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Functions, Role Payers and Types of Finanical Markets
During the initial phase of financial markets’ development, markets arose from the need for participants to reciprocally exchange goods and services. This was in order to exchange their diverse goods and services for others that would allow them to satisfya spectrum of desires and needs. However, as these markets developed over time, and became more sophisticated through refinement, so did the reasonsfor them, the participants in them and the financial instruments themselves.
Functions of Financial Markets
The primary reasons participants go to market are to Raise Capital, Profit incentive, Management of risk
The prominent role players that participate in international financial markets include Governments, Central Banks, Investment Banks, Insurance and Re-Insurance Companies, Clearing Houses, Dealers/Intermediaries/Brokers.
Sovereign states are also required to raise capital, sometimes in order to:
- Service debt (i.e. governments sometimes take loans to repay loans)
- Plug short-falls in revenue collection (taxes), and
- Other activities such as infrastructure spending.
The role of central banks within financial markets is a point of contention. Historically, the role of central banks was to monitor and maintain monetary supply. However, due the devastation of the last financial recession in 2008, central banks were forced to step in as market makers by flushing economies with cash (a policy known as quantitative easing or QE) in order to prevent economies from stalling. The effects of the intensive global QE cycles are still evident today in the form low interest rates globally, and bond and equity sensitivity to interest rate hikes.
This sensitivity to increases in interest rates has proliferated in the global markets since the start and subsequent ‘tapering’ of QE. As mentioned above, QE refers to the act of flushing an economy with money. This injection of money into the economy is usually done by the central/reserve bank buying up billions of bonds from banks and other financial lending institutions in the economy.
This injection (supply) of money causes the cost of money to decrease due to principles of supply and demand. The cost of money is essentially inflation. In essence, after QE there is so much money in the economy that interest rates are low. When interest rates are low, it’s cheap to buy credit (due to lower interest repayments) causing companies to stock up on cheap credit.
Companies that offer various financial goods and services which are often complex and offered on a large scale. Two examples are facilitators of mergers and acquisitions, and companies that act as intermediaries between issuers of securities and buyers of securities.
Insurance and re-insurance companies
Institutions that bear the risk of financial transactions and instruments by investing the premiums their clients pay into what are considered low-risk investment facilities, such as Treasury bills and government bonds.
Clearing houses refer to companies that facilitate all activities between the commitment of a transaction until that transaction is settled in bulk. Some of these activities include clearing trades, settling trading accounts, and reporting of trading data. Clearing houses also ensure members have sufficient balances in order to pay for their traded goods/services.
Dealers / intermediaries / brokers
Institutions and agents that act as middle-men, often not having the necessary licensing to act as a bank. They thus merely facilitate financial transactions on behalf of other parties, including banks and public investors.
Participants who wish to raise funds for operations and other business activities can approach financial markets as a source of raising capital, knowing that a larger market offers a greater chance for:•Competitive repayment terms (i.e. lower interest repayments),•More favorable payment horizons (short-term vs long-term), and•Better capital liquidity (ease of access to cash).
Participants are always seeking to put their money to the best possible use. The profit incentive drives more active lenders to the table, creating forces of competition which drives prices down. This competition also spurs technological advancement which seeks to leverage efficiency in process and service.
Every investment carries some degree of risk. The higher the risk, the higher the risk premium which is applied in order to compensate for this risk. However, in an efficient market, it is not enough to hope that the risk premium covers the potential risk of loss. Instead, participants can hedge their risk –that is to say, they can make alternative investments that cover the initial investment’s potential loss.
We can classify financial markets by•Type of asset traded•The maturity of the assets•The owner of the assets•The method of sale
In equity markets,institutions can raise capital by selling a portion of the company –which is divided into smaller components called shares/securities –then issuing these to investors. The investors are willing to purchase these shares in anticipation of dividend payouts (i.e. retained company earnings which are deferred to shareholders) and/or share price gains (i.e. capital gains).The most prominent form of instrument traded in equity markets are securities (a.k.a shares or stocks) that are available as:•Preference•Common
In debt markets,institutions take on debt as a means of securing financing. They can issue bonds which guarantee fixed interest repayments (coupon rate) for a known time period, in return for an initial capital sum provided by the bond holder (face value or par value). The bond’s face value is later repaid by the bond issuer (the bond principal) at the maturity of the bond.The most prominent bond issuers within debt markets include:•Government (sovereign debt)•Corporate•Treasury•Municipal
InDerivative marketsfutures contracts on commodities are bought and sold (futures markets) or where options on equities, futures, or currencies are bought and sold (options markets).Commodity markets refer to markets whereinstitutions engage in the trade of perishable goods, such as natural resources and agricultural produce. However, since the value of these commodities are extremely volatile, companies typically do not engage in ‘spot trading’. Instead, the primary instrument traded in commodities markets are derivative contracts, including but not MScFE 560 Financial Markets–Notes (1) Module 1: Unit 1©2019 -WorldQuant University –All rights reserved.8limited to futures contracts, that specifies transfer at a future date. Equally commodities markets are public, and therefore allow investors to acquire and trade commodities exclusively for profit.
Currency marketsrefer to financial markets that institutions use to trade various world currencies. Effectively, the currency markets enable these institutions to convert one national currency into another, thereby enabling these institutions to participate in international trade and investment. They also facilitate the crucial supply of currency for foreign exchange reserves, which are required by governments and central banks to hold in order to pay for foreign trade and investment.Two primary avenues for trading in currency markets, are spot markets, and futures markets. Spot markets refer to markets in which the trade of instruments or commodities that are for immediate transfer are made. Futures markets refer to marketplaces in which the trade ofinstruments or commodities that are for future delivery are made. The instruments traded in these markets are called futures contracts. Futures contracts are traded instruments which stipulate the transfer of a specific instrument or commodity, at a specific quantity and quality, at a specific date in the future.
Money marketsrefer to markets where highly liquid, short-term financial instruments are traded. Although there is no set period that defines ‘short-term’, the rule of thumb is that these instruments have a maturity of one year or less.The instruments that are traded within the money market environment are comparably low in risk and volatility, especially when compared to those in capital markets. Money market instruments include:•Deposits•Certificates of Deposit•Treasury Bills•Commercial Paper
Capital marketsrefer to markets in which institutions with longer investment/financing horizons will participate, in order to access capital that they can use to fund their activities. Two main avenues for engaging in finance and investing activities in the capital markets are debt and equity.
When a company offers stock for sale for the first time and the proceeds of the sale go to the company, the sale takes place in the primary (first) market. The Securities and Exchange Commission (SEC) regulates sales in the primary market.
After the initial public sale of stocks or bonds, the initial buyer of the stock or bond may choose to re-sell the asset to another party. When that happens, the sale takes place in the secondary market. Here the money for the sale goes to the initial buyer, with a notification to the original issuer (the company) that there is now a new owner of record. The Securities and Exchange Commission also regulates sales in the secondary markets.
In a dealer market, an individual (or firm) buying and selling securities (stocks or bonds) does so out of his or her own inventory, much as in a used-car dealership. The dealer makes money by purchasing the asset at one price and then sellingthe same asset later at a higher price.
In an auction market(such as the government bond market), many securities sell at the same time to many buyers. The various auctions for financial assets have specific procedures about who can bid, what type of bids are allowed, and how they distribute the financial assets to the winning bidders. The auctioneers, usually investment banks, receive a percentage of the sale as compensation for conducting the sale.
Thus far, our examination of financial markets has primarily focused on distinguishing and understanding various features that make up and drive how financial markets work. Here, we turn our focus to additional aspects that are not only by-products of the markets but also driving forces behind them.
Price determination and discovery
One of the underlying principles of market systems is that there must be an agreed-upon value attributed to a good or service. Price determination and price discovery refer to two processes according to which such a value may be set.
Price determination refers to the broader market price of a security, good, service or other instrument that is determined by the general level of what buyers are willing to pay and what sellers are willing to earn. This is affected by the general demand vs supply for the instrument.
Price discovery is the more specific agreement between buyer and seller in relation to the market context at the time of the trade. The instrument may be in high demand, or in excess supply. It may be of high quality in relation to its counterparts, or it may be of poor quality. These and other factors have an effect on the price of the specific instrument in question.
Think, for example, of how you would sell a car. First, you might establish the price by determining what other similar cars are sold for. Then, once a buyer has shown interest, you and they would determine a price based onthe specifics of the car.
Information aggregation and coordination
In financial markets, the speed and accuracy with which information can be delivered to market participants has a direct effect on the returns that can be made. It is no wonder that the areas surrounding the NYSE (New York Stock Exchange) have some of the most advanced processing technologies in the world. A trade can be executed in less than half a millionth of a second –more than a million times faster than a human being can make a decision –because technology has automated each step from order to payment.
Not only are trade speeds fast, but quantitative trade data is also easily and cheaply displayed on platforms throughout the world for anyone to access in real-time. Simply by visiting a website, anyone can see spot (real-time) prices for almost any publicly traded financial product or instrument available. The intense competition of the markets drives the development of these technologies and information platforms, which in turn fuels more efficient, competitive markets.
Risk sharing refers to the division of risk among more than one party so as to minimize the impact of loss. Another characteristic is that the risk is shared among those who have similar or equal risk of loss. It differs from insurance, which involves the transfer of risk from one party to another.
In traditional insurance, the associated risk is assumed to be known and, because the risk is known, the insurer can calculate, and therefore charge, a premium which the risk-averse party is willing to pay. Risk sharing differs from traditional insurance products in that the probability of loss is not fully known (as in the case of a new product).
For example, if a client (institution or government) requires a substantial loan from a bank, the bank may approach other banks and request that they assist with the risk by funding a portion of the loan each. This prevents the original bank from taking on the full risk of loss in the event the client defaults on their debt repayments.
Liquidity refers to the ease with which an asset can be converted into useable tender (cash mainly). It is an important concept in financial market practices, as it enables market participants to achieve their desired goals. Buyers and sellers want to be able to convert their product into cash as quickly as possible in order to meet the profit incentive (for investors in equity markets) or the borrowed principal sum (for lenders e.g. in the bond market) that motivated them to approach the market in the first place. This can only happen in a market arena that is constituted by efficiency of processes, shared information and availability of funds.
Where a market is illiquid, buyers and sellers are at risk of loss due to the time exposure involved. The recent boom and subsequent sell-off in crypto-currencies is a good example. During the sell-off period, there were so many sell-side instructions that exchanges were neither able to process them in time nor match the sell-side to an appropriate buy-side order. This left crypto traders sitting on their hands unable to trade, as they watched the value of their holdings dwindle.
By the time their trades were processed, their losses were exacerbated due to the illiquidity of the market or exchange.
Efficiency in a financial context refers to the fact that the specified prices reflect all available information regarding the particular instruments, making it impossible for participants to outperform the markets over time. The Efficient Market Hypothesis (EMH) states that: “asset prices fully reflect all available information. A direct implication is that it is impossible to ‘beat the market’ consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates (the latter may be predictable or unpredictable).” Though the theory is by no means watertight, it draws our attention to an important aspect of price setting in the global financial market: that prices are driven upward or downward to the point at which the available information reflects an equilibrium price.
In practice, let’s look at an example below:
If two different exchanges, the NYSE and the LSE, offered the same stock ABC Ltd on their platforms, and the NYSE sold ABC Ltdstock for $10, but the LSE sold ABC Ltd stock for $10.50, it could be assumed that the market could simultaneously buy up the cheaper ABC stock on the NYSE and sell it for more on the LSE.
This buying of shares on the NYSE would –through forces of supplyand demand –drive up the price of ABC Ltd on the NYSE, while the selling of ABC Ltd on the LSE would drive down the price on that exchange. This would go on until the prices find equilibrium. This example –which is an example of arbitrage -gives a good indication of the efficiency of the market in practice.
Managing Risk in Financial Markets
Risk poses a universal threat to all market participants, which makes it necessary to manage. In approaching the field of risk management, it is useful to consider some additional characteristics that define financial markets. Owing to their competitiveness and focus on profit, participants in financial markets are always driven by a universal desire to protect their assets from loss. The ability of participants to mitigate potential losses is another important factor. To cover risk, they need to be able to pay for it.
Basic insights such as these have given rise to the development of many techniques that market participants relyon in order to manage risk. Below we explore four of these techniques. Each has a different approach, but all can clearly be observed when analyzing market participants and the financial instruments they use.
The first, and perhaps most obvious risk management technique, is avoidance. It is quite extreme and offers very little, if any, reward for the participant. An institution that is 100% risk averse would seek investment opportunities that charge them no risk premium –that is to say, assets that have not had a risk charge built into their capital repayment structure. An example of this would be investing in US Treasury Bills (or T-bills). This specific financial instrument is considered risk-free as it is backed by the US government which has never defaulted on its loan repayments.
It is obvious to see, however, that this risk-free approach only relates to default risk –i.e. the risk of the issuer missing repayments. Avoidance does not protect against inflation which erodes the value of money over time. It can therefore be argued that if inflation is present in the market environment, there will always be a risk of loss through inflation, even though default risk may be avoided through this technique.
A second form of risk mitigation is loss prevention and reduction, in which risk is accepted while steps are taken to minimize the potential loss. Hedging is a popular and well-known example. It is a technique whereby the participant (or an agent acting on their behalf)will take the opposite position of their trade (known as an inversely correlated position). In this way, risk is mitigated as they stand to gain from either outcome, albeit to varying degrees.
Suppose you run a transport business. Fuel is therefore one of your largest expenses. You have heard that there are going to be cuts in the global supply of oil, which means the price of oil, and therefore fuel, is likely to increase in the coming months. This increase in expenses would harm your profit margin, so you decide to hedge your risk through a futures or forward contract which allows you to buy oil at a predetermined price at a date in the future.
Let us assume oil is priced at $50 per barrel. You buy oil, for delivery in six months, through a futures contract at a $60 per barrel future price, and six months later the oil price is $70 per barrel. You have offset your price risk by $10 per barrel ($70 -$60 = $10). In doing so you have essentially paid $10 less by buying oil ahead of time. Note, however that this saving is not strictly $10, since there may be costs associated with holding the asset until you need it.
Known colloquially by the expression “Don’t put all your eggs in one basket”, diversification is a common technique, particularly in cases that involve risk management in securities and bond markets. The approach of this method is to minimize the potential for loss by pooling assets with different risk weightings in the most risk-efficient manner. In this way, investors can decide what risk they are willing to accept. They will then weigh up their ‘risk appetite’ against the return they seek to earn; and create a weighted investment that meets these goals.
This technique mitigates risk by moving it from one party to another. This is done on the theoretical basis that the risk-averse party is willing to pay the loss-covering party a premium. An example of this is an insurance policy whereby a party pays frequent premiums. These premiums are determined bytaking into account a variety of factors, such as:
•The size of the potential loss,•The likelihood of the loss occurring, and•The profile of the risk-averse party.
In financial markets, participants can use one or a combination of the four above mentioned techniques to manage their risk. However, it is important to be aware that each approach has its own intrinsic cost. For instance, risk avoidance may remove the risk of non-payment as you are either not involved in the product at all, or you are receiving interest repayments from an entity who will not default(e.g. US government treasury bills).
This, however, still comes at the cost of lower investment returns (lower risk means lower repayment because compensation for risk is lower), which in turn undermines the repayment value through the erosion of the value of money over time due to inflation. Hedging, on the other hand, has an element of speculation which brings with it uncertainty, and therefore even greater risk.
Fundamentally, there is no participant operating in the financial market context that can be completely removed from the effects of risk. The best they can do is to attempt to manage it to an acceptable degree.
Risk and Financial Instruments
In this set of notes, we conclude the first module by focusing on some of the main financial instruments in relation to the risk they mitigate and are exposed to.Understanding investment instruments in relation to the risk they mitigate is essential for any market participant. A company can spend massive resources assessing their risk exposure, but ultimately, if they do not use the correct instrument to manage that risk, they will still be exposed to great potential loss.The alternative is also true. One does not do themselves any favors if they employ an investment instrument without knowing what risk that instrument exposes them to. Think of investing in a company’s stock without realizing that its share price can fluctuate with the profit performance of that company. For this reason, we unpack each instrument in its relation to risk a little further below.
Because interest repayment rates (coupon rate) are fixed, and given that the principal is determined before sale, the income earned, and repayments required are highly predictable.•Information concerning the reliability of the bond issuer is usually readily available through ratings agencies.
Generally, the function that a bond serves for the bond-holder is that it enables them to collect frequent payments, in the form of interest. If these payments are missed or neglected by the issuer, the investor will incur a loss. This is known as issuer, credit or default risk.
Bonds operate in an interest rate environment. When interest rates rise, the value of a bond decreases. An investor who holds bonds in an interest rate hiking cycle may be exposed to loss. This is known as interest rate risk
Equities offer ownership. Unlike with debt, this means you as the investor are not reliant on a third party for capital payments –although there is an aspect of this in the form of a dividend distribution. The difference here is that equity owners have rights to the capital, and in most cases, they also have voting rights which they can exercise in forcing a dividend payout. If the company in question goes bankrupt, ownership attributes certain rights to the holder which may also minimize loss, even though the normal shareholder does not have first rights to payment.
Equity holders have high price exposure as shares are openly traded. As equities are seen as being longer-term investment instruments, in the short-term they may experience price volatility and devaluation. Generally, an instruments exposure to higher volatility means investors need to spend more time in the market to receive greater returns. However, this is not a rule, as an investor can buy a share today and sell it tomorrow. Although, it is accepted as a long-term market, it ultimately depends on the investors action.•As mentioned above, a shareholder may exercise their vote to force a dividend distribution, but in cases where profits do not allow for a distribution, the shareholder will experience what is known as dividend risk.
Unlisted Securities Mitigation
Unlisted securities do not have to apply the same regulation standards as listed securities do. This means issuers can trade more cheaply and get to market quicker than going through an initial public offering (IPO).
Unregulatedmarkets/instruments are never a haven for safety. Participants in these environments are likely to experience market manipulation and all sorts.
There are types of risk that cannot be avoided. These types of risks are broadly categorized into two parts: systemic risk and black swan events.
This refers to risk that is not isolated to one particular company, trader, intermediary or institution. Systemic risk affects the underlying components of the integrated systems of the entire financial market or even the financial system itself. It is usually very hard to foresee as it can originate from almost anywhere in the system, and when it arrives, both its direct and indirect effects can be severe. This type of risk usually requires an overhaul or serious amendment of the system that perpetuated it. The most recent example of this was the 2008 financial recession, covered in more detailed elsewhere in the program, which was triggered by mortgage defaults in the United States.
A black swan event refers to a risk event that is infrequent (maybe once or twice in a lifetime), unpredictable (you cannot foresee it with sufficient time to act) and catastrophic in its impact. The tsunami of 2004 would fit this description in a natural context. In a financial context, any major and drastic turn down, such as the dot-com bubble of 2000, fits this description.
Often when we see failure in financial markets it’s usually quite clear (after the fact) what the cause was. Often times there is under-regulation to some degree, and the aftermath of the failure sees the enactment of new policy to ‘plug the gap’ which caused failure(s). Take the banking crisis of 2008 for example, investment banks, insurance companies and ratings agencies were colluding and trading in high risk investment products with insufficient collateral to cover their losses. The policy created to counter this was known as Dodd-Franks which – among many other things - stipulated capital reserve requirements for banks, to ensure they could cover their debt obligations. The Savings and Loan crisis of the 1980s and 1990s however, was not triggered by poor policy necessarily, but instead came about due to inflationary/stagflationary* pressures at the time. Policy makers then attempted to manage this inflation risk through regulatory changes which ultimately lead to the demise of the entire savings and loan market. Your task is to read the articles below and use your insight into market regulation to provide answers to the following questions: Identify key role players from the inception to the demise of the S&L market. (15% of total points) Identify and analyze shortfalls of the regulation which affected the S&L market. Your answer does not need to be contained to the crisis years. (15% of total points) In reference to article 2, make an argument for which level of regulation the article describes (see Lecture 2 M2) the Garn-St.Germain Depository Institutions Act was. (15% of total points) What did the Enron crisis and the Savings & Loan crisis have in common? (15% of total points) How were the ethics violations different in the Enron crisis and the S&L crisis? (15% of total points) Pick either Enron crisis OR S&L crisis (NOT BOTH) that you think the problem is more difficult to fix. Give a reason. (15% of total points) The structure and presentation of your submitted paper will be evaluated as well (see grading rubric). (10% of total points) *Stagflation is a process whereby an economy experiences stagnation in wages, employment and economic activity, while still experiencing high or growing inflationary pressure.
Más preguntas que respuestas siembran dudas sobre los motivos y el papel de los detenidos por el asesinato de Jovenel Moïse
The Role of Financial Regulation Background Context
In the USA, the early 1920’s was considered a golden age of prosperity. Even while the aftermath of World War I was still taking its toll on the European economies, the American industrialist movement was already in full swing. In the US economy, businesses were prospering, lucrative deals were being struck, and money was fluid.
The prevalence of these economic activities translated into serious economic growth. Between 1925 and 1929 the New York Stock Exchange grew from $27 billion to $87 billion. Had you placed your money in the stock market in 1925, you were likely to have seen a tripling of your initial investment in profits. Under these economic conditions, the US economy had grown to be the largest in the world, and the American people had become highly optimistic.
Then, over the course of a few days, devastation occurred. On October 24th, 1929 – now known as Black Thursday – the New York Stock Exchange saw the most significant stock market crash in US history. Instigated by a sudden panicked sell-off by stockholders, it continued for weeks and reached its lowest point in mid-November. By that time, substantial damage had already been done to the American economy.
Over 40% of the value of stocks had been erased from panic selling within the stock market, and this soon extended to money markets. Banks were among the most affected. Most saw massive withdrawals as people took their savings deposits home out of fear of losing them. As a result, an estimated 744 banks closed over the following 10 months alone.
The stock market crash is considered to have been the starting point of the USA’s 12-year-long Great Depression. During the latter period, more than 11,000 banks closed and 1-in-4 people who had been employed were left jobless, meaning that a vast number of working- and middle-class
citizen had to depend on soup rations to stay alive.
How could something like this have happened? How could the world’s economic super- power fall so far and so quickly? The answer is certainly not as straightforward as a stock market crash. Stock market crashes can be severe, but they do not bring down a nation’s banking systems. Ultimately, it was the faulty regulatory foundations of US financial systems that led to this catastrophe.
Banking practices during the Golden Era
The economic prosperity of the early 1920’s created a frenzy among investors for investment and credit. A lot of this was financed by margin, which meant that Americans were taking out loans to finance their investments in the stock market. This practice, however, was not as pervasive as the effects of the crash. Only 10% of the US population had invested in stocks at the time, but nearly 100% were affected. Why, then, was there such widespread devastation? The answer to this lies in how banks were operating during the investment frenzy of the golden era.
During this period, commercial banks were able to take clients’ savings-deposits and use the capital to invest in speculative opportunities. Even while managing loans on a large scale, there was no guarantee of security. Up to this point in US history, it was not common practice for the federal government to safeguard deposits, as they thought it would lead to a Socialist, dole-like relationship between the government and the people. This was the primary reason behind the high rate of ‘bank runs’ (i.e. the mass withdrawals of savings) and the subsequent bank failures.
Without security, individuals had no assurance that their savings were safe.
President Herbert Hoover, who served his term from 1929 until 1933, had taken a political stance that desired minimal federal government intervention. This meant that he did not want to nationalize key industries, nor offer state backing for banks. Instead, Hoover and his cabinet sought to implement agencies and support networks to promote collaboration between market participants. He thought this would create a healthier, longer-term answer to the financial downturn by enabling them to lift themselves out of the Depression.
After Hoover’s term ended in 1933, Franklin Delano Roosevelt was elected to office and began to address these issues differently. FDR and his cabinet created regulatory frameworks and oversight bodies that would prevent an economic downturn of this magnitude from ever happening again. They also added safeguards, detailed below, which restored investor confidence in the banking sector.
FDR’s assessment and application of financial policy over these years remains iconic as an example of well-actioned market regulation. Three of the most significant regulatory changes that were enacted during his term include:
1. The Banking Act of 1933 (the Glass-Steagall Act) which sought to separate the roles of commercial and investment banks. This act drew a legal distinction between these entities, so that the savings of the ordinary person could not be used for speculative investment purposes.
2. The Federal Deposit Insurance Corporation (FDIC) which was a regulatory body that guaranteed that the savings of individuals would be backed by the government in the event a bank failed.
3. The Securities Act of 1933, which gave rise to the regulatory body called the Securities and Exchange Commission (SEC). The SEC is an agent of the USA’s federal government responsible for monitoring and regulating market activities, as well as enforcing laws related to American securities markets.
Once these and similar regulations were put in place, the American economy recovered. This historic period offers great insight into the effects of regulation. Firstly, it shows a direct and powerful correlation between social well-being and financial well-being. This has important implications for financial regulation which is the framework for poor or prosperous financial standing.
Secondly, we see that both presidents enacted regulation in order to stem the devastation of the Great Depression. Both presidents worked hard to rectify the situation and cared for their people, but only one was effective in their outcome. The difference between them was the ability to assess the market and social environment and implement the right kind of regulation at that point in time. To elaborate on the traffic example in the earlier video, what Hoover did was try to let people get themselves out of their own jam. What FDR did was to build more roads and avenues so that they could.
This illustrates the role of regulation within financial markets in curbing the kinds of behavior that the very same markets produce, from the creation of financial instruments, to trading and the ethical or unethical treatment of investor funds in market activity.
We will now examine the various institutions that influence, apply and oversee regulation within international financial markets. At this point it is necessary to understand that one institution can implement a regulation but is not necessarily the entity that supervises the regulation’s enforcement. For example, the creation of the Securities and Exchange Commission (SEC) was established in the Securities Exchange Act of 1934, in response to the poor financial practices which contributed to the Great Depression. The US Congress (a leg of the US legislature) established the SEC as well as the Act, but the US Congress does not oversee the implementation of the SEC’s regulations.
Below, when we speak about role players, we refer to pure regulators, pure oversight entities, and those entities that perform a mix of both regulation and oversight.
Central banks, which were outlined in our very first lesson, refer to banking institutions that are primarily concerned with maintaining an economy’s monetary supply. Their primary roles are regulatory in nature, and their regulatory functions may be detailed as follows:
The first regulatory function central banks serve is to guarantee commercial bank deposits and to maintain fiscal stability in times of financial turmoil. This provides security to commercial bank deposits and in turn prevents people and businesses from withdrawing their funds and causing bank runs. By safeguarding these commercial deposits, central banks allow commercial credit lending (an essential economic function) to continue (as deposits are used to finance lending).
Controlling reserve requirements
The second, and arguably most important regulatory role played by central banks is to control reserve requirements. Reserves refer to the percentage of commercial bank deposits that the banks must maintain with the central bank at a given time, i.e. the percentage of their clients’ deposits that must be deposited with the central bank.
One of the ways in which central banks can control interest rates is by controlling the amount of capital that must be held in reserve. This is because a central bank can raise interest rates by increasing the reserve requirements for commercial banks. Increased reserves, in turn, mean that commercial banks will have less cash to lend out, in essence creating a shortage in the monetary supply that causes the interest rate to rise due to the effect decreased supply and increased demand has on price. This function is so integral to central banks’ operations that many central banks are known as ‘reserve banks’.
A third set of functions that central banks perform relate to oversight and regulation of commercial banks’ risk-related features, which are enforced through regular audits and asset/liability valuations. Central banks research and identify practices that constitute risk that would otherwise be unknown or unquantified. This form of regulatory oversight ensures that commercial banks operate within the safe limits that have been set out by the central bank to prevent excessive risk-taking. The continuous nature of central banks’ investigation and oversight enforced by this regulation helps promote transparency in the banking sector.
Monitoring of conflict of interest
Finally, central banks’ regulatory roles include activities which closely monitor conflicts of interest within the commercial banking sector. Of particular importance is the central banks’ ability to regulate or monitor loans issued by commercial banking institutions to businesses that may be considered ‘close’ to senior executives at the banks in question.
The fourth regulatory function is the prevention of discriminatory practices by commercial banks. Such regulations mandate that banks are not allowed to discriminate against creditors according to race, ethnicity, religious creed or other non-financial variables – a practice called ‘redlining’. This regulation is essential as there have been cases where commercial banks have charged higher interest rates to clients based on their ethnicity or race. For example, in the USA, banks were found to be charging Hispanics and African Americans higher interest rates on loans, requiring the Federal Reserve to step in and address the discrimination.
The International Monetary Fund (IMF)
The International Monetary Fund (IMF) is an institution created in 1945 under the Bretton-Woods Agreement (which also led to the establishment of the World Bank). Their primary functions relate to lending, technical assistance (education and upskilling), as well as surveillance.
Through lending, the IMF often seeks to influence the lender to introduce some form of financial or structural reform. As lenders, in this context, are countries and not individual people, the IMF exercises significant influence on global financial markets. Therefore, the IMF is not a regulatory authority in the traditional sense, but due to its international reach and size it is able to instigate regulation within the countries to which it lends funds.
For example, in mid-2015 Greece was on the brink of defaulting on its debt obligations. The IMF was willing to extend the Mediterranean nation a substantial loan to help the nation avoid defaulting. However, the IMF would only do so if Greece agreed to implement certain austerity measures. These measures resulted in a lot of social unrest, partly because they included tax hikes on individuals who were either unemployed or underpaid due to the ailing economy.
The Bank for International Settlements (BIS)
The Bank for International Settlements (BIS) was founded in 1930 as a vehicle for repatriation of assets after World War I. After its original function was complete, it became a forum for financial cooperation among its members, which are primarily central banks (their current membership is comprised of 60 central banks). Today, it is best described as a ‘central bank for central banks’, as its primary function is to support central banks in their ‘lender of last resorts’ function, which is achieved through:
Providing the member central banks with access to liquidity, by buying back tradeable instruments from them at competitive rates, Offering research and statistics, and facilitating workshops, discussions and think-tanks related to pertinent financial issues, Providing the member central banks with access to gold- and foreign-exchange transactions, and Acting as a holder of reserves for central banks.
The BIS has significant influence and input into global financial market regulation due to its role as a statistical researcher and disseminator and its membership in other committees and regulatory
bodies.
Financial Stability Board (FSB)
The Financial Stability Board (FSB) (previously named the Financial Stability Forum) is an international institution which brings together participants from regulatory bodies, central banks and finance ministries from around the world. It coordinates the formation and dissemination of regulatory policies and practices from various participants with the aim of creating standards for international regulation and policies that are aligned to the represented parties.
Because the parties involved have great influence over the financial sectors of their respective countries, the FSB has substantial influence in the agreements that result from their engagements.
This brings many influential members of financial markets to the same table and encourages them to debate and agree on policy and regulatory direction. The FSB also follows upon the agreed-upon actions, which in turn encourages the implementation of these agreements.
World Trade Organization (WTO)
The World Trade Organization is an intergovernmental institution that governs the rules of trade between its member nations. The WTO has 164 member-countries which have ratified trade rules in their respective parliaments. The WTO employs many secretariat members (lawyers, economists and analysts) who ensure that these trade regulations are being upheld by all members. Members of the WTO are subject to periodic evaluations to ensure their policies are in line with trade agreements.
The WTO also provides auxiliary functions such as: Trade negotiations, Dispute resolution, Trade capacity development, Outreach
As indicated by these examples, in addition to countless others which are not mentioned here, the markets are influenced by a multitude of regulatory participants which operate both directly and indirectly.
Up to this point, we have developed our understanding of what regulation is, who designs and implements it, and what effects it can have. Now we will examine the processes involved in creating regulations, from inception to implementation and oversight. A key point of this development is that the phases do not take place in isolated, linear parts; instead, they overlap with one another due to the dynamic nature of this process and the systems to which they apply.
Phase 1: Identification of the need for change
The first phase of any sort of regulation depends on the identification of specific and necessary changes that the regulation seeks to address. It does not simply start with the assumption that regulations are needed. Instead, it is a response to undesirable market conditions or activities. The creation, formulation, implementation and monitoring of regulation is costly in terms of money and time. Therefore, before parties attempt to create regulation there must be an identified need that the regulation seeks to address. This need must also be significant enough to warrant change.
During the identification phase, the regulatory party experiences the need in terms of significant discomfort under the status quo. This can take a multitude of forms on the different market levels, but from a high-level view, the discomfort usually comes from either:
Obstacles in the market that prevent a desired outcome. For example, excessive legal requirements for starting a business and outdated technology that holds back an industry (think about the introduction of cryptocurrencies to the markets).
Activities in the market that prevent a desired outcome. For example, discrimination of investors due to non-financial variables, such as race or ethnicity.
Once this need is large enough or presents a significant challenge, the identification phase draws to a close and gives way to the next phase, in which the person, organization, community or state which has brought the issue forward for change is known as the initiator.
Once the need is brought to light, the initiators are required to provide a proposed solution to their identified need. This is the embryonic stage of regulation during which both the problem and solution are shaped and take their first form.
Stakeholders must first address the need in detail, by: Clearly defining the need/problem, Identifying who the issue affects, and to what degree these parties are affected, Proposing legislation or policy that may address this issue, Drafting a proposal for the implementation of a regulatory oversight body, or the creation of one if none exists.
These proposals are formulated in conjunction with legal professionals and industry experts who collaboratively compile a draft which is submitted for debate. This phase is often undertaken alongside the following phase.
The reason the second and third phase often overlap is due to the information requirements presented by the second phase, in which instigators and their collaborators submit a coherent draft for deliberation. Although this phase of research compilation forms part of the proposal phase, it is distinct, going beyond simply compiling the original draft proposal.
The legislative body overseeing the conceptualization of the regulatory process (for example, a government ministry) will begin an independent research initiative aimed at: 1. Identifying the social, business, technological and financial impact of the problem versus the impacts of its proposed solution, and 2. Verifying the information contained in the draft proposal submitted.
During this phase, the proposal will be made accessible to the public for public comment and to industry-members for broad consultation. This may be done through media, workshops, censuses, and publication in governmental articles, such as gazettes.
Phase 4: Drafting and vetting of regulation
Once sufficient research has been collected and both society- and industry-members have provided input, the draft proposal will be assessed against the feedback provided. During this phase any oversights or incorrect data in the original proposal will be amended to reflect the more accurate data.
At this phase, the proposal should contain the following key elements, with the appropriate statistical data:
Clear problem definition – What is the real issue?
Stakeholder identification – Who is affected by the problem, who can help change legislation, and who should implement and oversee the regulation
Proposed solution – What should be done to solve the problem or address the need?
Value proposition – What are the benefits of this change?
Budgetary requirements – How much will implementation and oversight cost?
Once these key elements are present and substantiated by research, the proposal is sent to the appropriate legislative body for debate, amendment, rejection or acceptance. If the entity recommends that an amendment should be made, stakeholders will be required to engage the public, industry and legal experts again, as well as to provide an impact assessment of the proposed amendment(s).
If the regulation is rejected, the stakeholders can take the rejection on appeal and fight the rejection. This is usually done in the relevant court. Alternatively, the stakeholders can re- engage and seek a regulatory compromise, while their third option is simply to accept the rejection.
If the regulation is accepted and passed by the legislative arm of the government, it is then published, typically in a gazette so that all parties are informed of the change and the required timelines for implementation. At this point, the process moves into the implementation phase.
Phase 5: Implementation and oversight
This phase is only reached once a regulation has been accepted. Once a regulation is passed, and the appropriate stakeholders have been made aware of it, the overseeing body needs to implement the regulation in the relevant markets. In a case where there is no overseeing body – for instance, during the creation of the SEC – then this body will first need to be set up in accordance with the relevant legislation.
The overseeing body will establish and monitor the standards for the following activities: Reporting requirements – Which information must be reported? Frequency of reporting – When are parties required to report (e.g. monthly, quarterly, annually, etc.)? Format of reporting – Which type of reporting is required (for example, IFRS is used for financial reporting)? Punitive measures for non-compliance – Which punishment is enforced for which issue of non-compliance?
Following the implementation of regulation, the effects of the regulatory changes should then be monitored to assess and identify any changes of behavior within the market. Any abstract and unacceptable behavior that arises from the implementation of the regulation may give cause to amend or even repeal the regulation.
Some caveats to Types of Regulation and their Objectives
As mentioned at the start of this section, this process is described at a high-level and is generalized in order to give you an idea of regulatory formation and implementation. This is not a globally recognized framework and not all regulation will be formulated in this manner.
The above process makes certain assumptions. It assumes the existence of an open democracy in which the society and industry at large is encouraged to engage with its government in solution creation. Under certain dictatorships, for instance, this may not be the case.
This process will also vary in its details according to the myriad governmental frameworks around the world. The system followed by the Japanese government is different from that followed by the UK government, and that of the UK government differs from that of the US government, and so on. This will obviously have an impact on the speed, quality, and overall influence of the regulation in question.
Regulation versus Deregulation
Market regulation is a hotly debated issue within both political and financial forums. The stakes are always high and there are lobbyists on each side of the fence, promoting their own side’s agenda and detracting from their opponent’s. Politicians who have the ability to enact or repeal the regulation also have constituents to whom they answer, so political agendas often hold sway when much-needed regulation runs against campaign promises.
In this section, we examine the ‘pros and cons’ of regulation and deregulation. Rather than trying to convince you of a particular view, this section simply aims to equip you with facts that apply to both sides of the argument in order to make an informed decision in a given context.
Lower costs
Regulation is expensive – shortly after the 2008 financial crisis the IMF estimated that the various regulations put in place would affect an increase in lending rates as follows: 1. Europe – 17 basis points (bps) 2. Japan – 8 basis point (bps) 3. USA – 26 basis points (bps).
This meant consumers would pay between 0.08% and 0.26% more interest for credit due to the associated regulatory costs, which are passed on to the consumer.
Market participation
Fewer rules means fewer hurdles to jump to get to market with a product or service. This feature correlates with greater market participation. Greater market participation leads to increased competition and employment. Increased competition drives down prices. Lower prices lead to savings for consumers which means greater spending in other areas of the economy, or savings increases.
Increase response rate
Market participants have greater flexibility in their responsiveness to changes in the market environment. The speed at which a company can adjust to a significant opportunity or threat is substantially different when they do not have to spend crucial time and effort getting regulatory approval.
Rate of advancement
As previously mentioned in our section on market participation, deregulated environments are prone to faster rates of advancements in:
• Technological advancement, Industrial expansion, and Product and service creation.
To look at an example of the benefits of deregulation in non-financial sectors, see the following linked example of the effect of deregulation of the US Railroad industry in the 70s and 80s. We see from the example that productivity soared, and prices dropped significantly.
In summary, the benefit of deregulation is that it allows businesses to focus on doing what they do best without added distractions, constraints and costs of regulation – reducing the need for time, money and resources.
Regulation - An argument ‘for’ Inequality reduction
Inequality reduction An argument in favor of deregulation is often substantiated by the belief that it results in greater employment and income wages due to some of the factors mentioned previously. However, the research detailed in the graph below shows that periods of deregulation are characterized by higher rates of inequality.
The research the graph is based on examined the years in which regulation was imposed on US the financial/banking sector and the years in which regulation began to be repealed.
The aforementioned study focused on the US financial and banking sector over the last century to gauge the effect of regulation on the following areas: 1. Bank failures, 2. Share of income of the top 10% of the population (economic inequality), and 3. Failed deposits as a % of US GDP.
Who do you think benefits from deregulation? Interestingly, the graph shows that regulation in the financial sector has reduced inequality, reduced the rate of bank failures, and reduced deposits lost.
Regulation - An argument ‘for’ Less selfishness
Research also shows evidence that periods of deregulation in the financial sector tend to result in significantly higher average wages for individuals employed in the ‘deregulated’ sector – suggesting that there is less selfishness when distributing wages. However, this evidence may also illustrate why so many in the financial sector are vehemently against regulation if we view it as a demonstration of self-interest. If regulation means their commission, salary and bonuses are negatively impacted, it’s highly unlikely they will be advocates of regulation.
Regulation - An argument ‘for’ Justice and accountability
Below we see a graph compiled from research findings, conducted by Reuters, showing the rate of prosecution of financial crime in the United States after regulation was passed to enforce accountability.
Prosecutions
Prosecutions for financial crimes can clearly be seen increasing after the passing of the Financial Institutions Reform and Enforcement Act, showing that simply enacting legislation is insufficient as unethical parties will continue their activities until regulation is enforced. Prosecution of financial crimes, however, tended to decrease during the periods that followed the financial crisis of 2008. This was primarily due to the guilty parties (the big investment banks) settling out of court. Accountability is a key aspect in preventing history from repeating itself. Regulation seeks to hold those who are guilty to account for their crimes. Ultimately, you cannot have any kind of justice without regulation.
Regulation - An argument ‘for’ Consumer protection
When the goal is profit at any cost, the consumer can end up losing out badly. The reason behind most large financial scandals across the world can, in some way, be put down to greed that goes unchecked. Regulation seeks to put checks and balances in place so that participants in financial markets do not let their pursuit of profits overrule their responsibility to clients.
It is important to concede that the benefits of regulation are highly correlated with the quality of the regulation in question and how that regulation is applied within the context of the market at that point in time (think Hoover’s regulation vs FDR’s). The benefits we saw in the previous arguments did not come purely because of regulation for its own sake. In each case, regulation would have to have been creatively identified, and thoughtfully applied in order to have a powerful positive effect. The same rings true for any repeal of existing regulation
In Conclusion to the Role of Ethics in Financial Regulation
The context of each event is important to understand. Regulation or deregulation for its own sake does not lend itself to effective regulatory policy. One should always consider the market dynamics, the political and economic climate, and ultimately the human beings who are affected by the decision.
In the 1980s, the financial sector suffered through a period of distress that was focused on the nation’s savings and loan (S&L) industry. Inflation rates and interest rates both rose dramatically in the late 1970s and early 1980s. This produced two problems for S&Ls. First, the interest rates that they could pay on deposits were set by the federal government and were substantially below what could be earned elsewhere, leading savers to withdraw their funds. Second, S&Ls primarily made long-term fixed-rate mortgages. When interest rates rose, these mortgages lost a considerable amount of value, which essentially wiped out the S&L industry’s net worth. Policymakers responded by passing the Depository Institutions Deregulation and Monetary Control Act of 1980. But federal regulators lacked sufficient resources to deal with losses that S&Ls were suffering. So instead they took steps to deregulate the industry in the hope that it could grow out of its problems. The industry’s problems, though, grew even more severe. Ultimately, taxpayers were called upon to provide a bailout, and Congress was forced to act with significant reform legislation as the 1980s came to a close. S&Ls have their origins in the social goal of pursuing homeownership. The first S&L was established in Pennsylvania in 1831. These institutions were originally organized by groups of people who wished to buy their own homes but lacked sufficient savings to purchase them. In the early 1800s, banks did not lend money for residential mortgages. The members of the group would pool their savings and lend them back to a few of the members to finance their home purchases. As the loans were repaid, funds could then be lent to other members. S&Ls, sometimes called thrifts, are generally smaller than banks, both in number and in the assets under their control. But they were nevertheless important conduits for the US mortgage market. In 1980, there were almost 4,000 thrifts with total assets of $600 billion, of which about $480 billion were in mortgage loans (FDIC). That represented half of the approximately $960 billion in home mortgages outstanding at that time (Board of Governors 2013). The relatively greater concentration of S&L lending in mortgages, coupled with a reliance on deposits with short maturities for their funding, made savings institutions especially vulnerable to increases in interest rates. As inflation accelerated and interest rates began to rise rapidly in the late 1970s, many S&Ls began to suffer extensive losses. The rates they had to pay to attract deposits rose sharply, but the amount they earned on long-term fixed-rate mortgages didn’t change. Losses began to mount. As inflation and interest rates began to decline in the early 1980s, S&Ls began to recover somewhat, but the basic problem was that regulators did not have the resources to resolve institutions that had become insolvent. For instance, in 1983 it was estimated that it would cost roughly $25 billion to pay off the insured depositors of failed institutions. But the thrifts’ insurance fund, known as the FSLIC, had reserves of only $6 billion. As a result, the regulatory response was one of forbearance – many insolvent thrifts were allowed to remain open, and their financial problems only worsened over time. They came to be known as “zombies.” Moreover, capital standards were reduced both by legislation and by decisions taken by regulators. Federally chartered S&Ls were granted the authority to make new (and ultimately riskier) loans other than residential mortgages. A number of states also enacted similar or even more expansive rules for state-chartered thrifts. The limit on deposit insurance coverage was raised from $40,000 to $100,000, making it easier for even troubled or insolvent institutions to attract deposits to lend with. As a result of these regulatory and legislative changes, the S&L industry experienced rapid growth. From 1982 to 1985, thrift industry assets grew 56 percent, more than twice the 24 percent rate observed at banks. This growth was fueled by an influx of deposits as zombie thrifts began paying higher and higher rates to attract funds. These zombies were engaging in a “go for broke” strategy of investing in riskier and riskier projects, hoping they would pay off in higher returns. If these returns didn’t materialize, then it was taxpayers who would ultimately foot the bill, since the zombies were already insolvent and the FSLIC’s resources were insufficient to cover losses. Texas was the epicenter of the thrift industry meltdown. In 1988, the peak year for FSLIC-insured institutions’ failures, more than 40 percent of thrift failures (including assisted transactions) nationwide had occurred in Texas, although they soon spread to other parts of the nation. Emblematic of the excesses that took place, in 1987 the FSLIC decided it was cheaper to actually burn some unfinished condos that a bankrupt Texas S&L had financed rather than try to sell them. By the late 1980s, Congress decided to address the thrift industry’s problems. In 1989 it passed the Financial Institutions Reform, Recovery and Enforcement Act of 1989Offsite link that instituted a number of reforms of the industry. The main S&L regulator (the Federal Home Loan Bank Board) was abolished, as was the bankrupt FSLIC. In their place, Congress created the Office of Thrift Supervision and placed thrifts’ insurance under the FDIC. In addition, the Resolution Trust Corporation (RTC) was established and funded to resolve the remaining troubled S&Ls. The RTC closed 747 S&Ls with assets of over $407 billion. The thrift crisis came to its end when the RTC was eventually closed on December 31, 1995. The ultimate cost to taxpayers was estimated to be as high as $124 billion. Unfortunately, the commercial banking industry also suffered its own set of problems over this period, both in Texas and elsewhere. This banking crisis also resulted in major reform legislation that paved the way for a period of stability and profitability…until 2008.
Definition
Similar to financial markets, money markets do not have a universally agreed-upon definition and can be defined in a few different ways. It is therefore a good exercise to consider a few different definitions, paying attention to the themes that are common amongst them, and those that differentiate them.
Here are three definitions that can be found from a simple internet search:
1. “...the money market is where companies, governments and banks raise money by getting short-term loans from investors.” 2. “The money market is where financial instruments with high liquidity and very short maturities are traded. It is used by participants as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year.” 3. “...the money market became a component of the financial markets for assets involved in short- term borrowing, lending, buying and selling with original maturities of one year or less.”
The commonalities between these definitions are not hard to see — short-term lending and borrowing is indeed the central theme of money markets. The first definition emphasizes the types of borrowers and lenders that typically participate in the money markets — which we will pay particular attention to in a later section.
Another noteworthy aspect of these definitions is the idea of buying and selling instruments or assets. It is important to note that money market borrowing, or lending can take place in the form of a financial instrument, which is a contract or agreement of a financial nature. Entering into such a contract gives rise to a certain asset, the asset being the right to trade under the conditions specified in the contract (which are usually cash flows to be determined in some way). Of course, a financial instrument can also give rise to a liability (an asset of negative value) from the perspective of one of the parties to the contract, if it specifies that the party must make payments instead of receiving them.
Buying and Selling Money Market Instruments
Depositing money in the bank is a simple financial agreement that stipulates that the money will be returned upon the client’s request to withdraw it and is therefore based on a financial instrument. This creates both an asset for the depositor, and a liability for the bank. As such, depositing money into a bank account can be viewed as both lending and purchasing a simple financial instrument (or the corresponding asset). Of course, borrowing and lending can take place for terms longer than a year, which cause the underlying loans or instruments to be classified as instruments that belong to the bond (or fixed- income) markets. Comparing the long-term loans in the bond markets to the short-term loans in money markets reveals the rationale behind the term ‘money markets’ — as the term of the loan becomes shorter, the asset held by the lender increasingly resembles money or cash (that is, highly liquid capital that can spent immediately by its holder). In the very short-term, such as the overnight lending that takes place with bank deposits, the asset is virtually indistinguishable from cash, as the lender can simply withdraw their money if they wish to spend it.
A similar but slightly more formal money-market instrument is a certificate of deposit, where a deposit of money is formally documented in a contract which is issued to the depositor as a certificate. This certificate explicitly states the deposit agreement (the way in which the borrower will return the borrowed amount to the depositor). To buy a certificate of deposit is to give, (or in effect, lend) one’s money to a counter-party; the counter-party, who are borrowing the money, are said to have sold a particular financial instrument, namely the certificate of deposit. This certificate of deposit is not strictly tied to the money market, as the instruments conditions may also specify that it can be sold on the secondary market; that is, the lender who has bought the certificate might be allowed to sell it to a third party, who would then obtain the right to receive the repayment from the borrower.
It is not surprising that money markets exist — many parties in the economy have money but do not have to spend it in the short term, and many parties do not have money available but nevertheless require it. As described in Module 1, necessity is the crucial prerequisite to financial
markets, regardless of the type of market. Money markets serve the natural, economic requirement of connecting short-term lenders and borrowers, to their mutual benefit.
Deposits refer to an amount of money deposited into a bank (in fact, the most basic definition of a bank is an entity that accepts deposits). Typically, deposits can be withdrawn (or called) at any time the depositing party wishes — to emphasize this, they can be known as ‘call deposits’.
In certain cases, deposits cannot be withdrawn immediately, but must remain with the bank for a specified period. These deposits are called term or time deposits. Connecting to the concept of liquidity presented in Module 1, call deposits are highly liquid: it is very quick and easy to convert the deposit into usable cash by simply withdrawing the deposit. Term deposits are relatively less liquid, because they cannot be easily and immediately converted to cash (although a bank may allow a term deposit to be withdrawn if a penalty amount is paid). Nonetheless, term deposits are more liquid than many other instruments traded in other financial markets (such as a ten-year loan).
A certificate of deposit is a formalized type of term deposit, where the depositor is issued with a certificate indicating the deposit they have made, the deposit’s term and the amount that will be repaid to the depositor upon maturity. One can thus think of depositing money in this way as the purchasing of a certificate of deposit. Often, certificates of deposit can be traded in secondary markets (i.e., can be traded secondarily), in which case they are sometimes called negotiable certificates of deposit.
Negotiable certificates of deposit mean that, in addition to purchasing them from a deposit- accepting bank in the way we have described (a primary purchase), one can also purchase negotiable certificates of deposit from another party who originally purchased them. Equally, a party can also sell their negotiable certificate of deposit. These types of trades involving
secondary parties which occur after the original sale, or issue of the certificate, are known as secondary trades. This also means that if a certificate of deposit can be traded secondarily, its liquidity is enhanced: instead of waiting until maturity (when the deposit is returned), the holding
party has the option of selling the certificate for immediate cash.
Treasury bills, which are often termed T-bills, are short-term debt instruments that have been issued by a national government. Sometimes the government in question is unspecified, in which case it is assumed to be that of the United States, given the size of their government treasury and economy. As described in the previous video, treasury bills require the payment of the instrument’s par value at its maturity date, the price of which is determined prior to its maturity by market forces in the money market. Thus, this feature also determines the interest associated with the underlying loan. Municipal notes are another type of instrument which is extremely similar to treasury bills; the only significant difference is that the former is issued by a local government instead of one that is national.
Commercial paper refers to instruments that are also very similar in nature to treasury bills. The primary distinction between the two is that commercial papers are issued by commercial entities as opposed to national governments which issue T-bills. In this context the features of the
transaction remain the same, as the commercial entity sells the instrument, which in turn obligates them to pay a specified par value at a specified maturity.
Commercial entities (and governments) can of course issue longer-term debt instruments; that is, issue these types of debt instruments but with a maturity that is in more than a year’s time (in other words, they can seek longer term loans). In such cases, the instruments with a long maturity are usually termed bonds, which will be studied in greater detail in our next module. Conversely, short-term debt instruments are commonly termed notes or bills.
Despite their commonalities, there is an important difference between commercial paper issued by private entities, and government-issued treasury bills: governments have a much more robust ability to meet their obligation to pay the promised par value. This is because a commercial entity can go bankrupt at any time and have no money to repay it upon maturity; or it may be dissolved before an issued note has reached maturation. Although it is possible that a government ceases to exist in the short term, it is (usually) highly unlikely; and although governments can encounter financial distress, they always have the option of printing additional money in order to meet their obligations. Municipalities, which issue municipal notes, are typically stable and financially reliable institutions, but not to the extent that national governments are.
As you may recall from the previous module, this type of risk is known as default risk (or credit risk) and will be discussed in more detail in the next section, as it is a critical concept in finance. For now, we will pay attention to the fact that the prices of the instruments will reflect this default risk by virtue of supply and demand. For instance, an investor would typically prefer treasury bills to commercial paper of equal par value and maturity because the former has a larger probability of the par value being paid, and so treasury bills will command a higher price. At this stage, you may
be able to recognize the implication: the treasury bill will have a lower interest rate than the corresponding commercial paper. This idea will be outlined and discussed later.
A banker’s acceptance is a short-term debt instrument traded in the money market and is a variation of commercial paper. With a banker’s acceptance, a commercial entity still issues a note (i.e. they borrow an amount of money) that entitles the holder to a future payment of its par value. However, in the case of a banker’s acceptance, even if the issuing entity fails to make its promised payment the guaranteeing bank agrees to make the payment on the issuer’s behalf. This guarantee significantly mitigates the default risk of this type of instrument. A party may wish to lend money by purchasing a commercially issued note but may be unsure of the borrower’s ability to pay the par value upon maturity. Therefore, the guarantee provided by the bank can enable the loan to be made, as it is typically a larger and more stable entity than the issuer.
Federal funds refer to overnight loans made between two banks, whereby the lending party uses the reserves that they, as a bank, are required to keep at their governing central bank. This often refers to the United States, whose central bank, as you may recall, is named the Federal Reserve. The amount of money that a bank is required to keep at the central bank changes over time and is dependent on the relevant financial regulations and their financial positions (and is thus indirectly affected by factors, such as the political climate, discussed in Module 2). If a bank has a higher reserve amount than the stipulated requirement, they could withdraw it from the central bank or keep it in reserve and lend it to another bank that needs to increase its reserves. In such cases, the money would stay with the central bank under the name of the borrowing bank. The interest rate that banks negotiate for these loans is known as the federal funds rate, which is viewed as an important indicator of the economy’s well being. The federal funds rate gives an indication of the general level of interest rates and also suggests how banks perceive the likelihood of other banks defaulting on their loans.
Finally, repurchase agreements — or repos— can be viewed as a money market instruments (although they are not always classified as such). Repurchase agreements involve transactions whereby one party sells an asset that they own to their counter-party, with the agreement to buy it back (i.e. to repurchase it) at a pre-agreed time and price which is usually higher than the initial purchase price. This agreement resembles a loan: the selling party gets immediate access to the money and must repay it to the lending party with interest. Repayment in this context occurs when the borrowing party repurchases their asset, with the interest is the result of the increased repurchase-price. When viewing the arrangement as a loan, the asset that is being repurchased can be thought of as collateral underlying the loan. In effect the lender is allowed to hold onto this asset until the loan is repaid, which mitigates the default risk typically associated with loans, as the borrower forfeits the collateral in the event of default. It important to note that there can be additional complexities around repurchase agreements — such as how income or costs associated with the underlying asset are handled in the agreement; however, such considerations are beyond the scope of our current discussion.
Summary of Money Markets Instruments and Role Players
1. Money market instruments involve a loan between two entities, albeit an implicit loan. 2. The nature of the entities affects the nature of the loan; lending money to the United States government is a very different prospect to lending money to an unknown individual. 3. Money-market instruments are relatively liquid. Even those with longer terms are limited to a year, and secondary tradability enhances this liquidity. 4. Money-market loans are typically unsecured: they usually do not involve collateral, with repurchase agreements being the exception rather than the rule. This means that the lender usually faces default risk (i.e. they stand to lose in the event that the borrower defaults). However, this default risk is relatively minor — we will shortly see how the relatively short- term nature of money-market loans ensures this.
Functions and Risks of Money Markets from a Lender's Perspective
From the lender’s perspective the priority is to make profit and manage credit risk. The function of the money market is dependent on the perspective we look at it from. From the lender’s perspective, the function that the money market serves is to offer the opportunity for a profitable investment to be made. Accordingly, lenders will seek the highest interest rate possible. This function allows lenders to profit, which they would not be able to do if they kept their money in, say, their safe. Also, as we’ve mentioned previously, this investment is highly liquid. Therefore, if the lender suddenly requires the funds that they have invested in the money markets, it is relatively easy and fast for them to convert their investment into cash (i.e. to liquidate their investment). Another function of money markets we discussed in Module 1 was that of risk management — although this can amount to many different things in different contexts, here we should primarily note that lending in the money market can contribute to an intelligent risk management strategy, because of the reasons discussed in our video lecture; that is the low degree of inherent credit risk related to money-market instruments.
Functions and Risks of Money Markets from a Borrower's Perspective
From the borrower’s perspective the priority is to access funds. Conversely, from the borrower’s perspective, the availability of funds from the money market serve a variety of functions, which depends on the context and the particular borrower. For example, a company might see an opportunity to initiate a new business venture or to purchase a commodity whose price has dropped; in such a case money markets enable the company to finance their commerce and trade without incurring long-term debt. A company under financial strain might not have the funds to pay their employees’ salaries, in which case the money markets can give them access to the necessary funds. Governments can also face similar, and sometimes unrelated situations that may necessitate them to access short-term funding.
Functions and Risks of Money Markets from a Market 's Perspective
From the market perspective the priority is to stabilize the banking system, finance sector and economy. The money markets also serve some more general functions beyond just serving the role-players. This is because the money market increases the amount of liquid capital within an economy, and in turn increases the stability of the banking system to the benefit of the whole finance sector and economy. This is because banks can borrow via the money markets and use these funds to avoid otherwise problematic liquidity problems. The money market is also important for central banks, who often use the web of connections from money-market transactions to apply regulations and enact their policies, such as maintaining interest rates at a certain level.
In our previous video, we discussed how certain qualities of money-market instruments ensure that they have a high probability of fulfilling their intended functions for both the lender and borrower and are thus relatively low in risk for both parties. Since the maturities of money market
loans are over the short term, there is only a small probability that an entity will become unable to meet their promised loan obligations; a problem that may arise when longer-term instruments mature.
While it is possible for an entity’s financial standing to deteriorate suddenly, it is typically a gradual and discernible process. As you may recall from previous modules, financial markets tend to be efficient; as any information about an entity’s standing becomes available, it is incorporated
into market prices for everyone to see. It is important to note that it is also extremely unlikely for an entity to choose to not meet their obligations because they have in fact every incentive to meet their obligations if at all possible. Wherever this is not the case, the market will be reluctant to purchase the entity’s instruments in the future, causing the cost of borrowing for the entity to increase drastically, and in extreme cases make borrowing impossible.
While the default risk in money-market instruments is relatively low, as we have already seen supply and demand and market efficiency will causes prices to reflect any default risk that market participants perceive.
For instance, consider a treasury bill that promises to pay the holder 100 units of currency in 3 months’ time. The money market will determine the current price of this bill, and if, for example, its market value seems lower than it should be, investors will rush to enter what they view as a good investment opportunity, and demand will drive the price up. Now let’s suppose the market settles on a price of 98 for the treasury bill, and therefore you purchase a bill for 98, and after 3 months, the government will repay your 98 units of currency, plus 2 units as interest. This should be seen
as compensation for the fact that you (as the investor) had to forgo the use of your money for the 3-month period.
Now, after you’ve been reimbursed, you consider investing in commercial paper issued by a small company, in particular, one that is not directly comparable to the treasury bill. The commercial paper promises a repayment of 100 units of currency in 3 months’ time. As before, the market forces will determine the current price of the instrument, and because there is some probability that the company will run into financial distress in the next while, the price will be less than 98.
This is because the note is a less desirable investment than the treasury bill, and therefore its market-going price settles at a lower price of 97. Now you decide to purchase the note for 97 and then, assuming the entity does not default, you will receive your 97 units of currency back in 3 months, along with 3 additional units. These 3 units again should be seen as the usual interest- rate compensation, in addition to compensation for bearing the minor degree of default risk. Therefore, in this second case, you are also compensated for the possibility that the issuing entity does in fact default and will not meet their obligation to repay you the obligatory 100 units.
In conclusion, money-market instruments provide relatively low risk investments, although there can be some degree of default risk dependent on the issuing entity’s financial standing. Nonetheless the short-term maturity of money-market instruments make the potential default risk less significant than it could be. Liquidity risk may also be associated with certain instruments traded in money markets, whereby it may be difficult or impossible to convert the instrument to cash immediately. This can be minimized in some cases, but not completely eliminated in all, as one can avoid instruments that are not allowed to be traded secondarily, but not instruments that are tradeable but do not have any interested buyers. However, this is a minor factor relative to instruments from other markets, which have a greater degree of liquidity risk associated with them.
Despite the apparent lack of or, more factually, the minor degree of risk associated with money- market instruments, it is of critical importance to always compare money-market instruments with alternatives from other markets. In other words, one must assess the relative performance
risk that can be present, particularly in the context of long-term horizons, because other instruments might be preferable. Despite these alternatives typically being regarded as carrying more risk, they may nevertheless be more suitable to particular contexts.
It is important to recall the idea of risk premiums here, which we discussed in Module 1; riskier investments tend to perform better on average in terms of compensation for investors, who bear the risk of the larger variation of potential outcomes.
Sometimes, this risky variation is not problematic for particular investment contexts; for example, the daily fluctuations of stock prices is not problematic when investing over a thirty-year horizon. In such long-term cases, earning the corresponding risk premium can be attractive as it amounts to more profit, and therefore forgoing it by investing exclusively in money-market instruments might be a sub-optimal strategy. In other words, relative performance risk might be present. We will begin developing a formal framework that will allow us to express the interest rate earned from investing in a particular investment (or, equivalently, the interest rate paid by the issuing entity).
Prices, Interest Rates and Discount Factors in Money Markets
To start, let’s consider a loan, which can be in the form of a deposit, a bill or any other money-market instrument. For this loan, an initial amount represented by 𝑋𝑋0 is lent for a period 𝑇𝑇. For instance, 𝑋𝑋0 could be the purchase price of a bill.
Here, 𝑇𝑇 represents the length of the loan in years (e.g., the amount of time between the purchase of a bill and its maturity). If a loan is 3 months long, we would have 𝑇𝑇 = 0.25, as it is a quarter of a year.
Suppose that the promised repayment at time T is denoted 𝑋𝑋𝑇𝑇. This specification is at the core of the loan agreement, indicating how much is lent, for how long, and the amount repaid at the end.
One could view this payment 𝑋𝑋𝑇𝑇 as the repayment of the initial loan 𝑋𝑋0 as well as an interest payment of 𝑋𝑋𝑇𝑇−𝑋𝑋0.
It is important to note that some loans have more complicated repayment structures (involving more than one repayment at the end), but these are not important in the money market and are
not considered in this module.
Effective Interest Rate in Money Markets
The simplest interest rate one can define, called an effective interest rate over the period T, is just the rate of increase. The effective interest rate is the increase from the initial loan amount, 𝑋𝑋0, to the final amount, 𝑋𝑋𝑇𝑇, relative to 𝑋𝑋0.
𝑟𝑟𝑒𝑒 = 𝑋𝑋𝑇𝑇−𝑋𝑋0
𝑋𝑋0
Dividing by the initial loan amount removes the scale of the investment, so that the growth 𝑋𝑋𝑇𝑇−𝑋𝑋0 is not considered itself but is considered relative to the size of the loan. However, it does not correct for the length of the loan.
Annual Effective Interest Rate in Money Markets
We can calculate another type of interest, called the annual interest rate or the annual effective interest rate, that does make this second correction. The annual effective rate is simply a way to describe how an investment has increased, however it is a more intelligent way than the effective interest rate, because it corrects for both the investment or loan’s size, and its duration. This type of interest is calculated according to the formula in below Equation.
𝑟𝑟= �𝑋𝑋𝑇𝑇
𝑋𝑋0�
1
𝑇𝑇
−1
There is important logic behind the definition of this term. The annual interest rate applies over the period of one year, as the name suggests. This means that T=1 (and therefore that 𝑋𝑋𝑇𝑇 = 𝑋𝑋1), denoting the annual increase you will get on one’s money.
𝑋𝑋1 = 𝑋𝑋0(1 + 𝑟𝑟)
If T=2 (i.e. if the period of investment was two years), the annual interest rate would need to be applied twice. This is to reflect that in the first year, 𝑋𝑋0 (the initial investment) grows as per the above equation, but then this amount (including the increase from the first year’s interest) increases similarly in the second year.
𝑋𝑋2 = 𝑋𝑋0(1 + 𝑟𝑟)(1 + 𝑟𝑟) = 𝑋𝑋0(1 + 𝑟𝑟)2
Accordingly, we then get the following expression for a general time period T, meaning that we can assign any value to T to reflect any period we want to consider.
𝑋𝑋𝑇𝑇 = 𝑋𝑋0(1 + 𝑟𝑟)𝑇𝑇
We can then rearrange the formula in Equation (5) to get the formula in Equation (2). Note that equation 2 coincides with equation 1 when T=1; in this special case, the effective interest rate already applied to an annual duration and does not need any further adjustment to apply to one year.
Calculating the annual effective interest rate enables us to compare different money market investments. To demonstrate this, let’s imagine you want to purchase one of two bills: 1. Bill 1 costs 2450 and will reach maturity in 3 months with a par value of 2500, 2. Bill 2 costs 1922 and will reach maturity in 6 months with a par value of 2000.
Upon hearing these prices, you calculate the interest payment using 𝑋𝑋𝑇𝑇−𝑋𝑋0 and see that these bills involve interest payments of 50 and 78, respectively. However, you cannot immediately say how the effective interest rate fares relative to the different periods. This can be done by
calculating the annual effective interest rate using the formula in Equation (2):
For bill 1: 𝑟𝑟= �2500
2450�
1
0.25 −1 = 0.08416578473
For bill 2: 𝑟𝑟= �2000
1922�
1
0.5 −1 = 0.08281241032
Here we see that the annual interest rates offered by the two bills are 8,417% and 8,281%, respectively.
If we assume that default is not a material factor for this exercise, we see that the first bill offers a slightly better annual return on investment even though the gross amount of profit is less. The decreased gross amount of profit is more than compensated for by the short period of time that one’s money is lent for (which would enable you to re-lend your money after 3 months and continue to earn interest in a further loan).
This points to the inverse relationship between initial prices and interest rates, which is important to note. To demonstrate this, let’s consider a fixed repayment value, wherein a bill always pays 100 units in T-years’ time, so we can set 𝑋𝑋𝑇𝑇=100. If we were to apply the formula in Equation (2), we would see that a larger value for 𝑋𝑋0 results in a smaller annual interest rate while a smaller 𝑋𝑋0 results in a larger rate.
To ensure that you are comfortable with calculating the annual effective interest rate, it is a good idea to consider multiple examples of the two bills and experiment with different initial prices for the bills.
Discount Factor in Money Markets
Another way to describe this situation is to say that the future amount 𝑋𝑋𝑇𝑇 is discounted according to the interest rate. The quantity can be called a discount factor, and it is the amount that the future amount needs to be multiplied by in order to get the initial value. The discount factor can be calculated using Equation (6):
(1 + 𝑟𝑟)−𝑇𝑇
Like before, a larger interest rate results in a smaller discount factor, which indicates a greater decrease from the future value. Therefore, we again see the inverse relationship whereby a large interest rate results in a small initial price, and vice versa. Although we will largely ignore default for the remainder of these notes, recall how default risk — if perceived by the market — will reduce the price of a note or bill (via the usual forces of supply and demand); note that this price reduction corresponds to an increase in the interest rate. Remember that interest rates are just a language for expressing how a loan investment increases — the possibility of default is compensated for by a lower price, or, to say this same thing in different language, a higher interest rate. The increase in the interest rate when going from a default-free to a default-risky loan is known as a spread, which we study more specifically in Module 4.
The formula for calculating annual effective rate presented in Equation (2) is just one way — one language — to describe the increase in the loan investment (or, equivalently, the interest charged on the loan). There are other so-called interest-rate (or discounting) convention.
Annual Effective Interest Rate with periodic compounding
An important convention is the 𝑛𝑛-compounded annual interest rate, expressed as:
𝑟𝑟(𝑛𝑛) = 𝑛𝑛�𝑋𝑋𝑇𝑇
𝑋𝑋0�1𝑛𝑛𝑇𝑇− 𝑛𝑛
In Equation (3), we considered interest being applied each year, for some total number of years. Interest can instead be applied — or compounded — more often. If it were compounded twice a year, Equation (3) would need to be adjusted to:
𝑋𝑋1 = 𝑋𝑋0(1 + 𝑟𝑟(2)
2 )(1 + 𝑟𝑟(2)
2 ) = 𝑋𝑋0(1 + 𝑟𝑟(2)
2 )2
(8)
You may notice that the interest rate is divided by 2 in this equation (i.e. 𝑟𝑟(2)
2 ) — this new rate is still annual, it is just compounded more often. Instead of applying 𝑟𝑟 once, we cut it in half and apply it twice. The number 𝑛𝑛 is known as a compounding frequency and is sometimes given in qualitative terms.
For example, you may hear something like “12% p.a. compounded monthly”, where “p.a.” means per annum – confirming we are discussing annual rates; and “compounded monthly” indicates that we can apply Equation (7) if we set 𝑛𝑛= 12.
Note that an increased compounding frequency, all other things equal, will increase the final amount of the loan (for example, 12% p.a. compounded monthly end up charging more interest in total than 12% p.a. compounded semi-annually). This is because increased compounding involves interest being awarded to earlier interest payments. Also note that if n=1, Equation (7) is identical to Equation (2) — in other words, compounding once per year is exactly the same as giving a standard annual interest rate.
Discount Rates in Money Markets
Another way to express interest rates are with so-called discount rates. Instead of using a rate to increase 𝑋𝑋0 to make it equal 𝑋𝑋𝑇𝑇 (as in Equation 5) we can decrease 𝑋𝑋𝑇𝑇 to make it equal 𝑋𝑋0 using the following equation:
𝑋𝑋0 = 𝑋𝑋𝑇𝑇(1 −𝑑𝑑)𝑇𝑇
(9)
where 𝑑𝑑 is known as the annual discount rate. When we add the idea of a compound period to the equation, we get the following formula for the 𝑛𝑛-compounded annual discount rate:
𝑑𝑑(𝑛𝑛) = 𝑛𝑛−𝑛𝑛(𝑋𝑋0
𝑋𝑋𝑇𝑇) 1
𝑛𝑛𝑇𝑇
(10)
Would you be able to describe the logic behind this formula in full, in other words, can you write new versions of Equation (5) and Equation (8) using Equation (9)?
The term annual discount rate (without the specification of a compounding frequency) refers to Equation (9) in which 𝑛𝑛= 1. Therefore, if the compounding is not mentioned, it is assumed to coincide with the annual period of the return.
Discount rates, which shouldn’t be confused with discount factors, are quantitatively similar to interest rates. Suppose a deposit of 90 grows to 100 after one year, then the (annual) interest rate is 11,111%, while the (annual) discount rate is 10%. Both numbers are of similar magnitudes, and both describe the quantitative relationship between the principal value and return.
Simple Annual Interest Rate in Money Markets
Yet another way to express loan returns is with a simple annual interest rate or annual percentage rate (APR), which is calculated using the following equation:
𝑟𝑟(𝑠𝑠) = 1
𝑇𝑇�𝑋𝑋𝑇𝑇𝑋𝑋0 −1�
(11)
These rates are called simple, is because we do not use the mathematical idea of compounding interest. Equation (11) is determined according to a straightforward mathematical expression
relating 𝑋𝑋𝑇𝑇 and 𝑋𝑋0:
𝑋𝑋𝑇𝑇 = 𝑋𝑋0(1 + 𝑟𝑟(𝑠𝑠)𝑇𝑇)
(12)
This is simpler than the exponential functions involved in Equations (5) and (9).
Simple Annual Discount Rates in Money Markets
Finally, we can combine simple interest rates and discount rates to define the simple annual discount rate as:
𝑑𝑑(𝑠𝑠) = 1
𝑇𝑇(1 −𝑋𝑋0
𝑋𝑋𝑇𝑇)
(13)
Certificates of deposit are often traded in terms of simple annual discount rates. This means that instead of giving the current price of the certification (𝑋𝑋0), the bank, broker, or dealer will specify the simple discount rate, which allows you to calculate the price (using the part value of the certification and a re-arrangement of Equation (13)).
Investors often find this more informative, because — returning to an important concept — it adjusts for the size and length of the loan, and thus makes the investment more easily comparable to alternatives.
Summary of Instrument Valuation in Money Markets
All of these different types of rates may seem like an overwhelming list of formulae. Instead of attempting to memorize them, one should try to absorb the rationale behind each formula, and the different approaches taken because of their respective rationale.
In fact, there are really two main approach choices: interest-rate versus discount rate, and compound-rate vs simple-rate. If you understand these two choices, and the differences that either choice gives rise to, the formulae become much more manageable.
It is essential to consider and understand how these different types of interest rates can be used. None of what we have discussed can be used to deduce a suitable price for a money-market instrument — we are not valuing instruments in this sense (sometimes called a fundamental valuation).
Instead, what these interest rate conventions allow you to do is take an interest rate and, when we know how to apply it accurately, calculate a suitable price — the price comes from the interest rate, not out of thin air.
This can still be very useful for a host of reasons. The main reason is that — given the efficiency of the market – one can usually find the market-going interest rate. The money market prices all similar instruments so that they have the same interest rates. If interest rates are at 5% (due to some interest-rate convention), you can determine the market-related price of any given bill or note with one of the above formulae. If you are considering depositing your money, you can compare the available interest rate with the market one to determine whether you are getting good deal.
There are two important caveats — both explored in the next module — to this principle of a market-going interest rate. First, interest rates do tend to vary with the term of the underlying loan, so the interest rate used for a 3-month loan is not necessarily suitable to apply to a one-year loan (this idea is known as the term structure of interest rates). For example, the interest rate on a call deposit is different to that on a term deposit. Second, we have discussed how the possible default of a borrower is reflected by a higher interest rate, and so it is not necessarily appropriate to apply the same interest rate to instruments issued by different entities. The market interest rate is often understood to refer to instruments without material default risk (such as treasury bills), which we will expand upon in later modules.
Examples of Instrument Valuation in Money Markets
Example 1
A Bank has advertised that they will lend you $200,000 for up to 2 years at a simple annual interest rate or APR of 10% with interest compounded monthly. If you borrow $200,000 for 2 years, how much you have to pay total in 2 years?
FV = 200,000 (1+.10/12)^2*12 = $244,078.19
Example 2
A Bank has advertised one of its loan offerings as follows: “We will lend you $200,000 for up to 3 years at simple annual interest rate orAPR of 8.5% with interest compounded monthly.” If you borrow $200,000 for 1 year, how much interest expense will you have accumulated over the first year and what is the bank’s APY? (You make no payments during the year and the interest accumulates over the year).
Annual Percentage Rate = 8.5%
Compounding Period (m) = 12
Periodic interest rate = APR/m =8.5%/12 = 0.70833% = .0070833 APY or EAR = (1 + 0.0070833)12 - 1 = 1.0883909 - 1 = 8.83909%
Total interest expense after 1 year = .0883909 x $200,000 = $17,678.18
Example 3
Philip needs to borrow $70,000 to start a business expansion project. His bank agrees to lend him the money over a 5-year term at an APR of 9.25% and will accept quarterly payments with no change in the quoted APR. Calculate the periodic payment and the total amount paid.
n=20
i/y = 9.25%/4;
PV = 70000;
PMT=4,411.15
Total interest paid under quarterly compounding =
20 *$4,411.15 -$70,000 = $88,223 - $70,000 = $18,223
Bond Markets: The relationship between assets, equity and debt
We begin here by elaborating on the accounting equation: assets equal equity plus debt. One view of this equation is that all of the entity’s assets, or the entity itself (since it may be viewed as consisting of these assets) need to be purchased in one of two ways. Purchases can be conducted with either money contributed by the owners, or money that the owners have borrowed.
The owners’ contributions — the equity — does not just consist of the initial investment of capital the owners began with, but also includes profits that have been reinvested in the entity. This reinvestment of capital includes any money the entity produces or that belongs to the owners (if the obligations associated with the borrowings are accounted for) since it represents additional equity that they are effectively contributing.
Another view is that the equity of the business — the part that belongs to the owners — is simply the assets of the business minus any liabilities. These assets include, amongst other things, all the accumulated profits in the business’s bank account. Typically, the most significant liability is the
long-term debt of the business. According to this view, we have taken the debt to the other side of the equation: we have assets minus debt equals equity. Since the entity’s assets are ultimately funded by a combination of debt and equity, the debt holders and the equity holders are often
described as the primary stakeholders of the entity.
The debt holders are the lenders to the business, which could be a bank that has extended a loan or a collection of bond investors. The equity holders are the owners of the business, whether the sole founder of a small business or the millions of shareholders of a large corporation.
These primary stakeholders have a vested interest in the business (due to either a loan or an equity contribution), which they put forward in the hope of future rewards. These rewards may be either the repayment of the loan with compensating interest, or increased value derived from their equity, which follows from an increased share price or dividends received from the shares.
From the perspective of the entity itself, the equity holders and debt holders both represent liabilities or obligations: the entity must meet its debt obligations, and, because it is owned by its equity holders, it owes its eventual profits (or losses) to its owners. It is important to note that there is a crucial difference between these two obligations: the amount due to lenders is fixed, while the amount due to equity holders is flexible and depends on how much profit is made.
This flexibility makes the equity a less risky obligation from the perspective of the entity. This is because the equity holders are entitled to precisely what is available for them, even if that amount is negative. Therefore, if the entity makes a loss, this loss is just transferred over the equity holders. The fixed nature of the debt obligation makes it risky — the debt holders are entitled to a certain amount, whether or not the entity has this money available. If the entity does not have the required money, they will default on their debt obligations, with dire consequences. This can
potentially include the declaration of bankruptcy and the entity being wound up (the operations being terminated, and the individual assets sold so that the lenders recover some of their stake).
To illustrate this, suppose it takes 100 dollars to start a business. In scenario A, an individual contributes this 100, and becomes the sole stakeholder in the new business. In scenario B, the individual borrows 50 and contributes the remaining 50 needed. A year later, suppose the business in both scenarios has been equally profitable and is now worth 130 (net profits of 30 have been earned and thus added to the initial value).
In scenario A, this new, increased value belongs to the owners, who has made a good return on his investment (of 30%, the increase to the initial contribution). In scenario B, the new value of 130 does not only belong to the owner — the lender is entitled to the loan of 50, and an interest payment of 5. So, the owner’s contribution grows from 50 to 75, since 75 = 130-55 (which is a 50% increase/return). If the business makes no profit, there is no return in scenario A, but in scenario B, the owner in fact makes a loss — the owner’s stake has shrunk from 50 to 45, since 5=100-55,
noting that the lender is still entitled to their repayment with interest. The following table shows these outcomes as well as others, which you should verify by calculating the returns and comparing the two scenarios.