility of the share price and the time to
maturity.
o Option holders gain from volatility because their payoffs are not symmetrical.
If the stock price falls below the exercise price, the call option will have zero
value. But for every dollar the stock price rises above the exercise price, the
call will be worth an extra dollar.

Call Put
Stock Price + -
Exercise Price - +
Interest Rate + -
Volatility in the stock price + +
Expiration date + +

Put – Call parity (for European options) depicts the relationships between put and call
premiums: C + PV(K) = P + S
* K is the exercise price, S is the stock price
 If the equation does not hold true, there will be arbitrage opportunities

B S C a llp r ic e = C 0 = S ´ N ( d 1 ) - K e - rT ´ N ( d 2 )
2
σ
ln ( S / K ) + ( r + )T
d1 = 2
T d2 = d1 - T
3. Forward Contracts
 A legally binding contract where 2 parties agree today on the price of an asset to be
delivered and paid for at some future date
 Tailored to meet the needs of both parties
 No exchange of cash initially – only available to large, creditworthy corporations
(counterparty risk)
 Long position: agree to buy the asset at the future date
 Short position: agree to sell the asset at a future date
 Can virtually eliminate price risk a firm faces
o But also eliminates potential benefits from beneficial price move

4. Futures Contracts
 Similar to forwards, but traded on organized securities exchange
 Requires an upfront cash payment called margin

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o Relatively small to the value of the contract

o ‘Marked-to-market’ on a daily basis: to show the current market value of these
investments
 Clearinghouse guarantees performance on all contracts
 Clearinghouse and margin requirements virtually eliminate credit risk
 Futures long position $ profit = (Ft - Fo) * contract size
 Futures long position % profit = ((Ft - Fo) * contract size) / margin equity
 Futures SHORT position $ profit = - (Ft - Fo) * contract size
 Futures SHORT position % profit = - ((Ft - Fo) * contract size) / margin equity
 Pricing:
o Theoretical price of futures contract = cash or spot price + cost of carry
o Cost of carry = cost of financing the position – cash yield on the underlying
security
o Actual prices can depart from the theoretical future price
 Liquidating a position, can either
o Liquidate prior to the settlement date or
o Wait till the settlement date
o For some futures contracts (eg index futures), settlement is made in cash only
(cash-settlement contracts)

Index Futures
 Represents the right and obligation to buy and sell a portfolio of stocks characterized
by the index
 Cash settled
o No delivery of the underlying stocks
o Contract are market to market daily

Synthetic stock futures

 Form of stock option combination trading, consisting of 2 option legs
 Buyer of synthetic futures buys a call option and sell a put option with the same
underlying strike price and expiry date
 Seller of synthetic futures sells a call option and buys a put option with the same
features

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 Payoff of synthetic futures at expiration is similar to that of equity holding

Interest rate futures

5. Swaps
 A long term agreement between two parties to exchange cash flows based on
specified relationships
 Viewed as a series of forward contracts
 Generally limited to larger credit-worthy institutions or companies
 Interest rate swaps: net cash flow is exchanged based on interest rates
 Currency swaps: 2 currencies are swapped based on specified exchange rates or
foreign vs domestic interest rates

Interest rate swaps

 Both banks are exposed to interest rate risk because their liabilities and assets are not
matched in terms of interest rate exposure

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Credit Default Swap

 Buyer of the instrument acquires protection from the seller against a default by a
particular company or country
 Payments usually made quarterly in arrears
 In the event there is a default, there is a final accrual payment by the buyer
 Increasingly, settlement is in cash and an auction process determines cash amount
 CDS market  still relatively illiquid  not easy to buy protection on bonds issued
by small firms/countries
 Recovery rate, R: ratio of the value of the bond issued by reference entity
immediately after default to the face value of the bond

Example:
 Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year
protection against company X
 Premium is known as the credit default spread. It is paid for the life of contract or
until default
 If there is a default, the buyer has the right to sell bonds with a face value of $100
million issued by company X for $100 million (Several bonds may be deliverable)
 Suppose payments are made quarterly in the example just considered. What are the
cash flows if there is a default after 3 years and 1 month and recovery rate is 40%?

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Total Return Swaps

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Derivatives Market:
 Chicago Mercantile Exchange (CME) group
o Agriculture products (Dairy & Livestock)
o Financial Products (FX & Cross rates, Indices, Interest rates)
 Chicago Board of Trade (CBOT) group
o Agriculture products (Grains & Fertilizers)
o Financial Products (interest rates)
o Commodity exchange – industrial products (Base & precious metals)
 New York Mercentile Exchange
o Industrial Products (Energy, freight, ferrous metals)
o Agriculture products (Softs)

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