Financial Markets - cpe247.com

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Financial Markets:

A Comprehensive Overview

By Michael J. Walker, CPA, FRM

Version 12.0: 7/31/2021

Copyright © Michael J. Walker, CPA, FRM

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Introduction

Financial markets represent the lifeblood of our global economy. These mechanisms

promote greater economic efficiency by transferring funds from individuals, businesses

and governments with an excess of available funds to those with a shortage. Funds are

transferred in the financial markets through the purchase and sale of financial instruments

(such as stocks and bonds). Short-term financial instruments are available in money

markets, while longer-term financial instruments are purchased and sold in the world’s

capital markets. Many financial markets have been in existence for hundreds of years;

however the modern era has brought along many new innovations such as securitization

and the derivatives market.

This course provides an introductory overview of the world’s largest financial markets,

including the money, bond, stock, mortgage, foreign currency and derivatives markets.

This course reviews the various types of financial risk that impact these markets, as well

as the economic variables that influence market activity (such as interest rates and

monetary policy).

Learning Objectives

After completing this course, participants should be able to:

• Identify the unique characteristics of financial markets.

• Recognize the types of financial instruments traded in financial markets.

• Recognize how economic variables (such as interest rates and monetary policy)

and financial risks impact financial market activity.

Field of Study: Finance (100%)

Prerequisites: None

Level: Overview

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Table of Contents CHAPTER 1 – FINANCIAL MARKETS & INTERMEDIARIES ......................................................... 6

1.1 OVERVIEW OF FINANCIAL MARKETS .................................................................................................. 6 1.1.1 What are financial markets? ...................................................................................................... 6 1.1.2 Market participants .................................................................................................................... 6

1.2 STRUCTURE OF FINANCIAL MARKETS ................................................................................................. 8 1.2.1 Debt and equity markets ............................................................................................................ 8 1.2.2 Primary and secondary markets ................................................................................................ 8 1.2.3 Exchanges and over-the-counter markets .................................................................................. 9 1.2.4 Money and capital markets ........................................................................................................ 9

1.3 PRICING THEORY IN FINANCIAL MARKETS ....................................................................................... 11 1.3.1 Pricing mechanisms ................................................................................................................. 11 1.3.2 The efficient market hypothesis ................................................................................................ 12

1.4 FINANCIAL INTERMEDIARIES ............................................................................................................ 13 1.4.1 Role of financial intermediaries ............................................................................................... 13 1.4.2 Depository institutions ............................................................................................................. 14 1.4.3 Contractual savings institutions ............................................................................................... 16 1.4.4 Investment intermediaries ........................................................................................................ 16

CHAPTER 2 – INTEREST RATES ......................................................................................................... 21

2.1 OVERVIEW OF INTEREST RATES ........................................................................................................ 21 2.1.1 What are interest rates? ........................................................................................................... 21 2.1.2 Simple and compound interest ................................................................................................. 22 2.1.3 Fixed and floating interest rates .............................................................................................. 22 2.1.4 Annual percentage rates (APR) ............................................................................................... 23 2.1.5 Yield-to-maturity (YTM) ........................................................................................................... 23

2.2 DETERMINATION OF INTEREST RATES ............................................................................................... 23 2.2.1 Demand for “loanable funds” ................................................................................................. 24 2.2.2 Supply of “loanable funds” ...................................................................................................... 24 2.2.3 Market equilibrium .................................................................................................................. 25 2.2.4 Inflation and the Fisher effect .................................................................................................. 26

2.3 RISK STRUCTURE OF INTEREST RATES .............................................................................................. 28 2.3.1 Default risk............................................................................................................................... 28 2.3.2 Liquidity ................................................................................................................................... 29 2.3.3 Income tax considerations ....................................................................................................... 30 2.3.4 Estimating bond yields ............................................................................................................. 30

2.4 TERM STRUCTURE OF INTEREST RATES ............................................................................................ 32 2.4.1 The yield curve ......................................................................................................................... 32 2.4.2 Expectations theory .................................................................................................................. 33 2.4.3 Segmented markets theory ....................................................................................................... 34 2.4.4 Liquidity premium theory ......................................................................................................... 35

CHAPTER 3 – CENTRAL BANKING AND MONETARY POLICY.................................................. 39

3.1 THE FEDERAL RESERVE SYSTEM ...................................................................................................... 39 3.1.1 Federal Reserve Banks ............................................................................................................. 40 3.1.2 Member Banks ......................................................................................................................... 41 3.1.3 Board of Governors ................................................................................................................. 41 3.1.4 Federal Open Market Committee (FOMC) .............................................................................. 42 3.1.5 Federal Advisory Council (FAC) ............................................................................................. 42

3.2 MONETARY POLICY .......................................................................................................................... 43 3.2.1 Open market operations ........................................................................................................... 44 3.2.2 Reserve requirements ............................................................................................................... 45 3.2.3 Discount lending ...................................................................................................................... 47

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3.3 THE MONEY SUPPLY ......................................................................................................................... 50 3.3.1 Money supply measures ........................................................................................................... 50 3.3.2 History of the money supply and monetary policy ................................................................... 51

CHAPTER 4 – MONEY MARKETS ....................................................................................................... 55

4.1 INTRODUCTION TO MONEY MARKETS ............................................................................................... 55 4.1.1 Money markets defined ............................................................................................................. 55 4.1.2 Money markets participants ..................................................................................................... 56

4.2 MONEY MARKET INSTRUMENTS ....................................................................................................... 59 4.2.1 Treasury bills ........................................................................................................................... 59 4.2.2 Federal funds ........................................................................................................................... 60 4.2.3 Commercial paper.................................................................................................................... 62 4.2.4 Certificates of deposit .............................................................................................................. 65 4.2.5 Repurchase agreements ........................................................................................................... 67 4.2.6 Banker’s acceptances ............................................................................................................... 69

CHAPTER 5 – CAPITAL MARKETS (PART I) .................................................................................... 73

5.1 THE BOND MARKET .......................................................................................................................... 73 5.1.1 Bond markets defined ............................................................................................................... 73 5.1.2 Bond markets participants ....................................................................................................... 74

5.2 TYPES OF BONDS ............................................................................................................................... 74 5.2.1 U.S. Treasury bonds ................................................................................................................. 75 5.2.2 Municipal bonds ....................................................................................................................... 77 5.2.3 Corporate bonds ...................................................................................................................... 79

5.3 THE STOCK MARKET ........................................................................................................................ 83 5.3.1 Common and preferred stock ................................................................................................... 83 5.3.2 Stock quotations ....................................................................................................................... 85 5.3.3 Stock markets and exchanges ................................................................................................... 87 5.3.4 Stock indexes ............................................................................................................................ 89

CHAPTER 6 – CAPITAL MARKETS (PART II) .................................................................................. 94

6.1 THE MORTGAGE MARKET ................................................................................................................. 94 6.1.1 Mortgages defined.................................................................................................................... 94 6.1.2 Mortgage characteristics ......................................................................................................... 95 6.1.3 Mortgage-lending institutions .................................................................................................. 97 6.1.4 Mortgage underwriting process ............................................................................................... 98

6.2 MORTGAGE SECURITIZATION PROCESS ............................................................................................102 6.2.1 Definition and brief history .....................................................................................................102 6.2.2 Benefits of securitization .........................................................................................................103 6.2.3 Participants in the process ......................................................................................................103 6.2.4 Structuring the transaction .....................................................................................................105

6.3 TYPES OF MORTGAGE-BACKED SECURITIES .....................................................................................108 6.3.1 Mortgage pass-through securities ...........................................................................................109 6.3.2 Collateralized mortgage obligations .......................................................................................109 6.3.3 Stripped mortgage-backed securities ......................................................................................110

CHAPTER 7 – FOREIGN EXCHANGE MARKETS ...........................................................................115

7.1 INTRODUCTION TO FOREIGN EXCHANGE MARKETS .........................................................................115 7.1.1 Foreign exchange defined .......................................................................................................115 7.1.2 Market characteristics ............................................................................................................116 7.1.3 Payment & settlement systems ................................................................................................118 7.1.4 Institutional use of foreign exchange markets .........................................................................119

7.2 FOREIGN EXCHANGE RATES ............................................................................................................120 7.2.1 Exchange rates defined ...........................................................................................................120 7.2.2 Quotes .....................................................................................................................................120 7.2.3 Exchange rate determination ..................................................................................................121

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7.2.4 Purchasing Power Parity (PPP) .............................................................................................123 7.3 FOREIGN EXCHANGE TRANSACTIONS ..............................................................................................125

7.3.1 Spot transactions .....................................................................................................................125 7.3.2 Forward transactions ..............................................................................................................126

7.4 INTERNATIONAL ARBITRAGE ...........................................................................................................127 7.4.1 Locational arbitrage ...............................................................................................................128 7.4.2 Covered interest arbitrage ......................................................................................................128

CHAPTER 8 – DERIVATIVES MARKETS ..........................................................................................133

8.1 FINANCIAL RISK MANAGEMENT ......................................................................................................133 8.1.1 Financial risks ........................................................................................................................133 8.1.2 Hedging financial risk .............................................................................................................135 8.1.3 Derivative instruments ............................................................................................................135

8.2 FORWARD MARKETS ........................................................................................................................138 8.2.1 Forward contracts ..................................................................................................................138 8.2.2 Forward rate agreements ........................................................................................................139

8.3 FUTURES MARKETS .........................................................................................................................140 8.3.1 Futures contracts ....................................................................................................................140 8.3.2 Futures exchanges...................................................................................................................141 8.3.3 Market mechanics ...................................................................................................................142

8.4 SWAP MARKETS ...............................................................................................................................144 8.4.1 Swap contracts ........................................................................................................................144 8.4.2 Interest rate swaps ..................................................................................................................144 8.4.3 Other types of swaps ...............................................................................................................146

8.5 OPTIONS MARKETS ..........................................................................................................................147 8.5.1 Options contracts ....................................................................................................................147 8.5.2 Options trading .......................................................................................................................148 8.5.3 The Options Clearing Corporation (OCC) .............................................................................148

REVIEW ANSWERS ................................................................................................................................152

GLOSSARY ...............................................................................................................................................191

INDEX ........................................................................................................................................................210

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Chapter 1 – Financial Markets & Intermediaries

Learning Objectives:

After studying this chapter participants should be able to:

• Identify the unique characteristics of financial markets.

• Recognize the types of financial instruments traded in various financial markets.

• Recognize the key aspects of the efficient market hypothesis.

• Identify the roles that financial intermediaries play in financial markets; recognize the

various types of financial intermediaries.

1.1 Overview of Financial Markets

1.1.1 What are financial markets?

A financial market is a market in which funds are transferred from people who have an

excess of available funds to people who have a shortage.

Parties transfer funds in financial markets by purchasing and selling financial

instruments. A financial instrument (or “security”)1 is a claim on a borrower’s future

income that is sold by the borrower to the lender. There are numerous types of financial

instruments available to financial market participants (see Exhibit 1.1 on the next page).

Financial markets, such as bond and stock markets, promote greater economic efficiency

by transferring funds from people who do not have a productive use for them to those

who do. Well-functioning financial markets are a key factor in producing high economic

growth, and poorly performing financial markets are one reason that many countries in

the world remain desperately poor. Activities in financial markets also have direct effects

on personal wealth, the behavior of businesses and consumers, and the cyclical

performance of the economy.

1.1.2 Market participants

The main participants in financial market transactions are:

➢ Households (Individuals)

➢ Businesses (including financial institutions)

1 Note – the terms “financial instrument” and “security” are used interchangeably throughout this course.

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➢ Governments that purchase or sell financial instruments.

Those market participants that provide funds are called surplus units, while participants

that enter financial markets to obtain funds are called deficit units. The federal

government commonly acts as a deficit unit. The Treasury finances budget deficit by

issuing Treasury securities. The main providers of funds are households. Foreign

investors also commonly invest in U.S. Treasury securities, as does the Federal Reserve

System (the “Fed”).

Financial markets play a crucial role in helping participants obtain financing. They allow

individuals to obtain home mortgages and automobile loans. They allow corporations to

obtain long-term financing for expansion, and to obtain short-term financing when

experiencing a temporary shortage of funds. They also enable government agencies to

borrow funds. Most large expenditures in the economy are financed with funds obtained

in financial markets. Financial markets also play an important role in helping participants

invest in financial instruments. They offer alternative investment opportunities for

households or businesses with excess funds.

Exhibit 1.1 Common Types of Financial Instruments

Instrument Type Issued By

Common Investors

Common Maturities

Secondary Market Activity

Treasury bills Federal government

Households and businesses

13 weeks, 26 weeks, 1 year

High

Retail CDs Banks and savings institutions

Households 7 days to 5 years or longer

N/A

Negotiable CDs Large banks and savings institutions

Businesses 2 weeks to 1 year Moderate

Commercial paper Bank holding companies, finance companies, and other companies

Businesses 1 day to 270 days Low

Eurodollar deposits

Banks located outside the U.S.

Businesses and governments

1 day to 1 year N/A

Banker’s acceptances

Banks Businesses 30 days to 270 days

High

Federal funds Depository institutions

Depository institutions

1 day to 7 days N/A

Repurchase agreements

Non-financial businesses and financial institutions

Non-financial businesses and financial institutions

1 day to 15 days N/A

Treasury notes and bonds

Federal government


1 day to 15 days N/A

Municipal bonds State and local governments


10 to 30 years Moderate

Corporate bonds Businesses Households and businesses


Mortgages Individuals and businesses

Financial institutions


Equity securities Businesses Households and businesses

No maturity High (for stocks of large businesses)

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1.2 Structure of Financial Markets

1.2.1 Debt and equity markets

A firm or an individual can obtain funds in a financial market in two ways. The most

common method is to issue a debt instrument, such as a bond or a mortgage, which is a

contractual agreement by the borrower to pay the holder of the instrument fixed dollar

amounts at regular intervals (interest and principal payments) until a specified date (the

maturity date), when a final payment is made. The maturity of a debt instrument is the

number of years (term) until that instrument’s expiration date. A debt instrument is short-

term if its maturity is less than a year and long-term if its maturity is ten years or longer.

Debt instruments with a maturity between one and ten years are said to be intermediate-

term.

The second method of raising funds is by issuing equity instruments, such as common

and preferred stock, which are claims to share in the net income and the assets of a

business. If you own one share of common stock in a company that has issued one

million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-

millionth of the firm’s assets. Equities often make periodic payments (dividends) to their

holders and are considered long-term securities because they have no maturity date. In

addition, owning stock means you own a portion of a firm and thus have the right to vote

on issues important to the firm and to elect its directors.

The main disadvantage of owning a corporation’s equities rather than its debt is that an

equity holder is a residual claimant; that is, the corporation must pay all its debt holders

before it pays its equity holders. The advantage of holding equities is that equity holders

benefit directly from any increases in the corporation’s profitability or asset value

because equities confer ownership rights on the equity holders. Debt holders do not share

in this benefit, because their dollar payments are fixed.

1.2.2 Primary and secondary markets

A primary market is a financial market in which new issues of a security, such as a

bond or a stock, are sold to initial buyers by the corporation or governmental agency

borrowing the funds. The primary markets for securities are not well known to the public

because the selling of securities to initial buyers often takes place behind closed doors.

An important financial institution that assists in the initial sale of securities in the primary

market is the investment bank. It does this by underwriting the securities, which involves

guaranteeing a price for a corporation’s securities and then sells them to the public.

A secondary market is a financial market in which securities that have been previously

issued can be resold. The New York Stock Exchange and NASDAQ (National

Association of Securities Dealers Automated Quote System) are the best-known

examples of secondary markets. There is also a large secondary bond markets where

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previously issued bonds of major corporations and the U.S. government are bought and

sold. Other examples of secondary markets include foreign exchange markets, futures

markets and options markets.

Securities brokers and dealers are crucial to a well-functioning secondary market.

Brokers are agents of investors who match buyers with sellers of securities; dealers link

buyers and sellers by buying and selling securities at stated prices.

Secondary markets make it easier and quicker to sell financial instruments to raise cash;

that is, they make the financial instruments more liquid. Some financial instruments have

a more active secondary market than others. This is an important feature for financial

market participants to consider if they plan to sell security holdings prior to maturity.

1.2.3 Exchanges and over-the-counter markets

Secondary markets can be organized in two ways. One method is to organize exchanges,

where buyers and sellers of financial instruments (or their agents or brokers) meet in one

central location to conduct trades. The New York and American Stock Exchanges for

stocks and the Chicago Board of Trade for commodities (wheat, corn, silver and other

raw materials) are examples of organized exchanges.

The other method of organizing a secondary market is to have an over-the-counter

market. An over-the-counter (OTC) market is a decentralized market of financial

instruments not listed on an exchange where market participants trade over the telephone,

facsimile or electronic network instead of a physical trading floor. There is no central

exchange or meeting place for this market. In the OTC market, trading occurs via a

network of dealers who carry inventories of financial instruments to facilitate the buy and

sell orders of investors, rather than providing the order matchmaking service seen in

organized exchanges. The U.S. government bond market is set up as an over-the-counter

market.

1.2.4 Money and capital markets

Another way of distinguishing between markets is on the basis of the maturity of the

instruments traded in each market.

➢ The money market is a financial market in which only short-term debt instruments

(generally those with original maturity of less than one year) are traded.

➢ The capital market is the market in which longer-term debt (generally those with

original maturity of one year or greater) and equity instruments are traded.

Money market securities tend to be more liquid as they are usually more widely traded

than longer-term securities. They also have smaller fluctuations in prices than long-term

securities. As a result, corporations and banks actively use the money market to earn

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interest on surplus funds that they expect to have only temporarily. Capital market

securities, such as stocks and long-term bonds, are often held by financial institutions

such as insurance companies and pension funds, which have little uncertainty about the

amount of funds they will have available in the future.

Review Questions 1.1

1. Jack is drafting an article on the role of financial markets in the global

economy. Which of the following statements would Jack include in his article to

best describe the primary purpose of financial markets?

a. Financial markets provide the means for governments to levy taxes to

pay for public services.

b. Financial markets provide a mechanism for households, businesses and

governments to obtain financing.

c. Financial markets provide a consistent set of accounting principles used

by businesses when preparing financial statements.

d. Financial markets protect depositors from risky or improper investing by

banks and other financial institutions.

2. Which of the following financial market participants would most likely be

considered an example of a deficit unit?

a. Company A has a $2 million cash balance in a money market account.

b. Company B is seeking a $2 million loan from ABC Bank.

c. Company C reported $2 million positive cash flow from operations last

year.

d. Company D is seeking to purchase $2 million of fixed rate bonds.

Lost Corp. has issued a financial instrument by which it will remit principal and 5%

interest payments to the holder until a stated maturity date (10 years from the issue

date).

3. Lost Corp.’s financial instrument is most likely an example of:

a. A short-term equity instrument.

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b. A long-term equity instrument.

c. A short-term debt instrument.

d. A long-term debt instrument.

4. Lost Corp. most likely sold their financial instrument to an investor in a:

a. Over-the-counter market.

b. Money market.

c. Primary market.

d. Secondary exchange.

5. Which of the following financial transactions would most likely take place in a

money market?

a. Company A purchases U.S. Government Treasury bills.

b. Company B issues long-term corporate debt.

c. Company C purchases shares of Wal-Mart stock.

d. Company D obtains a second mortgage on its manufacturing plant.

1.3 Pricing Theory in Financial Markets

1.3.1 Pricing mechanisms

A key aspect of a financial market is its ability to function as a price mechanism for

financial instruments. A price mechanism generally refers to a system used to match up

buyers and sellers of a particular item.

The price mechanism for financial instruments generally uses bid and ask prices to match

up buyers and sellers. Generally speaking, when two parties wish to engage in a trade, the

purchaser will announce a price he or she is willing to pay (the bid price) and seller will

announce a price he or she is willing to accept (the ask price). The main advantage of

such a method is that conditions are determined in advance and transactions generally

proceed with no further permission or authorization from any participant. When any bid

and ask pair are compatible, a transaction occurs, in most cases automatically.

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1.3.2 The efficient market hypothesis

The expectations of market participants are critical when determining prices in financial

markets. Expectations of returns, risk and liquidity are key drivers in the demand for the

financial instruments traded in these markets. Therefore these expectations are critical in

understanding the behavior of financial markets.

A commonly used (but highly controversial) tool for analyzing such expectations is the

efficient market hypothesis. The efficient market hypothesis asserts that if financial

markets are efficient, the prices of financial instruments at any point in time should fully

reflect all available information. Under this hypothesis, market prices automatically

adjust as investors attempt to capitalize on new information that was not already

accounted for by the market.

The efficient market hypothesis was developed by Professor Eugene Fama at the

University of Chicago in the early 1960s. It states that efficient markets can be classified

into three forms:

1. Weak-form efficiency. Weak-form efficiency suggests that financial instrument prices

reflect all market-related information, such as historical price movements and volume of

trades. Thus, investors will not be able to earn abnormal returns on a trading strategy that

is solely based on past price movements.

2. Semi-strong-form efficiency. Semi-strong-form efficiency suggests that financial

instrument prices fully reflect all public information. The difference between public

information and market-related information is that public information also includes

announcements by firms, economic news or events, and political news or events. Market-

related information is a subset of public information. Thus, if semi-strong-form efficiency

holds, weak-form efficiency must hold as well. Yet weak-form efficiency could possibly

hold, while semi-strong-form efficiency does not. In this case, investors could earn

abnormal return by using the relevant information that was not immediately accounted

for by the market.

3. Strong-form efficiency. Strong-form efficiency suggests that security prices fully reflect

all information, public and private (including inside information2). If strong-form

efficiency holds, semi-strong-form efficiency must hold as well. However, semi-strong

form efficiency could hold, while strong-form efficiency does not, if insider information

leads to abnormal returns.

Certain investors and researchers have disputed the efficient market hypothesis (both

empirically and theoretically). Behavioral economists attribute the imperfections in

financial markets to a combination of cognitive biases such as overconfidence,

2 Inside information allows insiders (such as some employees or board members) an unfair advantage over

other investors. For example, if employees of a firm are aware of favorable news about the firm that is not

yet disclosed to the public, they may consider purchasing shares or advising their friends to purchase the

firm’s shares. While such actions are illegal, they still happen and can create market inefficiencies.

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overreaction, representative bias, information bias, and various other predictable human

errors in reasoning and information processing.

Many believe that the hypothesis implies that an instrument's price is a correct

representation of the value of that business, as calculated by what the business's future

returns will actually be. In other words, they believe that the hypothesis states that a

stock's price correctly predicts the issuing company's future results. Several reject the

efficient market hypothesis as false based on the observation that stock prices clearly do

not reflect future results in many cases.

However, the efficient market hypothesis does not state that the expected outcome (i.e. a

company’s future results) must occur given specific information (i.e. their current stock

price). Rather, it states that a stock's price represents an aggregation of the probabilities

of all future outcomes based on the best information available at the time. In other words,

the efficient market hypothesis does not assert that a stock's price must reflect a

company's future performance, but rather the best possible estimate of future performance

based on all publicly available information. That estimate may still be materially

incorrect without violating the efficient market hypothesis.

1.4 Financial Intermediaries

1.4.1 Role of financial intermediaries

Participants can transfer funds in financial markets through two distinct paths: direct and

indirect finance.

In direct finance, borrowers borrow funds directly from lenders in financial markets by

selling them financial instruments. Such instruments are assets for the participant that

buys them and liabilities for the participant that sells (issues) them. For example, if ABC

Corp. needs to borrow funds to pay for a new factory to manufacture electric cars, it

might borrow the funds directly from savers by issuing them a bond.

Funds can also move from lenders to borrowers via a second route known as indirect

finance. Indirect finance involves a third party (known as a financial intermediary) that

stands between the market participants (i.e. the lender-savers and the borrower-spenders)

and helps transfer from one to another. A financial intermediary does this by borrowing

funds from the lender-savers and then using these funds to make loans to borrower-

spenders. For example, a bank might acquire funds by issuing a liability to the public (an

asset for the public) in the form of savings deposits. It might then use the funds to acquire

an asset by making a loan to a business or by buying a U.S. Treasury bond in the

financial market. The ultimate result is that funds have been transferred from the public

(the lender-savers) to the business or the U.S. Treasury (the borrower-spender) with the

help of the financial intermediary (the bank).

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The process of indirect finance using financial intermediaries is known as financial

intermediation. It is the primary route for moving funds from lenders to borrowers.

If financial markets were perfect, all information about any financial instruments for sale

in primary and secondary markets would be continuously and freely available to investors

(including the credit worthiness of the security issuer). In addition, all information

identifying investors interested in purchasing or selling financial instruments would be

freely available. Furthermore, all instruments for sale could be broken down into any size

desired by investors, and transaction costs (i.e. the time and money spent in carrying out

financial transactions) would be nonexistent. Under these conditions, financial

intermediaries would not be necessary.

Because markets are imperfect, buyers and sellers of financial instruments do not have

full access to information and cannot always customize these instruments to their specific

needs. Financial intermediaries are needed to resolve the problems caused by market

imperfections. They receive requests from surplus and deficit units on what instruments

are to be purchased or sold, and they use this information to match up these buyers and

sellers. Without financial intermediaries, the information and transaction costs of

financial market transactions would be excessive.

There are three major categories of financial intermediaries: depository institutions

(banks), contractual savings institutions and investment intermediaries.

Exhibit 1.2 Flows of Funds through the Financial System

1.4.2 Depository institutions

Depository institutions (a.k.a. banks) are financial intermediaries that accept deposits

from individuals and institutions and make loans.

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Types of depository institutions include:

Commercial banks. These financial intermediaries raise funds primarily by issuing

checkable deposits (deposits on which checks are written), savings deposits (deposits that

are payable on demand but do not allow their owner to write checks) and time deposits

(deposits with fixed terms to maturity). They then use these funds to make commercial,

consumer and mortgage loans and to buy U.S. government securities and municipal

bonds.

Savings and Loan Associations (S&L’s) and Mutual Savings Banks. These depository

institutions obtain funds through savings deposits (often called shares) and time and

checkable deposits. In the past, these institutions were constrained in their activities and

mostly made mortgage loans for residential housing. Over time, these restrictions have

been loosened so that the distinction between these institutions and commercial banks has

blurred.

Credit Unions. These financial institutions are typically very small cooperative lending

institutions organized around a particular group: union members, employees of a

particular firm, and so forth. They acquire funds from deposits called shares and

primarily make consumer loans.

Depository institutions offer the following advantages:

• They offer deposit accounts that can accommodate the amount and liquidity

characteristics desired by most surplus units.

• They repackage funds received from deposits to provide loans of the size and maturity

desired by deficit units.

• They accept the risk on loans provided.

• They have more expertise than individual surplus units to evaluate the creditworthiness of

deficit units.

• They diversify loans among numerous deficit units and can absorb defaulted loans better

than individual surplus units could.

To appreciate these advantages, consider the flow of funds from surplus units to deficit

units if the depository institutions did not exist. Each surplus unit would have to identify

a deficit unit desiring to borrow the precise amount of funds available for the precise time

period in which funds would be available. Furthermore, each surplus unit would have to

perform the credit evaluation and incur the risk of default. Under these conditions, many

surplus units would likely hold their funds rather than channel them to deficit units. Thus,

the flow of funds from surplus units to deficit units would be disrupted.

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1.4.3 Contractual savings institutions

Contractual savings institutions are financial intermediaries that acquire funds at

periodic intervals on a contractual basis. They have generally long-term liabilities and

stable cash flows and are providers of term finance, not only to government and industry,

but also to municipal authorities and the housing sector.

Types of contractual savings institutions include:

Life insurance companies. Life insurance companies insure people against financial

hazards following a death and sell annuities (annual income payments upon retirement).

They acquire funds from the premiums that people pay to keep their policies in force and

use them mainly to buy corporate bonds and mortgages. They also purchase stocks, but

are restricted in the amount that they can hold. Fire and Casualty insurance companies. These companies insure their policy holders

against loss from theft, fire and accidents. They are very much like life insurance

companies, receiving funds through premiums for their policies, but they have a greater

possibility of loss of funds if major disasters occur. For this reason, they use their funds

to buy more liquid assets than life insurers do. Their largest holding of assets is generally

municipal bonds; they also hold corporate bonds and stocks and U.S. government

securities.

Pension funds and Government Retirement Funds. Private pension funds and state

and local retirement funds provide retirement income in the form of annuities to

employees who are covered by a pension plan. Funds are acquired by contributions from

employers and from employees, who either have a contribution automatically deducted

from their paychecks or contribute voluntarily. The largest asset holdings of pension

funds are corporate bonds and stocks. The establishment of pension funds has been

actively encouraged by the federal government, both through legislation requiring

pension plans and through tax incentives to encourage contributions.

Because contractual savings institutions can predict with reasonable accuracy how much

they will have to payout in benefits in the coming years, they do not have to worry as

much as depository institutions about losing funds quickly. Therefore the liquidity of

their assets is not as an important consideration for them as it is for depository

institutions, As a result, they tend to invest their funds primarily in long-term securities

such as corporate bonds, stocks and mortgages.

1.4.4 Investment intermediaries

This category of financial intermediaries includes:

Finance companies. Finance companies raise funds by selling commercial paper (a

short-term debt instrument) and by issuing stocks and bonds. They lend these funds to

consumers, who make purchases of such items as furniture, automobiles, and home

improvements. They also lend to small businesses. Some finance companies are

17

organized by a parent corporation to help sell its product. For example, Ford Motor

Credit Company makes loans to consumers who purchase Ford Automobiles.

Mutual funds. These financial intermediaries acquire funds by selling shares to many

individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.

Mutual funds allow shareholders to pool their resources so that they can take advantage

of lower transaction costs when buying large blocks of stocks or bonds. In addition,

mutual funds allow shareholders to hold more diversified portfolios than they otherwise

would. Shareholders can sell (redeem) shares at any time, but the value of these shares

will be determined by the value of the mutual fund’s holdings. Because these fluctuate

greatly, the value of mutual fund shares will too; therefore, investments in mutual funds

can be risky.

Money market mutual funds. These financial intermediaries have the characteristics of

a mutual fund but also function to some extent as a depository institution because they

offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that

are then used to buy money market instruments that are both safe and very liquid. The

interest on these assets is paid out to the shareholders. Shareholders are able to write

checks against the value of their shareholdings.

Investment banks. Despite its name, an investment bank is not a bank or a financial

intermediary in the ordinary sense; that is, it does not take in deposits and then lend them

out. Instead, an investment bank is a different type of intermediary that helps a

corporation issue securities. First, it advises the corporation on which type of securities to

issue (stocks or bonds) then it helps sell (or “underwrite”) the securities by purchasing

them from the corporation at a predetermined price and reselling them in the market.

Exhibit 1.3 – Participation of Financial Intermediaries in Financial Markets

Individual

Surplus Units

Policyholders

Employers and

employees

Depository

institutions

Finance

companies

Mutual funds

Insurance

companies

Pension funds

Deficit Units

Deposits

Purchase of

securities

Purchase of

shares

Premiums

Contributions

18


6. Under which of the following scenarios would the exchange of a financial

instrument most likely take place automatically?

a. A company hires an investment bank to underwrite its securities.

b. An insurance company wishes to purchase a customized derivative

contract in the OTC market.

c. A security buyer’s bid price matches a security seller’s ask price.

d. A commercial bank wishes to sell security positions in an inactive

secondary market.

7. Ben is a mutual fund manager that frequently invests in equity securities. Which

one of the following is the lowest form of market efficiency that would be

violated if Ben is able to earn excess return by buying stocks of firms with

historically higher-than-average share price appreciation?

a. Weak form.

b. Semi-weak form.

c. Semi-strong form.

d. Strong form.

8. Which of the following is an example of a borrower borrowing funds through

the use of direct finance?

a. Borrower A receives a loan from a commercial bank.

b. Borrower B issues a bond to a group of investors.

c. Borrower C purchases a debt security from a corporation.

d. Borrower D opens a line of credit at a finance company.

Institution A invests in stocks and bonds and secures funds by selling shares in these

investments to outside investors. Institution B makes consumer loans (including

mortgages) and funds them by taking in deposits. Institution C uses the premiums

that they receive on their annuity products to purchase mortgages and other

investments.

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9. Institution A is most likely an example of a:

a. Pension fund.

b. Credit union.

c. Life insurance Company.

d. Mutual fund.

10. Institution B is most likely an example of a/an:

a. Commercial bank.

b. Investment bank.

c. Fire and casualty insurance company.

d. Pension fund.

11. Institution C is most likely an example of a/an:

a. Savings and Loan Association.

b. Money market mutual fund.

c. Life insurance Company.

d. Credit union.

20

Chapter 1 Summary

• A financial market is a market in which funds are transferred from people who have an

excess of available funds to people who have a shortage. Parties transfer funds in

financial markets by purchasing and selling financial instruments, which are claims on a

borrower’s future income that are sold by the borrower(s) to the lender(s).

• The main participants in financial market transactions are households, businesses and

governments. Those participants that provide funds are called surplus units, while

participants that enter financial markets to obtain funds are called deficit units.

• A firm or individual can obtain funds in a financial market by either (1) issuing a debt

instrument (such as a bond or a mortgage), or (2) issuing an equity instrument (such as

common or preferred stock).

• A primary market is a financial market in which new issues of financial instruments are

sold to initial buyers by the entity borrowing the funds. A secondary market is a financial

market (such as the NYSE) in which financial instruments that have been previously

issued can be resold. Secondary markets can be organized as either centralized exchanges

or decentralized “over-the-counter” markets.

• A key aspect of a financial market is its ability to function as a price mechanism for

financial instruments. The expectations of market participants are critical when

determining prices in financial markets (including expectations of returns, risk and

liquidity).

• The efficient market hypothesis asserts that if financial markets are efficient, the prices of

financial instruments at any point in time should fully reflect all available information.

Under this hypothesis, market prices automatically adjust as investors attempt to

capitalize on new information that was not already accounted for by the market. The

hypothesis presents three forms of market efficiency (weak, semi-strong and strong) to

explain this relationship.

• Participants can transfer funds in financial markets through two distinct paths: direct and

indirect finance. In direct finance, borrowers borrow funds directly from lenders in

financial markets by selling them financial instruments. In indirect finance, a third party

(known as a financial intermediary) stands between the market participants and helps

transfer funds from one to another.

• Financial intermediaries include depository institutions (i.e. commercial and savings

banks), contractual savings institutions (i.e. certain insurance companies and pension

funds) and investment intermediaries (i.e. finance companies, mutual funds and

investment banks).

21

Chapter 2 – Interest Rates



• Calculate ‘simple’ and ‘compound’ interest.

• Identify how a bond’s stated interest rate and its yield-to-maturity impacts the price at

which it is traded.

• Recognize how interest rates are derived under the ‘loanable funds theory’.

• Calculate a bond’s yield given specific information regarding its risk structure.

• Identify how a yield curve illustrates the term structure of interest rates; recognize

various yield curve shapes and the theories behind them.

2.1 Overview of Interest Rates

2.1.1 What are interest rates?

An interest rate is the cost of borrowing money that is expressed as a percentage of the

amount of the borrowed funds. It also represents the compensation to the lender for the

service and risk of lending money. Without interest, many people would not be willing to

lend or even save their cash, both of which require a deferment of the opportunity to give

up spending in the present.

Interest is compensation to the lender for the risk of not being paid back, and for forgoing

other useful investments that could have been made with the loaned asset. These forgone

investments are known as the opportunity cost. Instead of the lender using the assets

directly, they are advanced to the borrower. The borrower then enjoys the benefit of using

the assets ahead of the effort required to obtain them, while the lender enjoys the benefit

of the fee paid by the borrower for the privilege.

Interest rates are among the most closely watched variables in the economy. There are

many interest rates – mortgage interest rates, car loan rates, and interest rates on many

different types of bonds. Their movements are reported almost daily by the news media

because they directly affect our everyday lives and have important consequences for the

health of the economy. They affect personal decisions such as whether to consume or

save money, whether to buy a house, or put funds into a savings account. Interest rates

also affect the economic decisions of businesses and households, such as whether to use

their funds to invest in new equipment for factories or to save their money in a bank.

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2.1.2 Simple and compound interest

The two main forms of interest are “simple interest” and “compound interest.” Simple

interest is a type of interest that is calculated based solely on the principal of the

financial instrument. If you borrow $1,000 from a bank that charges you 5% simple

interest, you will owe 5% more than $1,000 (or $1,050) at the end of the year (assuming

that you do neither borrow more funds nor pay back a portion of the original loan). The

$1,000 that you borrowed is referred to as the loan principal. By multiplying the principal

and the rate of interest (5%), you can determine the amount of interest ($50). The

addition of the interest amount and the principal amount results in a total of $1,050 due

after one year. With simple interest, if you don’t pay the loan back until the end of the

second year, you will have another $50 to pay for a total of $1,100. Your second year of

interest is based on your original principal.

Compound interest is interest that is calculated based on the both the principal of the

financial instrument and the previously accrued interest; it may be computed daily,

monthly, quarterly, semiannually, or annually. Compound interest is more common than

simple interest, but there are many nuances. Consider a bank that charges 5% interest on

that $1,000 loan, but the interest is compounded annually rather than not compounded

(simple). At the end of the first year, the first year’s interest, $50, is added (compounded)

to the principal. Your second year’s interest is then calculated based on your new

principal of $1,050. 5% of $1,050 is $52.50, so rather than owing $1,100 at the end of the

second year, you would owe $1,102.50. Such compounding can occur on a monthly or

daily basis, or even continuously. A 5% interest rate compounded monthly, paid to you

by a bank in return for your $1,000 deposit, leaves you with $1,051.16 in your bank

account at the end of the year assuming no further deposits or withdrawals. That is a little

more than the $1,050 of simple interest or interest compounded annually. If that same 5%

interest rate is compounded daily, your ending balance would be $1,051.27. Compounded

continuously, the 5% rate would also result in $1,051.27, but a fraction of a cent more

than the result of daily compounding.

2.1.3 Fixed and floating interest rates

Interest rates can be determined on a fixed or floating basis. A fixed interest rate is one

that is established upon purchase (or issuance) of a financial instrument and remains at

that predetermined rate for the entire term of the instrument. A floating interest rate

(a.k.a. a “variable” or “adjustable” interest rate) is one that adjusts up and down with the

rest of the market or along with a specified index. For example, residential mortgages can

be obtained with a fixed interest rate, which is static and can't change for the duration of

the mortgage agreement, or with a floating interest rate, which changes periodically with

the market. In the case of floating interest rates in mortgages, and most other floating rate

agreements, the prime lending rate is used as a basis for the floating rate, with the

agreement stating that the interest rate charged to the borrower is the prime interest rate

plus a certain fixed interest amount (known as the spread).

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2.1.4 Annual percentage rates (APR)

Interest rates on many consumer financial products are expressed as “annual percentage

rates”. An annual percentage rate (APR) is the yearly rate of interest that includes fees

and costs paid to acquire the loan. Lenders are required by law to disclose the APR

associated with a financial product. The rate is calculated in a standard way, taking the

average compound interest rate over the term of the loan, so borrowers can compare

loans. In mortgages, it is the interest rate of a mortgage when taking into account the

interest, mortgage insurance, and certain closing costs including points paid at closing.

2.1.5 Yield-to-maturity (YTM)

Of the several common ways of calculating interest rates, the most important is the yield-

to-maturity (YTM), which represents the interest rate that equates the present value of

cash flows received from a debt instrument with its value today.

Yield-to-maturity refers to the expected rate of return a bondholder will receive if they hold

a bond until maturity while reinvesting all coupon payments (i.e. bond interest cash flows)

at the bond yield. YTM is generally quoted in terms of Annual Percentage Rate (APR), and

is an estimation of future return (as the rate at which coupon payments can be reinvested

at is unknown).

Yield-to-maturity is a metric that is widely used by investors to compare bonds with

varying face values, coupon payments, and maturity periods. The comparison of a bond’s

YTM with its stated coupon rate will determine the price at which the instrument is traded:

• A bond with a stated coupon rate that is less than its YTM will trade at a discount.

• A bond with a stated coupon rate that is more than its YTM will trade at a premium.

• A bond with a stated coupon rate that is equal to its YTM will trade at par.

2.2 Determination of Interest Rates

Interest rate movements affect the values of financial instruments, and therefore affect the

performance of all types of financial institutions. For this reason, it is critical for

managers of financial institutions to understand why interest rates change, how their

movements affect performance, and how to manage their operations according to

anticipated movements.

24

The loanable funds theory, commonly used to explain interest rate movements, suggests

that the market interest rate3 is determined by the factors that control the supply and the

demand for loanable funds. The “loanable funds” market is a hypothetical market that

brings savers and borrowers together, also bringing together the money available in

commercial banks and lending institutions available for firms and households to finance

expenditures, either investments or consumption. Savers supply the loanable funds; for

instance, buying bonds will transfer their money to the institution issuing the bond, which

can be a firm or government. In return, borrowers demand loanable funds; when an

institution sells a bond, it is demanding loanable funds.

2.2.1 Demand for “loanable funds”

“Demand for loanable funds” is a widely used phrase in financial markets pertaining to

the borrowing activities of households, businesses and governments:

Households commonly demand loanable funds to finance housing expenditures,

as well as the purchases of automobiles and household items. Their demand for

loanable funds is inversely related to the rate of interest charged for those funds.

This simply implies that at any point in time, households would demand a greater

quantity of loanable funds at lower rates of interest.

Businesses demand loanable funds to invest in long-term and short-term assets.

The quantity of funds demanded by businesses depends on the number of business

projects to be implemented. As with the typical household, a business’s demand

for loanable funds is inversely related to interest rates at any point in time.

Governments demand loanable funds whenever their planned expenditures cannot

be completely covered by its incoming revenues from taxes or other sources.

Municipal (state and local) governments issue municipal bonds to obtain funds,

while the federal government and its agencies issue Treasury securities and

federal agency securities. Unlike households and businesses, federal government

expenditures and tax policies are generally considered to be independent of

interest rates. Thus the federal government’s demand for funds generally

insensitive to interest rates4.

2.2.2 Supply of “loanable funds”

“Supply of loanable funds” is a commonly used term to represent funds provided to

financial markets by savers. The household sector is the largest supplier, but loanable

funds are also supplied by some government units that temporarily generate more tax

3 The “market interest rate” is a generic term that refers to the various rates of interest paid on deposits and

other investments. 4 Note – this is generally not the case with municipal governments, which may postpone proposed

expenditures of the cost of financing them (i.e. the interest rate) is too high.

25

revenues that they spend or by some businesses whose cash inflows exceed outflows.

Households as a group, however, represent a net supplier of loanable funds, whereas

governments and businesses are net demanders of loanable funds.

Suppliers of loanable funds are willing to supply more funds if the interest rate (i.e. the

reward for supplying funds) is higher, other things being equal. A supply of loanable

funds exists even at a very low interest rate because some households choose to postpone

consumption until later years, even when the reward (interest rate) for saving is low.

2.2.3 Market equilibrium

Exhibit 2.1 presents a graphical depiction of the supply and demand for loanable funds.

The point on the graph where the aggregate demand line meets the aggregate supply line

is referred to as the equilibrium interest rate. From a theoretical perspective, the

equilibrium interest rate is the rate at which the demand for money and supply of money

are equal. If interest rates are set higher than the equilibrium rate, there is an excess

supply of money, resulting in investors holding less money and putting more into bonds.

This causes the price of bonds to rise, driving down the interest rate toward the

equilibrium rate. The opposite occurs when interest rates are lower than the equilibrium

rate: there is excess demand for money, causing investors to sell bonds to raise cash. This

decreases the price of bonds, causing the interest rate to rise to the equilibrium point.

In Exhibit 2.1, 5% represents the equilibrium interest rate. It also represents the “market

interest rate” of loanable funds at this particular point in time (under the loanable funds

theory). Exhibit 2.1 – Supply and Demand for Loanable Funds

26

2.2.4 Inflation and the Fisher effect

Inflation is defined as a rise in the general level of prices of goods and services in an

economy over a period of time. When the price level rises, each unit of currency buys

fewer goods and services; consequently, inflation also represents the erosion of the

purchasing power of money – a loss of real value in the internal medium of exchange and

unit of account in the economy. A chief measure of price inflation is the inflation rate, the

annualized percentage change in a general price index over time.

Several years ago, Irving Fisher proposed a theory (known as the Fisher effect) of interest

rate determination that incorporated the underlying concepts of the loanable funds theory

and inflation. The Fisher effect established a “real interest rate”, which represents the

nominal interest rate plus an adjustment for inflation. The basis for this theory is that a

quoted interest rate must be adjusted to reflect the real return that a saver would earn after

adjusting for the reduced purchasing power over the time period of the concern.


Linus Corp. has issued two debt instruments in order to raise funds. Bond #1 accrues

6% simple interest based on a $3,000,000 principal amount with a three year maturity.

Bond #2 accrues 3% compound interest based on a $10,000,000 principal amount

with a five year maturity. Both instruments accrue interest on an annual basis.

1. What is the amount of the annual interest that will accrue on Bond #1 during its

second year?

a. $0.

b. $180,000.

c. $360,000.

d. $540,000.

2. Assuming that no debt extinguishments take place, what is the principal

balance of Bond #2 at the end of its second year?

a. $10,000,000.

b. $10,300,000.

c. $10,600,000.

d. $10,609,000.

27

3. Which of the following bonds was most likely purchased at a discount?

a. Bond A has an 8% stated coupon (paid semi-annually) and an 8% YTM.

b. Bond B has a 5% stated coupon (paid annually) and a 7% YTM.

c. Bond C has a 6% stated coupon (paid semi-annually) and a 5% YTM.

d. Bond D has a 6% stated coupon (paid annually) and a 6% YTM.

4. Which of the following bonds was most likely purchased at par?

a. Bond A has a 6% stated coupon (paid semi-annually) and an 8% YTM.




5. Which of the following bonds was most likely purchased at a premium?

a. Bond A has a 4% stated coupon (paid semi-annually) and a 5% YTM.




6. Hurley, a market analyst, is attempting to predict market interest rate

movements. Which of the following economic indicators would most likely be

necessary in order for Hurley to make this prediction using the concepts of the

loanable funds theory?

a. Changes in the money supply.

b. The Dow Jones Industrial Average.

c. Foreign currency exchange rates.

d. The unemployment rate.

28

2.3 Risk Structure of Interest Rates

The supply and demand analysis of interest rate behavior presented in the previous

section focuses on the determination of just one interest rate. However in reality, interest

rates can vary significantly on bonds with similar (or even identical) terms-to-maturity.

Debt instruments offer varying yields because they exhibit different characteristics that

influence the yield to be offered. This concept is referred to as the risk structure of

interest rates. Under this concept, instruments with unfavorable characteristics will offer

higher yields to entice investors (as the instruments are considered ‘riskier’). Other

instruments with more favorable characteristics will generally offer lower yields (as the

instruments are considered ‘less risky’).

Under the risk structure of interest rates, the primary characteristics that affect the yields

on debt instruments are:

➢ Default risk

➢ Liquidity

➢ Income tax considerations

2.3.1 Default risk

One attribute of a bond that influences its interest rate is its risk of default (or its ‘default

risk’), which occurs when the issuer of the bond is unable or unwilling to make interest

payments when promised or pay off the face value when the bond matures.

A corporation suffering big losses might be more likely to suspend interest payments on

its bonds. The default risk on such bonds would generally be considered high. By

contrast, U.S. Treasury bonds have historically been considered to have no default risk

because the federal government can always increase taxes to pay off its obligations.

Most debt instruments are subject to the risk of default, and investors must consider the

creditworthiness of the security issuer when making an investment. These investors

generally demand compensation for their assumption of this risk. This compensation

generally comes in the form of a default risk premium, which is the additional amount

of interest investors must earn to be willing to hold a debt instrument that is subject to a

certain level of default risk. Thus, if all other characteristics are equal, a debt instrument

with a higher degree of default risk would have to offer a higher yield (that includes a

default risk premium) in order to be marketable to investors. This is especially true for

longer-term instruments that expose creditors to the possibility of default for a longer

time.

Bond ratings issued by ratings agencies (such as Moody’s Investor Service and Standard

and Poor’s Corporation) are a useful tool in assessing the credit-worthiness of

29

corporations that issue debt instruments. These ratings are based on a financial

assessment of the issuing corporation. Credit ratings are assigned to specific securities

based on the default risk and seniority of the issue, also taking into consideration any

collateral, back-up lines of credit or credit enhancement provided to support the

obligation. The higher the rating, the lower the perceived default risk. These ratings can

(and often do) change over time as economic conditions and other factors specific to the

issuer change.

Exhibit 2.2 gives examples of the different ratings that selected rating agencies assign to

bonds. Exhibit 2.2 – Bond Rating Grades

Credit Risk Moody’s Standard & Poor’s Fitch Ratings

Investment Grade Highest Quality Aaa AAA AAA High Quality Aa AA AA Upper Medium A A A Medium

Baa BBB BBB

Below Investment Grade Lower Medium Ba BB BB Lower Grade B B B Poor Grade Caa CCC CCC Speculative Ca CC CC Bankruptcy C D C In Default C D D

2.3.2 Liquidity

Another attribute of a bond that influences its interest rate is its liquidity. Liquidity is a

term used to describe the relative ease and speed with which an asset can be converted to

cash. A “liquid” asset is one that can be quickly and cheaply converted to cash if the need

arises. The more liquid an asset is, the more desirable it is (holding everything else

constant). U.S. Treasury bonds are the most liquid of all long-term bonds, because they

are so widely traded. Corporate bonds are not as liquid, because fewer bonds for any one

corporation are traded; thus, it can be costly to sell these bonds in an emergency, because

it might be hard to find buyers quickly.

The liquidity of a debt instrument generally impacts its stated interest rate. Assuming that

all other characteristics are equal, debt instruments with lower liquidity will have to offer

a higher yield in order to be marketable to investors. For investors who will not need their

funds until the instruments mature, lower liquidity is tolerable. The additional return

received by investors on these relatively illiquid instruments is referred to as a liquidity

risk premium. Other investors that require a higher degree of liquidity must accept a

lower return in exchange.

30

2.3.3 Income tax considerations

Investors are generally more concerned with after-tax income than pre-tax income earned

on financial instruments. If all other characteristics are similar, taxable securities would

have to offer a higher pre-tax yield to investors than tax-exempt securities (e.g. municipal

bonds) in order to be marketable to investors. The extra compensation required on such

taxable securities depends on the tax rates of the individual and institutional investors.

Investors in high tax brackets benefit most from tax-exempt securities.

2.3.4 Estimating bond yields

The appropriate yield to be offered on a debt security is based on the risk-free rate5 for

the corresponding maturity plus adjustments that capture the various characteristics

discussed thus far (default risk, liquidity and income tax considerations). This calculation

is summarized using the following equation:

TALPDPRFY +++=

Where RF = Risk free rate

DP = Default risk premium

LP = Liquidity risk premium

TA = Adjustment due to difference in tax status

For example, if a three-month T-bill’s annualized rate was 8 percent (a “risk free rate”)

and a corporation planned to issue 90-day commercial paper, it would need to determine

the default premium (DP) and liquidity premium (LP) to offer its commercial paper to

make it as attractive to investors as a three-month T-bill. The federal tax status on

commercial paper is the same as on T-bills. Yet, income earned from investing in

commercial paper is subject to state taxes, whereas income earned from investing in T-

bills is not. Investors may require a premium for this reason alone if they reside in a

location where state and local taxes apply.

Assume that the corporation believed that a 0.7 percent default risk premium, a 0.2

percent liquidity premium and a 0.3 percent tax adjustment were necessary to sell its

commercial paper to investors. The appropriate yield to be offered on the commercial

paper is 9.2%, which equals the risk-free rate (8 %) plus the default risk premium (0.7%)

plus the liquidity risk premium (0.2%) plus the tax adjustment (0.3%).

5 The “risk-free rate” is the theoretical rate of return of an investment with no risk. The risk-free rate

represents the interest an investor would expect from an absolutely risk-free investment over a specified

period of time. The interest rate on a three-month U.S. Treasury bill is often used as a proxy for the risk-

free rate.

31

As time passes, the appropriate commercial paper rate would change, perhaps because of

changes in the risk-free rate, default risk premium, liquidity risk premium or tax

adjustment.


7. Dharma Corp. recently issued debt instruments to finance an expansion of their

foreign operations. Dharma has reported material net losses in their income

statements for the past three years. Under the risk structure of interest rates,

which of the following interest rate characteristics would be most likely be

adjusted to compensate Dharma’s bond investors for the increased risk of loss?

a. Liquidity risk premium.

b. Interest rate risk premium.

c. Default risk premium.

d. Foreign exchange risk premium.

8. Which of the following debt instruments would most likely have the highest

default risk premium?

a. Bond A (AAA rated, 10 year maturity).

b. Bond B (A rated, 5 year maturity).

c. Bond C (B rated, 8 year maturity).

d. Bond D (AA rated, 20 year maturity).

9. Which of the following investors would most likely seek the highest degree of

liquidity when making investment decisions?

a. Investor A has a large amount of short-term liabilities.

b. Investor B has a short cash conversion cycle.

c. Investor C has a small amount of short-term liabilities.

d. Investor D has a large amount of excess cash.

10. Based on the risk structure of interest rates, which of the following investments

would likely have the lowest yield-to-maturity?

a. Bond A is a long-term corporate bond.

32

b. Bond B is a long-term security issued by Fannie Mae.

c. Bond C is a short-term corporate bond.

d. Bond D is a short-term U.S. Treasury bond.

11. Sawyer, Inc. has recently issued corporate bonds to fund an expansion of their

operations. The default risk premium and liquidity risk premium associated with

these bonds is 0.8% and 1.3%, respectively. The tax adjusted risk free rate equals

4.6%. The implied yield on these bonds most likely equals:

a. 2.5%.

b. 4.6%.

c. 4.8%.

d. 6.7%.

2.4 Term Structure of Interest Rates

We have seen how risk, liquidity and tax considerations (collectively embedded in the

risk structure) can influence interest rates. Another factor that influences the interest rate

on a bond is its term to maturity. Bonds with identical risk, liquidity and tax

characteristics may have different interest rates because the time remaining to maturity is

different. This concept is referred to as the term structure of interest rates.

2.4.1 The yield curve

A plot of yields on bonds with differing terms to maturity but the same risk, liquidity and

tax considerations is called a yield curve. The yield curve describes the term structure of

interest rates for particular types of bonds, such as government bonds. Yield curves can

be classified as upward-sloping, flat and downward-sloping. When yield curves slope

upward (the most usual case), the long-term interest rates are above the short-term

interest rates; when yield curves are flat, short- and long-term interest rates are the same;

and when yield curves slope downward, the long-term interest rates are below the short-

term interest rates.

Exhibit 2.3 provides a diagram of two yield curves:

• The blue line on the chart is the more standard (upwardly sloping) yield curve in which

the longer-maturities feature higher yields. The spread between the long maturity issues

over the short maturity ones is positive.

33

• The pink line is an example of an inverted (or downward sloping) yield curve. An

inverted yield curve is often considered an indication of a pending downturn in the

economy as the higher return on short term money will tend to prevent longer-term

investment. Exhibit 2.3 – Yield Curve

Three theories have been put forward to explain the term structure of interest rates – that

is, the relationship among interest rates on bonds of different maturities reflected in yield

curve patterns. These theories include:

• The expectations theory

• The segmented markets theory

• The liquidity premium theory

2.4.2 Expectations theory

According to the expectations theory, the term structure of interest rates (as reflected in

the shape of the yield curve) is determined solely by expectations of future interest rates.

More specifically, the theory states that the interest rate on a long-term bond will equal an

average of the short-term interest rates that people expect to occur over the life of the

long-term bond.

34

For example, if people expect that short-term interest rates will be 10% on average over

the coming five years, the expectations theory predicts that the interest rate on bonds with

five years to maturity will be 10% too. If the short-term interest rates were expected to

rise even higher after this five year period, so that the average short-term interest rate

over the coming 20 years is 11%, then the interest rate on 20-year bonds would equal

11% and would be higher than the interest rate on five-year bonds.

The key assumption behind the expectations theory is that buyers of bonds do not prefer

bonds of one maturity over another, so they will not hold any quantity of a bond if its

expected return is less than that of another bond with a different maturity. Bonds that

have this characteristic are said to be perfect substitutes (i.e. their expected returns are

equal).

The expectations theory explains why the term structure of interest rates (as represented

by yield curves) changes at different times:

When the yield curve is upward-sloping, the expectations theory suggests that short-term

interest rates are expected to rise in the future. In this situation, in which the long-term

rate is currently higher than the short-term rate, the average of future short-term rates in

expected to be higher than the current short-term rate, which can occur only if short-term

interest rates are expected to rise.

When the yield curve is downward-sloping (inverted), the average of future short-term

interest rates is expected to be lower than the current short-term rate, implying that short-

term interest rates are expected to fall (on average) in the future.

When the yield curve is flat, the expectations theory suggests that short-term interest rates

are not expected to change (on average) in the future.

The expectations theory has one significant shortcoming: it cannot explain why yield

curves almost always slope upward. The typical upward slope of yield curves implies that

short-term interest rates are usually expected to rise in the future. In practice, short-term

interest rates are just as likely to fall as they are to rise, and so the expectations theory

suggests that the typical yield curve should be flat rather than upward-sloping.

2.4.3 Segmented markets theory

According the segmented markets theory, investors and borrowers choose securities

with maturities that satisfy their forecasted needs. For example, pension funds and life

insurance companies may generally prefer long-term investments that coincide with their

long-term liabilities. Commercial banks may prefer more short-term investments to

coincide with their short-term liabilities. If investors and borrowers participate only in the

maturity market that satisfies their particular needs, markets are segmented. A transfer by

investors (or borrowers) from the long-term market to the short-term market or vice versa

would occur only if the timing of their cash needs changed. According to the segmented

35

markets theory, the choice of long-term versus short-term maturities is predetermined

according to need rather than expectations of future interest rates.

The key assumption in the segmented markets theory is that bonds of different maturities

are not substitutes at all, so the expected return from holding a bond of one maturity has

no effect on the demand for a bond of another maturity. This theory of the term structure

is the exact opposite of the expectations theory, which assumes that bonds of different

maturities are perfect substitutes.

The segmented markets theory has support because some participants are likely to choose

a maturity based on their needs. A corporation that needs additional funds for 30 days

would not consider issuing long-term bonds for such a purpose. Savers with short-term

funds are restricted from some long-term investments, such as 10-year certificates of

deposit that cannot be easily liquidated.

A limitation of the segmented markets theory is that some borrowers and savers have the

flexibility to choose among various maturity markets. For example, corporations that

need long-term funds may initially obtain short-term financing if they expect interest

rates to decline. Investors with long-term funds may make short-term investments if they

expect interest rates to rise. Some investors with short-term funds available may be

willing to purchase long-term securities that have an active secondary market.

Also, if maturity markets were completely segmented, an adjustment in the interest rate

in one market would have no impact on other markets. Yet, there is clear evidence that

interest rates among maturity markets move closely in tandem over time, proving there is

some interaction among markets, which implies that funds are being transferred across

markets.

Although markets are not completely segmented, the preference of particular maturities

can affect the prices and yields of securities with different maturities and therefore affect

the yield curve’s shape. Therefore, the segmented markets theory appears to be a partial

(but not complete) explanation for the yield curve’s shape.

2.4.4 Liquidity premium theory

The liquidity premium theory of the term structure augments the expectations theory. It

states that the interest rate on a long-term bond will equal an average of short-term

interest rates expected to occur over the life of the long-term bond plus a liquidity

premium that responds to supply and demand conditions for that bond.

Some investors may prefer to own short-term rather than long-term securities because a

shorter maturity represents greater liquidity. In this case, they may require additional

compensation (i.e. a liquidity premium) in return for holding longer-term, less liquid

securities. This preference for the more liquid short-term securities places upward

pressure on the slope of a yield curve.

36

The liquidity premium theory’s key assumption is that bonds of different maturities are

substitutes, but not perfect substitutes as it allows investors to prefer one bond maturity

over another. Investors tend to prefer shorter-term bonds because their prices are less

sensitive to movements in interest rates. Therefore investors must be offered a positive

liquidity premium to induce them to hold longer-term bonds.

The relationship between the expectations theory and the liquidity premium theory is

shown in Exhibit 2.4.

Exhibit 2.4 – Relationship between the Liquidity Premium and Expectations Theory

Interest

rate

Years to

maturity

Expectations

theory yield curve

Liquidity premium

theory yield curve

Liquidity

premium

In this example, the yield curve implied by the expectations theory is flat. Notice that

because the liquidity premium is always positive and typically grows as the term to

maturity increases, the yield curve implied by the liquidity premium theory is always

above the yield curve implied by the expectations theory (and generally has a steeper

slope.

Although the addition of a liquidity premium places significant upward pressure on a

yield curve, it is still possible for the curve to become inverted under this theory. Such an

occurrence would occur at times when short-term interest rates are expected to fall so

much in the future that the average of the expected short-term rates is well below the

current short-term rate. Even when the positive liquidity premium is added to the

average, the resulting long-term rate will still be lower than the current short-term rate.

The liquidity premium theory is the most widely accepted theory of the term structure of

interest rates because it explains the major empirical facts about the term structure so

well. As we have seen, it combines the features of both the expectations theory and the

segmented markets theory by asserting that a long-term interest rate will be the sum of a

37

liquidity premium and the average of the short-term interest rates that are expected to

occur over the life of the bond.


12. On 5/1/201X, bonds A, B & C are being offered in the market under the

following terms: Bond A pays 3% interest with a 5 year term-to-maturity; Bond B

pays 5.5% interest with an 8 year term-to-maturity; Bond C pays 8.5% interest

with a 12 year term-to-maturity. The risk, liquidity and tax profiles of the three

bonds are identical. Under this scenario, the bond yield curve on 5/1/201X is

most likely:

a. Downward sloping.

b. Flat.

c. Upward sloping.

d. Inverted.

13. Which of the following practices would provide support for the liquidity

premium theory that explains the term structure of interest rates?

a. Investor A invests exclusively in short-term debt instruments due to their

liquidity requirements.

b. Investor B requires a higher yield as the term-to-maturity of the debt

instrument increases.

c. Investor C invests in floating rate debt instruments whenever possible.

d. Investor D will accept lower yields on debt instruments that are rated

“AAA”.

38

Chapter 2 Summary

• An interest rate is the cost of borrowing money that is expressed as a percentage of the

amount of the borrowed funds. It also represents the compensation to the lender for the

service and risk of lending money. The two main forms of interest are simple interest and

compound interest.

• A fixed interest rate is one that is established upon purchase (or issuance) of a financial

instrument and remains at that predetermined rate for the entire term of the instrument. A

floating interest rate (a.k.a. a “variable” or “adjustable” interest rate) is one that adjusts

up and down with the rest of the market or along with a specified index.

• A yield-to-maturity (YTM) represents the interest rate that equates the present value of cash

flows received from a debt instrument with its value today. The comparison of a bond’s

YTM with its stated coupon rate will determine the price at which the instrument is traded:

A bond with a stated coupon rate that is less than its YTM will trade at a discount.

A bond with a stated coupon rate that is more than its YTM will trade at a premium.

A bond with a stated coupon rate that is equal to its YTM will trade at par.

• Many financial market participants attempt to understand why interest rates change, how

their movements affect performance, and how to manage according to anticipated

movements. The loanable funds theory, commonly used to explain interest rate

movements, suggests that interest rates are determined by the factors that control the

supply and the demand for loanable funds. Another theory known as the Fisher effect

modifies the underlying concepts of the loanable funds theory by including an adjustment

for inflation.

• The risk structure of interest rates explains why interest rates can vary significantly on

bonds with similar (or even identical) terms-to-maturity. Under this theory, the

appropriate yield to be offered on a debt security equals the theoretical risk free interest

rate plus yield adjustments that reflect the primary characteristics of the debt instrument,

including (1) default risk, (2) liquidity and (3) income tax considerations. Debt

instruments with unfavorable characteristics offer higher yields to encourage investors to

purchase them.

• The term structure of interest rates explains why bonds with identical risk, liquidity and

tax characteristics may have different interest rates because the time remaining to

maturity is different. A yield curve represents a graphical depiction of the term structure

of interest rates. Yield curves can be classified as upward-sloping, flat and downward-

sloping; there are several theories that explain why yield curves have varying shapes,

including (1) the expectations theory. (2) the segmented markets theory and (3) the

liquidity premium theory.

39

Chapter 3 – Central Banking and Monetary Policy



• Recognize the role that the Federal Reserve System (“the Fed”) plays in financial

markets.

• Identify the tools used by the Fed to conduct its monetary policy and explain how these

tools impact the U.S. money supply.

• Calculate the two measures used by the Federal Reserve to estimate the U.S. money

supply (M1 & M2).

3.1 The Federal Reserve System

The Federal Reserve System (the “Fed”) is the central bank of the United States; it has

the responsibility of conducting national monetary policy. Such policy influences interest

rates and other economic variables that determine the prices of financial instruments.

Participants in the financial markets therefore closely monitor the Fed’s monetary policy.

It is important that they understand how the Fed’s actions may influence security prices,

so that they can manage their portfolios in response to the Fed’s policies.

The Federal Reserve System was created in response to several banking panics that

occurred in the later 1800’s and early 1900’s. The Federal Reserve Act of 1913 created

this central banking system and established reserve requirements for those commercial

banks that desired to become members. Rather than establishing one centralized bank (as

was typical in many foreign countries), the Federal Reserve Act established an elaborate

system that included 12 district banks located across the United States. Such an approach

was adopted in response to the fear of centralized power that permeated American

politics in the early 1900’s. In fact, several other attempts to create an effective central

banking system in the United States in the 1800’s failed for precisely that reason.

The Federal Reserve System, as it exists today, has five major components:

Federal Reserve Banks (FRBs)

Member banks

Board of Governors

Federal Open Market Committee (FOMC)

Federal Advisory Committee

40

Exhibit 3.1 – Organization of the Federal Reserve System

3.1.1 Federal Reserve Banks

Each of the 12 Federal Reserve districts (as displayed in Exhibit 3.2) has one main

Federal Reserve Bank, which may have branches in other cities in the district. The three

largest Federal Reserve Banks in terms of assets are those in New York, Chicago and San

Francisco – combined they hold more than 50% of the assets of the Federal Reserve

System.

Each of the Federal Reserve Banks is a quasi-public (part private, part government)

institution owned by the private commercial banks in the district that are members of the

Federal Reserve System. These member banks have purchased stock in their district

Federal Reserve Bank (a requirement of membership), and the dividends paid by the

stock are limited by law. The member banks elect six directors for each district bank;

three more are appointed by the Board of Governors. Together, these nine directors

appoint the president of the bank (subject to the approval of the Board of Governors).

The 12 Federal Reserve Banks perform the following functions:

Clear checks

Issue new currency

Withdraw damaged currency from circulation

Administer and make discount loans to banks in their districts

Evaluate proposed mergers and applications for banks to expand their activities

Act as liaisons between the business community and the Federal Reserve System

Examine bank holding companies and state-chartered member banks

Collect data on local business conditions

41

Exhibit 3.2 – The Federal Reserve Districts

3.1.2 Member Banks

Commercial banks can elect to become member banks if they meet specific

requirements of the Board of Governors. All national banks (chartered by the

Comptroller of the Currency) are required to be members of the Fed, while other banks

(chartered by their respective states) are not. Currently 37% of the commercial banks in

the United States are members of the Federal Reserve System, having declined from a

peak figure of 49% in 1947.

3.1.3 Board of Governors

The Board of Governors (a.k.a. the Federal Reserve Board) is made up of seven

members with offices in Washington D.C. Each member is appointed by the President of

the United States (and confirmed by the Senate) and serves a nonrenewable 14-year term.

Such a long term is thought to reduce political pressure on these members and thus

encourage the development of policies that will benefit the U.S. economy over the long

run. Each member’s starting terms have been staggered so that one term expires in every

even-numbered year.

One of the seven board members is selected by the president to be Federal Reserve

chairman for a four year term, which may be renewed. The chairman has no more voting

power than any other member, but may have more influence. The current Chairman is

Ben S. Bernanke.

The board has two main roles:

42

1. Regulating commercial banks. The Board supervises and regulates commercial

banks that are members of the Fed and bank holing companies. It oversees the

operation of the 12 Federal Reserve districts banks in their provision of services

to depository institutions and their supervision of specific commercial banks. It

also establishes regulations in consumer finance.

2. Controlling monetary policy. The Board has direct control in two monetary

policy tools. First, it has the power to revise reserve requirements imposed on

depository institutions. Second, it authorizes changes in the discount rate, or the

interest rate charged on Fed district bank loans to depository institutions.6

Through legislation, the Board of Governors has often been given duties not directly

related to the items discussed above, including setting the salary of the president and all

officers of each Federal Reserve Bank and reviewing the bank’s budget.

3.1.4 Federal Open Market Committee (FOMC)

The Federal Open Market Committee (FOMC) is made up of the seven members in

the Board of Governors plus presidents of five Fed districts banks (the New York district

bank plus four of the other eleven Fed district banks as determined on a rotating basis).

Presidents of the seven remaining Fed district banks typically participate but are not

allowed to vote on policy decisions. The chairman of the Board of Governors serves as

chairman of the FOMC.

The FOMC usually meets eight times a year (about every six weeks) to review economic

conditions and make decisions regarding the conduct of open market operations7, which

influence the money supply and interest rates.

The main goals of the FOMC are to promote high employment, economic growth and

price stability. Achievement of these goals would stabilize financial markets, interest

rates, foreign exchange values, and so on. Because the FOMC may not be able to achieve

all of its main goals simultaneously, it may concentrate on resolving a particular

economic problem.

3.1.5 Federal Advisory Council (FAC)

The Federal Advisory Council (FAC), which is composed of twelve representatives of

the banking industry, consults with and advises the Board on all matters within the

Board's jurisdiction. The council ordinarily meets four times a year, the minimum

number of meetings required by the Federal Reserve Act. These meetings are always held

in Washington, D.C., customarily on the first Friday of February, May, September, and

6 The concept of “monetary policy” is discussed in further detail in section 3.2. 7 The concept of “open market operations” is discussed in further detail in section 3.2.

43

December, although occasionally the meetings are set for different times to suit the

convenience of either the council or the Board. Each year, each Reserve Bank chooses

one person to represent its District on the FAC, and members customarily serve three

one-year terms. The members elect their own officers.


1. Jack, a market analyst, is researching U.S. central banking practices and their

impact on interest rates. Which of the following institutions would likely have the

greatest impact on market interest rates in the United States?

a. The Internal Revenue Service.

b. The Securities and Exchange Commission.

c. The Federal Reserve System.

d. The Financial Accounting Standards Board.

2. Which of the following scenarios most accurately depicts a central banking

practice in the United States?

a. The Board of Governors votes to raise tax rates on capital gains.

b. The Federal Reserve Bank reviews and approves a proposed merger

between two commercial banks.

c. The Securities and Exchange Commission raises the discount rate

charged for primary credit.

d. The Comptroller of the Currency establishes reserve requirements.

3.2 Monetary Policy

As the United States’ central bank, the Federal Reserve System is responsible for

formulating and implementing monetary policy.

The formulation of monetary policy involves developing a plan aimed at pursuing the

goals of stable prices, full employment and, more generally, a stable financial

environment for the economy. In implementing that plan, the Federal Reserve uses the

tools of monetary policy to induce changes in interest rates, and the amount of money and

credit in the economy. Through these financial variables, monetary policy actions

influence the levels of spending, output, employment and prices.

44

The conduct of monetary policy by the Federal Reserve involves actions that affect its

balance sheet (i.e. its holdings of assets and liabilities):

Exhibit 3.3 – Federal Reserve System Balance Sheet

Federal Reserve System

Assets Liabilities Government securities Currency in circulation

Discount loans Bank reserves

The basic link between monetary policy and the economy is through the market for bank

reserves. The term ‘bank reserves’ refers to funds that banks maintain in a non-interest

earning account at a Federal Reserve Bank (plus vault cash). In the bank reserves market

(more commonly known as the federal funds market), banks and other depository

institutions trade their non-interest-bearing reserve balances held at the Federal Reserve

with each other, usually on an overnight basis. On any given day, depository institutions

that are below their desired reserve positions borrow from others that are above their

desired reserve positions. The benchmark interest rate charged for the short-term use of

these funds is called the federal funds rate. The Federal Reserve’s monetary policy

actions have an immediate effect on the supply of or demand for reserves and the federal

funds rate, initiating a chain of reactions that transmit the policy effects to the rest of the

economy.

The Federal Reserve can change reserves market conditions by using three main tools:

Open market operations

Reserve requirements

Discount lending

3.2.1 Open market operations

The term ‘open market operations’ refers to the primary tool used by the Federal

Reserve to implement its monetary policy. Open market operations by the Federal

Reserve involve the buying and selling of government securities in the secondary market

in which previously issued securities are traded. When the Fed buys securities from a

dealer, it pays by crediting the reserve account of the dealer’s bank at a Federal Reserve

Bank; in effect, the Fed pays for its purchase by writing a check on itself. Since this

transaction involves no offsetting changes in reserves at other depository institutions, the

rise in the reserves of the dealer’s bank increases the aggregate volume of reserves in the

monetary system. When the Fed sells securities to a dealer, the reserve consequence is

exactly the opposite — the payment by the dealer reduces reserves of the dealer’s bank

and of the monetary system.

45

The Federal Reserve normally conducts its open market operations in the U.S. Treasury

securities market. The Fed’s Open Market Desk generally uses two general approaches to

add or drain reserves through changes in the System’s portfolio of securities:

1. Outright purchases and sales. When significant reserve shortages or excesses are

expected to persist for a relatively long period, the Open Market Desk may make outright

purchases or sales (and redemptions) of securities that permanently affect the size of the

Federal Reserve System’s portfolio and the supply of reserves. The Desk generally

conducts outright transactions in the market only a limited number of times each year, to

accommodate long-term reserve needs.

2. Repurchase agreements8. The Desk uses short-term “system” repos with dealers to add

reserves on a temporary basis. Under the repurchase arrangement, the Open Market Desk

buys securities from dealers who agree to repurchase them at a specified price on a

specified date. The added reserves are extinguished automatically when the repos mature.

It is much more convenient for the Fed to inject large amounts of reserves on a temporary

basis through system repos than through outright purchases. Repos allow the Desk to

respond quickly when reserves fall short of desired levels and they can smooth the pattern

of reserves for the maintenance period by meeting needs for particular days. Moreover,

transaction costs for repos are very low, and acceptable collateral is broadly based to

include Treasury bills, notes and bonds and certain federal agency securities held by both

dealers and their customers.

The Fed’s securities transactions have a different impact than another institution’s

transactions. For example, a purchase by the Fed results in additional bank reserves and

increases the ability of banks to make loans and create new deposits. An increase in

reserves can allow for a net increase in deposit balances and therefore an increase in

money supply. Conversely, the purchase of government securities by someone other than

the Fed results in offsetting reserve positions at commercial banks.

3.2.2 Reserve requirements

Reserve requirements, under which depository institutions must hold a fraction of their

deposits as reserves, represent a second monetary policy tool. These requirements are set

by the Board of Governors of the Federal Reserve System.

All depository institutions in the United States, as in many other countries, are subject to

reserve requirements on their customers’ deposits. Commercial banks and thrift

institutions – mutual savings banks, savings and loan associations and credit unions –

whose checkable deposits exceed a certain size are required to maintain cash reserves

equal to a specified fraction of those deposits.

Depository institutions hold required reserves either as cash in their own vaults or as

deposits at their District Federal Reserve Bank. To provide banks and thrifts with

8 Repurchase agreements are discussed in detail in Section 4.2.5.

46

flexibility in meeting their requirements, the Federal Reserve allows them to hold an

average amount of reserves over two-week reserve maintenance periods ending on

alternate Wednesdays, rather than a specific amount on each day. Large banks generally

apply all of their vault cash toward meeting requirements, since their required reserves

exceed their vault cash. Small banks and thrift institutions may hold more vault cash than

their required reserves because they need more cash to meet customer demands than they

do to meet reserve requirements.

In managing their reserve positions, depository institutions attempt to balance two

opposing considerations. As profit-seeking enterprises, they try to keep their reserves,

which produce no income, close to the required minimum. Yet they also must avoid

reserve deficiencies, which carry a penalty charge. In addition, if a depository institution

frequently fails to meet requirements, its senior management is given a warning that

continued failure would put the institution under scrutiny. To clear their ongoing

financial transactions through the Federal Reserve and to maintain a cushion of funds in

order to avoid penalty charges, many depository institutions arrange with their Reserve

Banks to maintain supplementary accounts for required clearing balances. These

additional balances effectively earn interest in the form of credits that can be used to pay

for Federal Reserve services, such as check-clearing and wire transfers of funds and

securities.

Managing the reserve position of a depository institution is a difficult job. The

institution’s reserve position is affected by virtually all of its transactions – whether

carried out for its customers or on its own account. A bank or thrift institution, for

example, loses reserves when it pays out cash or transfers funds by wire on behalf of its

customers. Customer checks to pay out-of-town bills funnel back through its Federal

Reserve Bank and are charged against its reserve or clearing account; customer checks to

pay in-town bills also drain reserves, on a net basis, as accounts among banks are settled.

A bank may also lose reserves when it advances loans or buys securities. On the other

hand, a bank gains reserves from deposits of customer checks and currency, sales of

securities and numerous other transactions. At the end of each day, after the close of wire

transfers of funds and securities, a bank’s reserve position reflects the net of reserve

losses and gains resulting from all of its transactions.

A depository institution facing a reserve deficiency has several options. It can:

Borrow reserves for one or more days from another depository institution.

Sell liquid assets, such as Government securities, pulling in funds from the buyer’s bank.

Bid for funds in the money market, such as large certificates of deposits (CDs) or

Eurodollars.

Borrow from its District Reserve Bank at the prevailing discount rate to compensate for

unforeseen reserve losses (using Government securities or other acceptable collateral).

Note – this is typically done as a last resort.

47

Because the reserve requirement ratio affects the degree to which money supply can

change, it is sometimes modified by the Board of Governors to adjust the money supply.

When the Board of Governors reduces the reserve requirement ratio, it increases the

proportion of a bank’s deposits that can be lent out by depository institutions. As the

funds loaned out are spent, a portion of them will return to the depository institutions in

the form of new deposits. The lower the reserve requirement ratio, the greater the

lending capacity of depository institutions, so any change in bank reserves can cause a

larger change in the money suppliers.

3.2.3 Discount lending

Discount lending represents a third tool for administering monetary policy. The Federal

Reserve Banks lend funds directly to depository institutions at the discount window. All

depository institutions that maintain accounts subject to reserve requirements are entitled

to borrow at the discount window. These include commercial banks, thrift institutions,

and United States branches and agencies of foreign banks.

Federal Reserve Banks have three lending programs for depository institutions:

1. Primary credit. Federal Reserve Banks extend primary credit on a short-term basis

(typically overnight) to depository institutions with strong financial positions and ample

capital, at a rate above the target federal funds rate. An eligible institution need not

exhaust other sources of funds before coming to the discount window, nor are there

restrictions on the purposes for which the borrower can use primary credit. Reserve

Banks determine eligibility for primary credit according to a set of criteria that is uniform

throughout the Federal Reserve System, based mainly on the borrower's examination

ratings and capital.

2. Secondary credit. Reserve Banks offer secondary credit to institutions that do not

qualify for primary credit. As with primary credit, secondary credit is available as a

backup source of liquidity on a short-term basis, provided that the loan is consistent with

a timely return to a reliance on market sources of funds. Longer-term secondary credit

also is available, if necessary, for the orderly resolution of a troubled institution.

3. Seasonal credit. The Fed provides seasonal credit to small- and mid-sized depository

institutions able to demonstrate a clear pattern of recurring intra-year fluctuations in

funding needs. Primary users of seasonal credit are small depository institutions in

agricultural communities. Resort-area banks are another, though less significant, user of

seasonal credit. An interest rate that varies with the level of short-term market interest

rates is applied to seasonal credit.

The discount rate is the interest rate charged to commercial banks and other depository

institutions on loans they receive from their regional Federal Reserve Bank's discount

window. The discount rate charged for primary credit (the primary credit rate) is set

48

above the usual level of short-term market interest rates9. The discount rate on secondary

credit is above the rate on primary credit. The discount rate for seasonal credit is an

average of selected market rates. Discount rates are established by each Reserve Bank's

board of directors, subject to the review and determination of the Board of Governors of

the Federal Reserve System. The discount rates for the three lending programs are the

same across all Reserve Banks except on days around a change in the rate.

To increase money supply, the Fed (specifically the Board of Governors) could authorize

a reduction in the discount rate. This would encourage depository institutions that are

short on funds to borrow from the Fed rather than from other courses such as the federal

funds market. To decrease the money supply, it could attempt to discourage use of the

discount window by increasing the discount rate. Depository institutions in need of short-

term funds would likely obtain funding from alternative sources. As existing discount

loans were repaid to the Fed while new loans were obtained from sources other then the

discount window, there would be a decrease in the level of reserves.


On 12/31/1X, the Federal Reserve reports having the following asset & liability

balances: Securities $1.2 trillion; Currency in circulation $1.5 trillion; Discount loans

$0.8 trillion.

3. Given the information above, the balance of Reserves reported on the Fed’s

12/31/1X balance sheet must have equaled:

a. $0 trillion.

b. $0.5 trillion.

c. $1.1 trillion.

d. $1.9 trillion.

4. Given the information above, the total assets reported on the Fed’s 12/31/1X

balance sheet must have equaled:

a. $0.8 trillion.

b. $1.2 trillion.

c. $1.5 trillion.

d. $2.0 trillion.

9 Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at

times uses the term "discount rate" to mean the primary credit rate.

49

5. Which of the following actions would most likely increase the U.S. money

supply?

a. The Fed purchases government securities in the open market.

b. The Fed sells government securities in the open market.

c. Commercial Bank 1 purchases corporate bonds in the open market.

d. Commercial Bank 2 sells corporate bonds in the open market.

6. Hurley Bank currently has insufficient reserves in their Federal Reserve account.

Which of the following actions would the Bank most likely take in order to

increase their reserves balance?

a. Borrow funds directly from the Federal Reserve.

b. Purchase government securities in the open market.

c. Decrease their reserve requirement ratio.

d. Purchase funds in the federal funds market.

7. Which of the following represents the most likely scenario in which the U.S.

money supply is decreased?

a. A Federal Reserve Bank replaces damaged currency with new

currency.

b. The FOMC purchases government securities in the open market.

c. The Fed Board of Governors increases the primary credit rate.

d. A Member Bank increases its reserve requirement ratio.


money supply is increased?

a. The Federal Reserve increases the reserve requirement ratio.

b. The Federal Reserve increases the foreign exchange rate for the U.S.

dollar.

c. The Federal Reserve increases the discount rate.

d. The Federal Reserve increases its outright purchases of government

securities in the market.

50

3.3 The Money Supply

Thus far we have discussed in detail how actions taken by the Federal Reserve in

accordance with its monetary policy can affect the money supply. However the term

‘money supply’ actually has several definitions.

The U.S. money supply comprises currency (i.e. dollar bills and coins issued by the

Federal Reserve System and the U.S. Treasury) and various kinds of deposits held by the

public at commercial banks and other depository institutions such as thrifts and credit

unions.

3.3.1 Money supply measures

The Federal Reserve publishes weekly and monthly data on two money supply measures.

These measures reflect the different degrees of liquidity that different types of money

have:

$ The narrowest measure, M1, is restricted to the most liquid forms of money; it consists of

currency in the hands of the public; travelers’ checks; demand deposits, and other

deposits against which checks can be written.

$ M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in

retail money market mutual funds.

Exhibit 3.4 – Money Supply Measures (Sample Data)

51

Exhibit 3.4 shows the relative sizes of the two monetary aggregates. In April 2008, M1

was approximately $1.4 trillion, more than half of which consisted of currency. While as

much as two-thirds of U.S. currency in circulation may be held outside the United States,

all currency held by the public is included in the money supply because it can be spent on

goods and services in the U.S. economy. M2 was approximately $7.7 trillion and largely

consisted of savings deposits.

A third measure of money, known as M3, included M2 plus large time deposits,

institutional money-market funds, short-term repurchase agreements, along with other

larger liquid assets. As discussed below, M3 is no longer published.

3.3.2 History of the money supply and monetary policy

The Federal Reserve began reporting monthly data on the level of currency in circulation,

demand deposits, and time deposits in the 1940s, and it introduced the aggregates M1,

M2, and M3 in 1971. The original money supply measures totaled bank accounts by type

of institution. The original M1, for example, consisted of currency plus demand deposits

in commercial banks. Over time, however, new bank laws and financial innovations

blurred the distinctions between commercial banks and thrift institutions, and the

classification scheme for the money supply measures shifted to be based on liquidity and

on a distinction between the accounts of retail and wholesale depositors.

The Full Employment and Balanced Growth Act of 1978, known as the Humphrey-

Hawkins Act, required the Fed to set one-year target ranges for money supply growth

twice a year and to report the targets to Congress. During the heyday of the monetary

aggregates, in the early 1980s, analysts paid a great deal of attention to the Fed's weekly

money supply reports, and especially to the reports on M1. If, for example, the Fed

released a higher-than-expected M1 figure, the markets surmised that the Fed would soon

try to curb money supply growth to bring it back to its target, possibly increasing short-

term interest rates in the process.

Following the introduction of NOW accounts nationally in 1981, however, the

relationship between M1 growth and measures of economic activity, such as Gross

Domestic Product, broke down. Depositors moved funds from savings accounts—which

are included in M2 but not in M1—into NOW accounts, which are part of M1. As a

result, M1 growth exceeded the Fed's target range in 1982, even though the economy

experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for

monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.

By the early 1990s, the relationship between M2 growth and the performance of the

economy also had weakened. Interest rates were at the lowest levels in more than three

decades, prompting some savers to move funds out of the savings and time deposits that

are part of M2 into stock and bond mutual funds, which are not included in any of the

money supply measures. Thus, in July 1993, when the economy had been growing for

more than two years, Fed Chairman Alan Greenspan remarked in Congressional

52

testimony that "if the historical relationships between M2 and nominal income had

remained intact, the behavior of M2 in recent years would have been consistent with an

economy in severe contraction." Chairman Greenspan added, "The historical

relationships between money and income, and between money and the price level have

largely broken down, depriving the aggregates of much of their usefulness as guides to

policy. At least for the time being, M2 has been downgraded as a reliable indicator of

financial conditions in the economy, and no single variable has yet been identified to take

its place."

A variety of factors continue to complicate the relationship between money supply

growth and U.S. macroeconomic performance. For example, the amount of currency in

circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build

up their holdings of the most liquid form of money, and then it showed no increase (even

on a seasonally adjusted basis) in the first half of 2000. Also, the size of the M1

aggregate has been held down in recent years by "sweeps"—the practice that banks have

adopted of shifting funds out of checking accounts that are subject to reserve

requirements into savings accounts that are not subject to reserve requirements.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges

for money supply growth expired, the Fed announced that it was no longer setting such

targets, because money supply growth does not provide a useful benchmark for the

conduct of monetary policy. However, the Fed said, too, that "…the FOMC believes that

the behavior of money and credit will continue to have value for gauging economic and

financial conditions." Moreover, M2, adjusted for changes in the price level, remains a

component of the Index of Leading Economic Indicators, which some market analysts

use to forecast economic recessions and recoveries.

In March 2006, the Federal Reserve Board of Governors ceased publication of the M3

monetary aggregate. M3 did not appear to convey any additional information about

economic activity that was not already embodied in M2. Consequently, the Board judged

that the costs of collecting the data and publishing M3 outweigh the benefits.


Kate, an analyst at the Federal Reserve Bank, calculated the following balances of

U.S. money supply as of 12/31/1X:

Currency in circulation $4.2 trillion

Demand deposits $1.7 trillion

Money market funds (retail) $0.2 trillion

Savings accounts $2.2 trillion

Short-term repos $1.6 trillion

Traveler’s checks $0.6 trillion

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9. Based on the above balances, M1 equals:

a. $2.3 trillion.

b. $4.2 trillion.

c. $6.5 trillion.

d. $8.9 trillion.


a. $6.5 trillion.

b. $8.7 trillion.

c. $8.9 trillion.

d. $10.5 trillion.

11. Which of the following actions would most likely result in a theoretical reduction

of the M2 money measure?

a. Consumer A purchases a government security from the Fed using

money from a checking account.

b. Consumer B transfers money from a savings account to a checking

account.

c. Consumer C purchases travelers’ checks using money from a checking

account.

d. Consumer B transfers money from a checking account to a retail

money market mutual fund.

54

Chapter 3 Summary

• The Federal Reserve System (the “Fed”) is the central bank of the United States; it has

the responsibility of conducting national monetary policy. Such policy influences interest

rates and other economic variables that determine the prices of financial instruments. The

Federal Reserve System, as it exists today, has five major components:

Federal Reserve Banks (FRBs)

Member banks

Board of Governors

Federal Open Market Committee (FOMC)

Federal Advisory Committee

• The Federal Reserve is responsible for formulating and implementing monetary policy,

which involves developing a plan aimed at pursuing the goals of stable prices, full

employment and, more generally, a stable financial environment for the economy. In

implementing that plan, the Fed uses the tools of monetary policy to induce changes in

interest rates, and the amount of money and credit in the economy.

• The primary tool used by the Federal Reserve to implement its monetary policy is

referred to as open market operations. Open market operations primarily involve the Fed

buying and selling of government securities in the secondary market. The Fed generally

conducts open market operations using two general approaches: (1) outright purchasing

and selling securities and (2) transacting repurchase agreements.

• Reserve requirements, under which depository institutions must hold a fraction of their

deposits as reserves, represent a second monetary policy tool. These requirements are set

by the Board of Governors of the Federal Reserve System. All depository institutions in

the United States are subject to reserve requirements on their customers’ deposits. The

reserve requirement ratio is sometimes modified by the Board of Governors to adjust the

money supply.

• Discount lending represents a third tool for administering monetary policy. The Federal

Reserve Banks lend funds directly to depository institutions at the discount window; the

Fed lending programs include primary, secondary and seasonal credit. The discount rate

is the interest rate charged to commercial banks and other depository institutions on loans

they receive from the Fed. To increase (or decrease) money supply, the Fed could reduce

(or increase) the discount rate.

• The U.S. money supply comprises currency (i.e. dollar bills and coins issued by the

Federal Reserve System and the U.S. Treasury) and various kinds of deposits held by the

public at commercial banks and other depository institutions such as thrifts and credit

unions. There are two money supply measures that are currently used: M1 & M2. The use

of a third measure, M3, was discontinued by the Federal Reserve in 2006.

55

Chapter 4 – Money Markets



• Recognize the primary characteristics the money markets.

• Identify the types of financial instruments that would be traded in the money markets.

• Recognize how money market instruments would be utilized by market participants given

specific scenarios.

4.1 Introduction to Money Markets

4.1.1 Money markets defined

The money market is traditionally defined as the market for financial assets that have

original maturities of one year or less. In essence, it is the market for short-term debt

instruments. Money – as in actual currency – is not traded in the money markets. Instead,

financial assets traded in this market include such instruments as U.S. Treasury bills,

commercial paper, banker’s acceptances, federal funds, repurchase agreements, and so

on. These instruments are discussed in detail in section 4.2.

The workings of the money market are largely invisible to the average retail investor. The

reason is that the money market is the province of relatively large financial institutions

and corporations. Namely, large borrowers (e.g. the U.S. Treasury, agencies and banks)

seeking short-term funding as well as large institutional investors with excess cash

willing to supply funds in the short-term. Typically, the only contact that retail investors

have with the money market is through money market mutual funds.

Money market transactions do not take place in any one particular location or building.

Instead, traders usually arrange purchases and sales between participants over the phone

and complete them electronically. Because of this characteristic, money market securities

usually have an active secondary market (i.e. after the security has been sold initially, it is

relatively easy to find buyers who will purchase it in the future). An active secondary

market makes money market securities very flexible instruments to use to fill short-term

liquidity needs.

Another characteristic of the money markets is that they are wholesale markets. This

means that most transactions are very large, usually in excess of $1 million. The size of

these transactions prevents most individual investors from participating directly in the

money markets. Instead, dealers and brokers, operating in trading rooms of large banks

and brokerage houses, bring customers together.

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4.1.2 Money markets participants

The money market is a market in which the cash requirements of market participants who

are surplus units are met along with the requirements of those that are deficit units. This

is identical to any financial market; the distinguishing factor of the money market is that

it provides for only short-term cash requirements. The market will always, without fail,

be required because the needs of surplus and deficit market participants are never

completely synchronized.

The participants in the market are many and varied, and large numbers of them are both

borrowers and lenders at the same time. They include:

• U.S. Treasury Department. The U.S. Treasury Department is unique because it is

always a demander of money market funds and never a supplier. The U.S Treasury is the

largest of all money market borrowers worldwide. It issues Treasury bills (often called

T-bills) and other securities that are popular with other money market participants.

Short-term issues enable the government to raise funds until tax revenues are received.

The Treasury also issues T-bills to replace maturing issues.

• Federal Reserve System. The Federal Reserve is the Treasury’s agent for the

distribution of all government securities. The Fed holds vast quantities of Treasury

securities that it sells if it believes that the money supply should be reduced. Similarly,

the Fed will purchase Treasury securities if it believes that the money supply should be

expanded. The Fed’s responsibility for the money supply makes it the single most

influential participant in the U.S. money market.

• Commercial Banks. Commercial banks hold a larger percentage of U.S. government

securities than any other group of financial institutions. This is partly because of

regulations that limit the investment opportunities available to banks. Specifically, banks

are prohibited from owning risky financial instruments, such as stocks or corporate

bonds. There are no restrictions against holding Treasury securities because of their low

risk and high liquidity. Banks are also the major issuer of negotiable certificates of

deposit (CDs), banker’s acceptances, federal funds and repurchase agreements.

• Businesses. Many businesses buy and sell securities in the money markets. Such activity

is usually limited to major corporations because of the large dollar amounts involved. As

discussed earlier, the money markets are used extensively by businesses both to

warehouse surplus funds and to raise short-term funds.

• Investment and Securities Firms. These firms include:

o Investment Companies. Large diversified brokerage firms are active in the money

markets. The primary function of these dealers is to “make a market” for money market

securities by maintaining an inventory from which to buy or sell. These firms are very

important to the liquidity of the money market because they ensure that sellers can

readily market their securities.

o Finance Companies. Finance companies raise funds in the money markets primarily by

selling commercial paper. They then lend the funds to consumers for the purchase of

durable goods such as cars, boats or home improvements.

57

o Insurance Companies. Property and casualty insurance companies must maintain

liquidity because of their unpredictable need for funds. When four hurricanes hit Florida

in 2004, for example, insurance companies paid out billions of dollars in benefits to

policy holders. To meet this demand for funds, the insurance companies sold some of

their money market securities to raise cash.

o Pension Funds. Pension funds invest a portion of their cash in the money markets so

that they can take advantage of investment opportunities that they may identify in other

financial markets. Like insurance companies, pension funds must have sufficient

liquidity to meet their obligations. However, because their obligations are reasonably

predictable, large money market security holdings are unnecessary.

• Individuals. Individuals can participate in the money market by investing in money

market mutual funds. The advantage of these funds is that they give investors with

relatively small amounts of cash to invest access to large-denomination securities.

Exhibit 4.1 – Money Market Participants

Participant Role U.S. Treasury Department Sells U.S. Treasury securities to fund national debt

Federal Reserve System Buys and sells U.S. Treasury securities as its primary method of

controlling the money supply

Commercial banks Buy U.S. Treasury securities; sell certificates of deposit and make

short-term loans; offer individual investors accounts that invest in

money market securities

Businesses Buy and sell various short-term securities as a regular part of their

cash management

Investment companies Trade on behalf of commercial accounts

Finance companies Lend funds to individuals

Insurance companies Maintain liquidity needed to meet unexpected demands

Pension funds Maintain funds in money market instruments in readiness for

investment in other financial instruments (such as stocks and bonds)

Individuals Buy money market mutual funds

58


An auditor for Sawyer Bank observes that the institution executed several

transactions in the money markets during the current reporting period.

1. Which of the following most likely summarizes the terms of these transactions?

a. Long terms-to-maturity; large denominations.

b. Short terms-to-maturity; small denominations.

c. Long terms-to-maturity; small denominations.

d. Short terms-to-maturity; large denominations.

2. Which of the following statements best describes Sawyer Bank’s ability to sell

their money market instruments to meet short-term cash needs?

a. Money market instruments have an active secondary market and are

considered highly liquid.

b. Money market instruments have no secondary market and are

considered highly illiquid.

c. Money market instruments have long terms-to-maturity and complex

terms, thus making them difficult to sell in the secondary market.

d. Money market instruments are already a form of currency.

3. Which of the following statements best summarizes the U.S. Treasury’s

participation in the money markets?

a. The U.S. Treasury purchases commercial paper of most major U.S.

corporations.

b. The U.S. Treasury issues long-term debt securities to fund Social Security

obligations.

c. The U.S. Treasury issues T-bills to finance current federal deficits.

d. The U.S. Treasury purchases shares of common stock for investment

purposes.

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4.2 Money Market Instruments

A variety of money market instruments are available to meet the diverse needs of market

participants. However these instruments have three basic characteristics in common:

They are usually sold in large denominations.

They have low default risk.

They mature in one year or less from their original issue date. Most money market

instruments mature in less than 120 days.

This section will discuss the primary characteristics of money market securities and how

market participants use them to manage their cash.

4.2.1 Treasury bills

Treasury bills (a.k.a. T-bills) are short-term securities issued by the U.S. Treasury. The

Treasury sells bills at regularly scheduled auctions to refinance maturing issues and to

help finance current federal deficits. It also sells bills on an irregular basis to smooth out

the uneven flow of revenues from corporate and individual tax receipts. Persistent federal

deficits have resulted in rapid growth in Treasury bills over the past several decades.

Treasuries bills are considered to be risk-free because they are backed by the United

States government.

Treasury bills were first authorized by Congress in 1929. After experimenting with a

number of bill maturities, the Treasury in 1937 settled on the exclusive issue of three-

month bills. In December 1958 these were supplemented with six-month bills in the

regular weekly auctions. In 1959 the Treasury began to auction one-year bills on a

quarterly basis. The quarterly auction of one-year bills was replaced in August 1963 by

an auction occurring every four weeks. The Treasury in September 1966 added a nine-

month maturity to the auction occurring every four weeks but the sale of this maturity

was discontinued in late 1972. Since then, the only regular bill offerings have been the

offerings of three- and six-month bills every week and the offerings of one-year bills

every four weeks. The Treasury has increased the size of its auctions as new money has

been needed to meet enlarged federal borrowing requirements.

In addition to its regularly scheduled sales, the Treasury raises money on an irregular

basis through the sale of cash management bills, which are usually "re-openings" or sales

of bills that mature on the same date as an outstanding issue of bills. Cash management

bills are designed to bridge low points in the Treasury's cash balances. Many cash

management bills help finance the Treasury's requirements until tax payments are

received.

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Auctioning New T-Bills

Weekly offerings of three- and six-month Treasury bills are typically announced on

Tuesday. The auction is usually conducted on the following Monday, with delivery and

payment on the following Thursday. Bids, or tenders, in the weekly auctions must be

presented at Federal Reserve Banks or their branches, which act as agents for the

Treasury, by 1:00 p.m. New York time on the day of the auction.

Bids may be made on a competitive or noncompetitive basis:

➢ Competitive bids are generally made by large investors who are in close contact with the

market. In making a competitive bid the investor states the quantity of bills he desires and

the price he is willing to pay per $100 of face value. He may enter more than one bid

indicating the various quantities he is willing to take at different prices.

➢ Non-competitive bids are limited to $1 million for each new offering of three- and six-

month bills. As a result, these bids are usually made by only individuals and other small

investors. In making a noncompetitive bid the investor indicates the quantity of bills

desired and agrees to pay the weighted-average price of accepted competitive bids.

The results of weekly auctions of 13-week and 26-week Treasury bills are summarized in

major daily newspapers each Tuesday. Some of the more commonly reported statistics

include the dollar amount of applications and Treasury securities sold, the average price

of the accepted competitive bids, and the coupon equivalent (annualized yield) for

investors who paid the average price.

4.2.2 Federal funds

The federal funds market was introduced during the discussion of U.S. monetary policy

in Chapter 3. Federal funds (a.k.a. ‘fed funds’) are the heart of the money market in the

sense that they are the core of the overnight market for credit in the United States.

Moreover, current and expected interest rates on federal funds are the basic rates to which

all other money market rates are anchored. Understanding the federal funds market

requires, above all, recognizing that its general character has been shaped by Federal

Reserve policy. From the beginning, Federal Reserve regulatory rulings have encouraged

the market's growth. Equally important, the federal funds rate has been a key monetary

policy instrument.

Three features taken together distinguish federal funds from other money market

instruments:

Fed funds are short-term borrowings of immediately available money – funds

which can be transferred between depository institutions within a single business

day.

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Fed funds can be borrowed by only those depository institutions that are

required to hold reserves with Federal Reserve Banks. They are commercial

banks, savings banks, savings and loan associations, and credit unions.

Depository institutions are also the most important eligible lenders in the market.

The Federal Reserve, however, also allows depository institutions to classify

borrowings from U.S. government agencies and some borrowings from non-bank

securities dealers as federal funds.

Federal funds borrowed are exempt from both reserve requirements and

interest rate ceilings.

The supply of and demand for federal funds arise in large part as a means of efficiently

distributing reserves throughout the banking system. On any given day, individual

depository institutions may be either above or below their desired reserve positions.

Reserve accounts bear no interest, so banks have an incentive to lend reserves beyond

those required plus any desired excess. Banks in need of reserves borrow them. The

borrowing and lending take place in the federal funds market at a competitively

determined interest rate known as the federal funds rate.

Methods of Federal Funds Exchange

Federal funds transactions can be initiated by either the lender or the borrower. An

institution wishing to sell (loan) federal funds locates a buyer (borrower) directly through

an existing banking relationship or indirectly through a federal funds broker. Federal

funds brokers maintain frequent telephone contact with active funds market participants

and match purchase and sale orders in return for a commission. Normally, competition

among participants ensures that a single funds rate prevails throughout the market.

However, the rate might be tiered so that it is higher for a bank under financial stress.

Moreover, banks believed to be particularly poor credit risks may be unable to borrow

federal funds at all.

Two methods of federal funds transfer are commonly used. To execute the first type of

transfer, the lending institution authorizes the district Reserve Bank to debit its reserve

account and to credit the reserve account of the borrowing institution. Fedwire, the

Federal Reserve System's wire transfer network, is employed to complete a transfer.

The second method simply involves reclassifying respondent bank demand deposits at

correspondent banks as federal funds borrowed. Here, the entire transaction takes place

on the books of the correspondent. To initiate a federal funds sale, the respondent bank

simply notifies the correspondent of its intentions. The correspondent purchases funds

from the respondent by reclassifying the respondent's demand deposits as “federal funds

purchased.” The respondent does not have access to its deposited money as long as it is

classified as federal funds on the books of the correspondent. Upon maturity of the loan,

the respondent's demand deposit account is credited for the total value of the loan plus an

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interest payment for use of the funds. The interest rate paid to the respondent is usually

based on the nationwide average federal funds rate.

Types of Federal Funds Instruments

The most common type of federal funds instrument is an overnight, unsecured loan

between two financial institutions. Overnight loans are, for the most part, booked without

a formal, written contract. Banks exchange oral agreements based on any number of

considerations, including how well the corresponding officers know each other and how

long the banks have mutually done business. Brokers play an important role by

evaluating the quality of a loan when no previous arrangement exists. Formal contracting

would slow the process and increase transaction costs. The oral agreement as security is

virtually unique to federal funds.

Federal funds loans are sometimes arranged on a longer-term basis, e.g., for a few weeks.

Two types of longer-term contracts predominate: term and continuing contract federal

funds.

• Term federal funds contracts specify a fixed term to maturity together with a fixed daily

interest rate. It runs to term unless the initial contract explicitly allows the borrower to

prepay the loan or the lender to call it before maturity.

• Continuing contract federal funds are overnight federal funds loans that are

automatically renewed unless terminated by either the lender or the borrower. This type

of arrangement is typically employed by correspondents who purchase overnight federal

funds from respondent banks. Unless notified by the respondent to the contrary, the

correspondent will continually roll the inter-bank deposit into federal funds, creating a

longer-term instrument of open maturity.

In some cases federal funds transactions are explicitly secured. In a secured transaction

the purchaser places government securities in a custody account for the seller as collateral

to support the loan. The purchaser, however, retains title to the securities. Upon

termination of the contract, custody of the securities is returned to the owner. Secured

federal funds transactions are sometimes requested by the lending institution.

4.2.3 Commercial paper

Commercial paper is a short-term unsecured promissory note issued by corporations

and foreign governments. For many large, creditworthy issuers, commercial paper is a

low-cost alternative to bank loans. Issuers are able to efficiently raise large amounts of

funds quickly and without expensive Securities and Exchange Commission (SEC)

registration by selling paper, either directly or through independent dealers, to a large and

varied pool of institutional buyers. Investors in commercial paper earn competitive,

market-determined yields in notes whose maturity and amounts can be tailored to their

specific needs.

63

The Securities Act of 1933 requires that securities offered to the public be registered with

the Securities and Exchange Commission. Registration requires extensive public

disclosure, including issuing a prospectus on the offering, and is a time-consuming and

expensive process.10 Most commercial paper is issued under Section 3(a)(3) of the 1933

Act which exempts from registration requirements short-term securities as long as they

have certain characteristics.

The exemption requirements have been a factor shaping the characteristics of the

commercial paper market. These requirements include:

The maturity of commercial paper must be less than 270 days. In practice, most

commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the

average maturity. Many issuers continuously roll over their commercial paper, financing

a more-or-less constant amount of their assets using commercial paper. Continuous

rollover of notes does not violate the nine-month maturity limit as long as the rollover is

not automatic but is at the discretion of the issuer and the dealer. Many issuers will adjust

the maturity of commercial paper to suit the requirements of an investor.

Notes must be of a type not ordinarily purchased by the general public. In practice, the

denomination of commercial paper is large: minimum denominations are usually

$100,000, although face amounts as low as $10,000 are available from some issuers.

Because most investors are institutions, typical face amounts are in multiples of $1

million. Issuers will usually sell an investor the specific amount of commercial paper

needed.

Proceeds from commercial paper issues must be used to finance "current

transactions." This includes the funding of operating expenses and the funding of current

assets such as receivables and inventories. Proceeds cannot be used to finance fixed

assets, such as plant and equipment, on a permanent basis. The SEC has generally

interpreted the current transaction requirement broadly, approving a variety of short-term

uses for commercial paper proceeds. Proceeds are not traced directly from issue to use, so

firms are required to show only that they have a sufficient "current transaction" capacity

to justify the size of the commercial paper program (for example, a particular level of

receivables or inventory). Firms are allowed to finance construction as long as the

commercial paper financing is temporary and to be paid off shortly after completion of

construction with long-term funding through a bond issue, bank loan, or internally

generated cash flow.

Like Treasury bills, commercial paper is typically a discount security: the investor

purchases notes at less than face value and receives the face value at maturity. The

difference between the purchase price and the face value is the interest received on the

investment. Occasionally, investors request that paper be issued as an interest-bearing

note. The investor pays the face value and, at maturity, receives the face value and

accrued interest. All commercial paper interest rates are quoted on a discount basis.

10 Registration for short-term securities is especially expensive because the registration fee is a percent of

the face amount at each offering. Thirty-day registered notes, rolled over monthly for one year, would cost

12 times as much as a one-time issuance of an equal amount of one-year notes.

64

Placement

Most firms place their paper through dealers who, acting as principals, purchase

commercial paper from issuers and resell it to the public. Most dealers are subsidiaries of

investment banks or commercial bank holding companies. A select group of very large,

active issuers, called direct issuers, employ their own sales forces to distribute their

paper.

When an issuer places its commercial paper through a dealer, the issuer decides how

much paper it will issue at each maturity. The dealer is the issuer's contact with investors

and provides the issuer with relevant information on market conditions and investor

demand. Dealers generally immediately resell commercial paper purchased from issuers

and do not hold significant amounts of commercial paper in inventory. Dealers will

temporarily hold commercial paper in inventory as a service to issuers, such as to meet an

immediate need for a significant amount of funds at a particular maturity.

The secondary market in commercial paper is small, primarily because of the

heterogeneous characteristics and short maturity periods of the instruments. Dealers will

sometimes purchase paper from issuers or investors, hold the paper in inventory and

subsequently trade it. Bids for commercial paper of the largest issuers are available

through brokers.


4. Default risk would least likely be associated with which of the following financial

assets?

a. Company A’s long-term corporate bond.

b. Company B’s mortgage loan portfolio.

c. Company C’s Treasury bill.

d. Company D’s non-agency debt security.

5. Which of the following scenarios depicts the most likely use of federal funds

purchased in the money market?

a. Bank A purchases federal funds to earn interest income.

b. Bank B purchases federal funds to cover a reserve deficiency.

c. Bank C purchases federal funds as a speculative investment.

d. Bank D purchases federal funds to fund a capital project.

65

Kwon Corp. is planning to issue commercial paper on January 1st to meet certain

financing requirements. They wish to avoid the costs associated with registering this

issuance with the SEC. They plan to place their commercial paper through a dealer.

6. Which of the following scenarios would disqualify Kwon Corp.’s commercial

paper issuance from the registration exemption provided in the Securities Act

of 1933?

a. The instrument pays a 6% fixed rate of interest.

b. The proceeds will be used to fund current period expenses.

c. The maturity date of the issuance is October 31st (of the same year).

d. The instrument will be issued at a discount.

7. Which of the following best describes the role that the dealer would most likely

play in the issuance of Kwon Corp.’s commercial paper?

a. The dealer would purchase the paper directly from Kwon Corp. and

market it to individual investors.

b. The dealer would determine the issuance amount and maturity.

c. The dealer would distribute the proceeds received from the issuance.

d. The dealer would purchase the paper in the secondary market.

4.2.4 Certificates of deposit

Since the early 1960s, certificates of deposit (CDs) have been used by banks and other

depository institutions as a source of purchased funds and as a means of managing their

liability positions. These instruments have also been an important component of the

portfolios of money market investors.

A certificate of deposit (CD) is a document evidencing a time deposit placed with a

depository institution. The certificate states the amount of the deposit, the maturity date,

the interest rate and the method under which the interest is calculated. Its minimum

denomination is $100,000; large negotiable CDs are generally issued in denominations of

$1 million or more.

A CD can be legally negotiable or nonnegotiable, depending on certain legal

specifications of the CD:

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Negotiable CDs can be sold by depositors to other parties who can in turn resell them.

Nonnegotiable CDs generally must be held by the depositor until the instrument’s

maturity.

A CD may be payable to the bearer or registered in the name of the investor. Most large

negotiable CDs are issued in bearer form because investors can resell bearer CDs more

easily. Registration adds complication and costs to the process of transferring ownership

of CDs.

Federal banking agency regulations limit the minimum maturity of a time deposit to

seven days. Most CDs have original maturities of 1 to 12 months, although some have

maturities as long as five years or more.

Interest rates on CDs are generally quoted on an interest-bearing basis with the interest

computed on the basis of a 360-day year. A $1 million, 90-day CD with a 3 percent

annual interest rate would after 90 days entitle the holder of the CD to:

$1,000,000 x [1 + (90/360) x 0.03] = $1,007,500.

This method of calculating interest is known as “actual/360 basis.” At some banks,

however, interest on CDs is computed on the basis of a 365-day year. When calculated on

an “actual/365 basis”, a $1 million, 90-day CD would have to pay a stated rate of 3.04

percent to offer the holder a return equivalent to a CD that paid 3 percent on a CD basis:

$1,000,000 x [1 + (90/365) x 0.0304] = $1,007,500.

Banks usually pay interest semiannually on fixed-rate CDs with maturities longer than

one year, although the timing of interest payments is subject to negotiation.

Variable-Rate CDs

Variable-rate CDs, also called variable-coupon CDs or floating-rate CDs, have been

available in the United States since 1975 from both domestic banks and the branches of

foreign banks. These instruments have the distinguishing feature that their total maturity

is divided into equally long rollover periods, also called legs or roll periods, in each of

which the interest rate is set anew. The interest accrued on a leg is paid at the end of that

leg.

The interest rate on each leg is set at some fixed spread to a certain base rate which is

usually either a composite secondary market CD rate, a Treasury bill rate, LIBOR, or the

prime rate. The maturity of the instrument providing the base rate is equal in length to

that of the leg. For example, the interest rate on a variable-rate CD with a one-month roll

might be reset every month with a fixed spread to the composite one-month secondary

market CD rate. The most popular maturities of variable-rate CDs are 18 months and two

years, and the most popular roll periods are one and three months.

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Variable-rate CDs are used by issuing banks because they improve their liquidity

positions by providing funds for relatively long periods. They are purchased by money

market investors who want to invest in instruments with long-term maturities but wish to

be protected from loss if interest rates increase. The largest investors in variable-rate CDs

are money market funds. Money market funds are allowed by SEC regulations to treat

their holdings as if they had maturities equal to the length of the roll.

Issuing Banks

Only money center banks and large regional banks are able to sell negotiable CDs in the

national market. Large CDs perform two important functions for these banks. First, large

CDs can be issued quickly to fund new loans. Second, they enable banks to limit their

exposure to interest rate risk that can arise when there is a difference between the interest

rate sensitivity of their assets and their liabilities. For example, a bank may find that on

average its assets mature or re-price every nine months while its liabilities mature or re-

price every six months. Should interest rates rise, this bank's interest earnings on its

assets would rise more slowly than its cost of funds so that its net income would decline.

To limit this risk, the bank may increase the average maturity of its liabilities by issuing

fixed-rate, negotiable CDs with maturities of one year.

Deposit Notes and Bank Notes

In the mid-1980s a number of large U.S. banks began issuing deposit notes and bank

notes:

• Deposit notes are essentially equivalent to negotiable CDs. They are negotiable time

deposits, generally sold in denominations of $1 million, have federal deposit insurance

covering only $100,000 of the deposit, are sold largely to institutional investors, and

normally carry a fixed rate of interest. Deposit notes differ from most negotiable CDs by

calculating their interest payments in the same manner as on corporate bonds. Banks

began issuing deposit notes in an attempt to appeal to investors who typically invested in

medium-term corporate bonds, so they have maturities in the 18-month to five-year

range. U.S. branches of foreign banks are major issuers of deposit notes. There are no

data available on outstanding amounts of deposit notes since these notes are reported by

banks as large CDs on financial statements to federal regulators.

• Bank notes were developed by banks as a way to gather funds not subject to federal

deposit insurance premiums. Bank notes are identical to deposit notes except that they

are not reported as deposits on issuing banks' financial statements. Instead bank notes are

reported along with several other liabilities as "borrowed money." There is no data

available on the outstanding amounts of bank notes.

4.2.5 Repurchase agreements

The terms repurchase agreement (repo) and reverse repurchase agreement refer to a

type of transaction in which a money market participant acquires immediately available

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funds by selling securities and simultaneously agreeing to repurchase the same or similar

securities after a specified time at a given price (which typically includes interest at an

agreed-upon rate). Such a transaction is referred to as a repo when viewed from the

perspective of the supplier of the securities (the party acquiring funds) and a reverse repo

when described from the point of view of the supplier of funds.

In many respects, repos are hybrid transactions that combine features of both secured

loans and outright purchase and sale transactions but do not fit cleanly into either

classification. The use of margin (or “haircuts”) in valuing repo securities, the right of

repo borrowers to substitute collateral in term agreements, and the use of mark-to-market

provisions are examples of repo features that typically are characteristics of secured

lending arrangements but are rarely found in outright purchase and sale transactions. The

repo buyer's right to trade the securities during the term of the agreement, by contrast,

represents a transfer of ownership that typically does not occur in collateralized lending

arrangements.

Characteristics of Repurchase Agreements

Maturities. Repurchase agreements usually are arranged with short terms-to-maturity:

overnight or a few days. Longer-term repos are arranged for standard maturities of one,

two, and three weeks and one, two, three, and sometimes six months. Other fixed-term,

multi-day contracts are negotiated occasionally and repos also may be arranged on an

"open" or continuing basis. Continuing contracts resemble a series of overnight repos;

they are renewed each day with the repo rate or the amount of funds invested adjusted to

reflect prevailing market conditions. If, for example, the market value of the securities

being held as collateral were to fall below an agreed-upon level, the borrower would be

asked to return funds or provide additional securities. Continuing contracts usually may

be terminated on demand by either party.

Principal Amounts. Repo transactions are usually arranged in large dollar amounts.

Overnight contracts and term repos with maturities of a week or less are often arranged in

amounts of $25 million or more, and blocks of $10 million are common for longer-

maturity term agreements. Although a few repos are negotiated for amounts under

$100,000, the smallest customary amount for transactions with securities dealers is $1

million.

Yields. The lender or buyer in a repurchase agreement is entitled to receive compensation

for use of the funds provided to its counterparty. In some agreements, this is

accomplished by setting the negotiated repurchase price above the initial sale price, with

the difference between the two representing the amount of interest owed to the lender. It

is more typical, however, for the sale and repurchase prices to be the same, with an

agreed-upon rate of interest to be paid separately by the borrower on the settlement date.

Repo Rates & Returns

The interest rate paid on repo funds, the repo rate of return, is negotiated by the repo

counterparties and is set independently of the coupon rate (or rates) on the underlying

69

securities. In addition to factors related to the terms and conditions of individual repo

arrangements, repo interest rates are influenced by overall money market conditions, the

competitive rates paid for comparable funds in related markets, and the availability of

eligible collateral.

Repo rates are quoted on an investment basis with a bank discount annualization factor.

The dollar amount of interest earned on funds invested in a repo is determined as follows:

Interest earned = funds invested * repo rate * (number of days/360)

For example, a $1 million overnight repo investment at a 5.75 percent rate would yield an

interest return of $159.72:

$1,000,000 x .0575 x (1/360) = $159.72.

If the funds were invested in a ten-day term agreement at the same rate of 5.75 percent,

the investor's interest earnings would look as follows:

$1,000,000 x .0575 x (10/360) = $1,597.22.

As a final example, suppose that the investor had entered into a continuing contract with

the borrower at an initial rate of 5.75 percent, but withdrew from the arrangement after a

period of five days. Assuming repo rates changed as indicated below, the investor's return

over the period would be $802.22:

Day Repo Rate Calculation Interest

1 5.75% $1,000,000 * 0.575 * (1/360) = $159.72

2 5.80% $1,000,000 * 0.580 * (1/360) = $161.11

3 5.83% $1,000,000 * 0.583 * (1/360) = $161.94

4 5.78% $1,000,000 * 0.578 * (1/360) = $160.56

5 5.72% $1,000,000 * 0.572 * (1/360) = $158.89

Total interest earned $802.22

If the investor had entered into a five-day term agreement at the rate of 5.75 percent

prevailing on the first day, he would have earned only $798.60 in interest. Thus, in this

hypothetical example, the movement in rates worked to the investor's advantage.

4.2.6 Banker’s acceptances

A banker’s acceptance is a time draft drawn on and accepted by a bank. Before

acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer

to the bank to pay a specified sum of money on a specified date to a named person or to

the bearer of the draft. Upon acceptance, which occurs when an authorized bank

employee stamps the draft "accepted" and signs it, the draft becomes a primary and

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unconditional liability of the bank. If the bank is well known and enjoys a good

reputation, the accepted draft may be readily sold in an active market.

Acceptances arise most often in connection with international trade: U.S. imports and

exports and trade between foreign countries. An American importer may request

acceptance financing from its bank when, as is frequently the case in international trade,

it does not have a close relationship with and cannot obtain financing from the exporter it

is dealing with. Once the importer and bank have completed an acceptance agreement, in

which the bank agrees to accept drafts for the importer and the importer agrees to repay

any drafts the bank accepts, the importer draws a time draft on the bank. The bank

accepts the draft and discounts it; that is, it gives the importer cash for the draft but gives

it an amount less than the face value of the draft. The importer uses the proceeds to pay

the exporter.

The bank may hold the acceptance in its portfolio or it may sell (or “rediscount”) it in the

secondary market. In the former case, the bank is making a loan to the importer; in the

latter case, it is in effect substituting its credit for that of the importer, enabling the

importer to borrow in the money market. On or before the maturity date, the importer

pays the bank the face value of the acceptance. If the bank rediscounted the acceptance in

the market, the bank pays the holder of the acceptance the face value on the maturity

date.

An alternative form of acceptance financing available to the importer involves a letter of

credit. If the exporter agrees to this form of financing, the importer has its bank issue a

letter of credit on its behalf in favor of the exporter. The letter of credit states that the

bank will accept the exporter's time draft if the exporter presents the bank with shipping

documents that transfer title on the goods to the bank. The bank notifies the exporter of

the letter of credit through a correspondent bank in the exporter's country.


Shephard Bank has issued a new $100,000 time deposit product. The instrument has a

4% annual interest rate; interest is paid at the end of ninety days based on an

actual/360 basis. The holder is able to sell the instrument to a third party under the

terms of the instrument.

8. Shephard Bank’s financial product is most likely an example of:

a. A repurchase agreement.

b. A nonnegotiable certificate of deposit.

c. A reverse repurchase agreement.

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d. A negotiable certificate of deposit.

9. The interest due to the holder of Shephard Bank’s financial product upon

maturity equals:

a. $0.

b. $1,000.

c. $4,000.

d. $16,000.

Libby Bank has entered into a contract wherein they will (1) purchase a fixed income

security with a $10,000,000 par value from Hurley Bank today at a specified price and

(2) sell the same security back to Hurley Bank tomorrow at the same price. This

transaction has a 3.5% rate of return that is calculated on an actual/360 basis.

10. Libby Bank’s transaction with Hurley Bank is most likely an example of:

a. A reverse repurchase agreement.

b. A variable rate certificate of deposit.

c. A repurchase agreement.

d. A fixed coupon certificate of deposit.

11. Under the specified terms, __________ will be paid approximately _________ of

interest at the conclusion of this transaction.

a. Hurley Bank; $959.

b. Hurley Bank; $972.

c. Libby Bank; $959.

d. Libby Bank; $972.

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Chapter 4 Summary

• The money market is the market for short-term debt instruments (i.e. financial assets that

have original maturities of one year or less), including U.S. Treasury bills, commercial

paper, banker’s acceptances, federal funds, repurchase agreements, etc. Money market

transactions normally take place electronically and have an active secondary market.

Most money market transactions are very large, usually in excess of $1 million.

• The most active participants in the money markets are large governmental institutions

(such as the U.S. Treasury Department and Federal Reserve System) and financial

institutions (including commercial banks, investment and securities firms).

• Treasury bills (a.k.a. T-bills) are short-term securities issued by the U.S. Treasury. The

Treasury sells bills at regularly scheduled auctions to refinance maturing issues and to

help finance current federal deficits.

• Federal funds (a.k.a. ‘fed funds’) are short-term borrowings available to member banks of

the Federal Reserve System. This money market instrument is designed to enable

member banks that are temporarily short of their reserve requirement to borrow funds

from other banks that have excess reserves. The borrowing and lending take place in the

federal funds market at a competitively determined interest rate known as the federal

funds rate. The most common type of federal funds instrument is an overnight, unsecured

loan between two financial institutions (however longer term transactions are available).

• Commercial paper is a short-term unsecured promissory note issued by corporations and

foreign governments. Commercial paper allows issuers to efficiently raise large amounts

of funds quickly and without expensive Securities and Exchange Commission (SEC)

registration. In order to be exempt from this registration: The maturity of commercial paper must be less than 270 days.

Notes must be of a type not ordinarily purchased by the general public.

Proceeds from commercial paper issues must be used to finance "current transactions."

• A certificate of deposit (CD) is a document evidencing a time deposit placed with a

depository institution. The certificate states the amount of the deposit, the maturity date,

the interest rate and the method under which the interest is calculated. CD’s may (1) be

negotiable or non-negotiable and (2) pay interest based on a fixed or variable rate.

• Repurchase agreements (repos) are a type of transaction in which a money market

participant acquires immediately available funds by selling securities and simultaneously

agreeing to repurchase the same or similar securities after a specified time at a given

price, which typically includes interest at an agreed-upon rate (known as the repo rate of

return). These transactions typically have very short terms-to-maturity (overnight or a

few days) and large principal amounts. The dollar amount of interest earned on funds

invested in a repo equals the funds invested * repo rate * (number of days/360).

• A banker’s acceptance is a time draft drawn on and accepted by a bank. Acceptances

arise most often in connection with international trade: U.S. imports and exports and

trade between foreign countries. A similar type of agreement is known as a letter of

credit.

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Chapter 5 – Capital Markets (Part I)



• Recognize the primary characteristics the bond and stock markets.

• Identify the unique attributes of Treasury, municipal and corporate bonds.

• Calculate the taxable equivalent yield of a municipal bond.

• Recognize the differences between common and preferred stock.

• Locate specific information included in standard bond and stock price quotations.

A capital market is a market for securities (debt or equity), where business enterprises

and governments can raise long-term funds. Long-term securities include those with

original maturities greater than one year.

Capital markets in the United States provide the lifeblood of capitalism. Companies turn

to them to raise funds needed to finance the building of factories, office buildings,

airplanes, trains, ships, telephone lines, and other assets; to conduct research and

development; and to support a host of other essential corporate activities. Much of the

money comes from such major institutions as pension funds, insurance companies, banks,

foundations, and colleges and universities. Increasingly, it comes from individuals as

well.

Capital markets include:

➢ The bond market (discussed in this chapter)

➢ The stock market (discussed in this chapter)

➢ The mortgage market (discussed in Chapter 6)

5.1 The Bond Market

5.1.1 Bond markets defined

A bond is a debt instrument in which an investor loans money to an entity (corporate or

governmental) that borrows the funds for a defined period of time at a specified interest

rate. Bonds are used by companies, municipalities, states and U.S. and foreign

governments to finance a variety of projects and activities. The bond market is the

financial market where participants buy and sell bonds.

74

Firms that issue bonds and the investors who buy them have very different motivations

than those who operate in the money markets. Firms and individuals use the money

markets primarily to warehouse funds for short periods of time until a more important

need or a more productive use for the funds arises. By contrast, firms and individuals use

the bond markets for long-term investments.

Bond market trading occurs in either the primary market or the secondary market. The

primary market is where new bond issuances are introduced. When firms sell securities

(debt or equity) in the primary market, the issue is referred to as an initial public

offering (IPO). The bond markets have well-developed secondary markets, as most

investors plan to sell long-term bonds before they reach maturity.

5.1.2 Bond markets participants

The primary issuers of bonds are federal and local governments and corporations. The

U.S. federal government issues long-term notes and bonds to fund the national debt. State

and municipal also issue long-term notes and bonds to finance capital projects, such as

school and prison construction.

Corporations may issue bonds because they do not have sufficient capital to fund their

investment opportunities. Alternatively, firms may choose to enter the bond markets

because they want to preserve their capital to protect against unexpected needs. In either

case, the availability of efficiently functioning capital markets is crucial to the continued

health of the business sector.

The largest purchasers of bond market securities are households. Frequently, individuals

and households deposit funds in financial institutions that use the funds to purchase bond

market instruments. Exhibit 5.1 (on the next page) provides additional details on how

financial institutions participate in the bond markets.

5.2 Types of Bonds

Bonds are securities that represent a debt owed by the issuer to the investor. Bonds

obligate the issuer to pay a specified amount at a given date, generally with periodic

interest payments. The par value (a.k.a. the face or maturity value) of the bond is the

amount that the issuer must pay at maturity. The coupon rate is the rate of interest that

the issuer must pay. This rate is usually fixed for the duration of the bond and does not

fluctuate with market interest rates. If the repayment terms of a bond are not met, the

holder of a bond has a claim on the assets of the issuer.

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Exhibit 5.1 – Participation of Financial Institutions in Bond Markets

Financial Institution Participation in Bond Markets

Commercial banks and

savings and loan

associations (S&Ls)

• Purchase bonds for their asset portfolio

• Place municipal bonds for municipalities

• Issue bonds as a secondary source of capital

Finance companies • Issue bonds as a source of long-term funds

Mutual funds • Use funds received from the sale of shares to purchase bonds (of

varying types)

Brokerage firms • Facilitate bond trading by matching up buyers and sellers of bonds in

the secondary market

Investment banking

firms • Place newly issued bonds for governments and corporations

Insurance companies • Purchase bonds for their asset portfolio

Pension funds • Purchase bonds for their asset portfolio

Exhibit 5.2 (on the next page) provides an example of a corporate bond. The par value of

the bond ($1,000) is stated in the top left and right corners. The interest rate (4½%) and

maturity is also stated several times on the face of the bond.

Long-term bonds traded in the bond market include:

U.S. Treasury notes and bonds

Municipal bonds

Corporate bonds

5.2.1 U.S. Treasury bonds

The U.S. Treasury commonly issues Treasury bonds and Treasury notes to finance

governmental expenditures. The minimum denomination for Treasury bonds or notes is

$1,000. The key difference between a bond and a note is that note maturities are usually

less than 10 years, while bond maturities are 10 years or more.

Federal government notes and bonds are considered free of default risk because the

government can always print money to pay off debt if necessary. For this reason,

Treasury bonds offer very low interest rates. However this does not mean that these

instruments are completely risk-free. They are subject to other types of risk, such as

interest rate risk (as defined in section 8.1.1).

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Exhibit 5.2 – Bond Certificate

The yield from holding a Treasury bond, as with other bonds, depends on the coupon rate

and on the difference between the purchase price and selling price. Investors in Treasury

bonds and notes receive semiannual interest payments from the Treasury. Although

interest is taxed by the federal government as ordinary income, it is exempt from state

and local taxes (if any exist). Domestic and foreign firms and individuals are common

investors in Treasury notes and bonds.

Treasury Bond Quotations

Exhibit 5.3 – Example of Bond Price Quotations

Rate Maturity Date Bid Ask Bid Change Yield

10.75 Aug 2011 120:17 120:23 +07 8.37%

8.38 Aug. 2011-16 100:09 100:15 +11 8.32%

8.75 Nov. 2011-16 103:05 103:11 +10 8.34%

Quotations for Treasury bond prices are provided in financial newspapers such as The

Wall Street Journal, Barrons, and Investors Business Daily. They are also provided in

USA Today and local newspapers. A typical format of Treasury bond quotations is shown

in Exhibit 5.3 (above). Each row represents a specific bond. The coupon rate, shown in

the first column, will vary substantially among bonds, because the bonds that were issued

when interest rates were high (such as in the early 1980’s) will have higher coupon rates

than when interest rates were low (such as in the early 1990’s).

The Treasury bonds are organized in the table according to their maturity (shown in the

second column), with those bonds nearest to maturity listed first. This allows investors to

77

easily find Treasury bonds that have a specific maturity. If the bond contains a call

feature allowing the issuer to repurchase the bonds prior to maturity, it is specified beside

the maturity date in the second column. For example, the second and third bonds in

Exhibit 5.3 mature in the year 2016 but can be “called” from the year 2011 thereafter.

The bid price (what a buyer is willing to pay) and ask price (what a holder is willing to

sell the bond for) are quoted per hundreds of dollars of par value, with fractions (to the

right of the colon) expressed as thirty-seconds of a dollar. For example, if the first bond

had a face value of $100,000, its ask price would be $120,719. The price of this bond is

much higher than the other two bonds shown, primarily because it offers a higher coupon

rate. However its yield-to-maturity (noted in the last column) is similar to the other

bonds. From an investor’s point of view, the coupon rate advantage over the other two

bonds is essentially offset by the high price to be paid for that bond.

Other Types of Treasury Bonds

Special types of Treasury bonds include:

Treasury Inflation Protected Securities (TIPS). TIPS are a special type of Treasury

note or bond that offers protection from inflation. Like other Treasuries, an inflation-

indexed security pays interest every six months and pays the principal when the security

matures. However the coupon payments and underlying principal of TIPS are

automatically increased to compensate for inflation as measured by the consumer price

index (CPI). If U.S. Treasuries are the world's safest investments, then you might say that

TIPS are the safest of the safe. This is because your real rate of return, which represents

the growth of your purchasing power, is guaranteed. The downside is that, because of this

safety, TIPS offer a low return.

Treasury STRIPS. The term “STRIPS” is an acronym for 'separate trading of registered

interest and principal securities'. Treasury STRIPS are fixed-income securities sold at a

significant discount to face value and offer no interest payments because they mature at

par. The periodic interest payments are separated (or ‘stripped’) from the final principal

repayment, thus making each component (i.e. each interest and principal payment) a

zero-coupon security11. Each component has its own identifying number and can be held

or traded separately. For example, a Treasury note with five years remaining to maturity

consists of a single principal payment at maturity and ten interest payments, one every six

months for five years. When this note is stripped, each of the ten interest payments and

the principal payment becomes a separate security. Thus, the single Treasury note

becomes 11 separate securities that can be traded individually.

5.2.2 Municipal bonds

Municipal bonds (a.k.a. “munis”) are bonds issued by states, cities, counties and various

districts to raise money to finance operations or to pay for projects. The projects they

11 A zero-coupon security is one that doesn't pay interest (a coupon) but is traded at a deep discount,

rendering profit at maturity when the bond is redeemed for its full face value.

78

finance include hospitals, schools, power plants, office building, airports, etc.

Municipalities levy taxes as their first source of revenue. When tax revenue is insufficient

to cover their spending needs, municipalities may turn to issuing bonds as a way to raise

additional funds.

Individual investors purchase the majority of municipal bonds. These bonds are usually

issued in $5,000 face-value denominations or multiples of $5,000. They mature in

anywhere from one to fifty years. Like other bonds, they may also be bought at a

discount.

Tax Exemption

Interest income generated on most municipal bonds is not taxable for federal income tax

purposes. This income is also free of most state and local taxes in the state in which they

are issued. These features make munis very popular among small investors. (Note –

capital gains on municipal bonds are not exempt from taxes.)

The taxable equivalent yield formula can be used to compare the returns on a municipal

bond with those of a taxable bond. Using this formula, an investor can calculate how

much he or she would need to earn on a taxable bond to equal the return on a municipal

bond. Taxable equivalent yield is calculated using the following formula:

Taxable Equivalent Yield = Tax-free yield

1- Tax Rate

For example, assume that your federal tax rate is 28 percent. Now suppose that you are

considering buying a municipal bond that earns 6% interest. You would have to earn

8.33% on a taxable bond to equal the 6% return on the municipal bond. This is calculated

as follows:

Taxable Equivalent Yield = 6 = 6 = 8.33%

1- 0.28 0.72

Types of Municipal Bonds

Municipal bonds come in a variety of forms, including:

• General Obligation bonds (GO bonds). GO bonds are unsecured instruments that

finance municipal operations. They have maturities of 10 years or more. The

creditworthiness of the issuing city or state is the only "guarantee" they provide. GO

bonds finance projects that do not produce revenue. The municipal issuer repays the

bonds with funds raised by fees or property sales. If the issuer is unable to pay, it may

turn to taxation to guarantee interest and principal payments. Generally, all the individual

bonds in a GO bond issue have the same maturity date.

79

• Revenue bonds. Revenue bonds are secured instruments that finance specific projects.

The revenues generated by these projects are used to secure the bonds. Such revenues

include tolls, fees and lease payments. For example, a city may issue revenue bonds to

pay for a new stadium. It will pay bondholders their interest and principal from the

stadium's revenues. Revenue bonds generally involve higher risk than GO bonds because

of the possibility that the projects financed may not generate enough revenue to pay

bondholders. Revenue bondholders are compensated for this assumed risk by receiving

higher yields on the instruments. Specific types of revenue bonds include:

o Industrial revenue bonds, which finance public projects.

o Project notes, which are short-term debts that finance public housing construction.

o New Housing Authority bonds, which finance low-income housing.

o Special tax bonds, which are backed by excise taxes such as those on cigarettes and

alcohol. Special assessments on those who will benefit directly from a particular project

may also back them.

o Double-barreled bonds, which are backed by both revenue and the municipality's

creditworthiness.

o Anticipation notes, which allow work to begin on a project early while the municipality

awaits revenue from other sources. These are technically not bonds because their

maturities are too short (one month to one year) to qualify them as bonds.

Many municipals, especially revenue bonds, have an interesting additional feature: They

may be insured by outside agencies. These insurers guarantee that they will pay

bondholders their interest and principal if the issuers default. Two well-known municipal

bond insurers are the Municipal Bond Insurance Association (MBIA) and the American

Municipal Bond Assurance Corporation (AMBAC). Large commercial banks also

sometimes guarantee bonds.

5.2.3 Corporate bonds

When corporations need to borrow for long-term periods, they issue corporate bonds,

which usually pay the owner interest on a semi-annual basis. The minimum denomination

is $1,000. The degree of secondary market activity varies; some big corporations have a

large amount of bonds outstanding in the market, which increases secondary market

activity and the bond’s liquidity. Common purchasers of corporate bonds include many

financial and some non-financial institutions as well as individuals.

Corporate bonds can be described according to a variety of unique terms, including:

Sinking-fund provision. A sinking-fund provision is a requirement that the issuing firm

retire a certain amount of the bond issue each year. This provision is considered to be an

advantage to the remaining bondholders, because it reduces the payments necessary at

maturity as well as the default risk associated with the instrument. For this reason, the

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presence of a sinking-fund provision normally reduces the investor’s yield on that

instrument.

Protective covenants. Protective covenants are restrictions placed on the issuing firm

that are designed to protect the bondholders from being exposed to increasing risk during

the investment period. These terms frequently limit the amount of dividends and

corporate officers’ salaries the firm can pay and also restrict the amount of additional

debt the firm can issue. Other financial policies may be restricted as well.

Call provisions. Most bonds include a provision allowing the firm to “call” (i.e. buy

back) the bonds. A call provision normally requires the firm to pay a price above par

value when it calls its bonds. The difference between the bond’s call price and par value

is the call premium. Call provisions generally benefit the bond issuers, especially when

market interest rates are volatile. If market interest rates decline after a bond issue has

been sold, the firm might end up paying a higher rate of interest than the prevailing rate

for a long period of time. Under these circumstances, the firm may consider selling a new

issue of bonds with a lower interest rate and using the proceeds to retire the previous

issue by calling the old bonds. Call provisions are normally viewed as a disadvantage to

bondholders because it can disrupt their investment plans and reduce their investment

returns. As a result, firms must pay slightly higher rates of interest on bonds that are

callable (all else being equal).

Bond collateral agreements. Bonds can be classified according to whether they are

secured by collateral and by the nature of that collateral. Real property (such as land

and/or buildings) is the most common form of collateral. Bonds unsecured by specific

property are referred to as debentures. These long-term instruments are backed only by

the general creditworthiness of the issuer.

The terms of a corporate bond issuance are formalized in a bond indenture. The bond

indenture is a legal document specifying the rights and obligations of both the issuing

firm and the bondholders. It is very comprehensive (normally several hundred pages) and

is designed to address all matters related to the bond issue (collateral, payment dates,

default provisions, call provisions, etc.)

Federal law requires that for each bond issue of significant size a trustee be appointed to

represent the bondholders in all matters concerning the bond issue. This includes

monitoring the issuing firm’s activities to ensure compliance with the terms of the

indenture. If the terms of the indenture are violated, the trustee initiates legal action

against the issuing firm and represents the bondholders in that action. Bank trust

departments are frequently hired to perform the duties of trustee.

Recall from Chapter 2 (Section 2.3.1) that all bonds are rated by various ratings agencies

according to their default risk. These companies study the issuer’s financial

characteristics and make a judgment about the issuer’s possibility of default. A bond with

a rating of AAA has the highest grade possible. Bonds at or above Moody’s Baa or

Standard and Poor’s BBB rating are considered of investment grade. Those rated below

this level are usually considered speculative. Speculative grade bonds are often called

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junk bonds. Exhibit 5.4 gives examples of the different ratings that selected rating

agencies assign to bonds. Exhibit 5.4 – Bond Rating Grades

Credit Risk Moody’s Standard & Poor’s Fitch Ratings

Investment Grade Highest Quality Aaa AAA AAA High Quality Aa AA AA Upper Medium A A A Medium

Baa BBB BBB

Below Investment Grade Lower Medium Ba BB BB Lower Grade B B B Poor Grade Caa CCC CCC Speculative Ca CC CC Bankruptcy C D C In Default C D D


1. Which of the following transactions would most likely occur in the bond

market?

a. Company A has purchased equity shares for its investment portfolio.

b. Company B has purchased funds to meet its U.S. reserve requirements.

c. Company C has issued debt to finance a long-term construction

project.

d. Company D has issued 30-day instrument to finance current expenses.

Oceanic Bank has purchased a bond portfolio that includes one U.S. Treasury bond,

one municipal bond and one corporate bond.

2. Which of the following characteristics could apply to all three instruments

included in Oceanic’s portfolio?

a. The instruments have been rated ‘below investment grade’ by

Moody’s.

b. Interest income is not taxable for federal income tax purposes.

c. The par value is paid to the holder at maturity.

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d. There is an assumption of no default risk.

3. The municipal bond included in Oceanic’s portfolio earns 4% interest. Oceanic

Bank’s federal tax rate is 32%. Based on this information, the taxable equivalent

yield on their municipal bond investment is approximately:

a. 1.3%.

b. 2.7%.

c. 4.0%.

d. 5.9%.

4. The municipal bond included in Oceanic’s portfolio is a secured instrument that

was issued to finance the construction of a new public auditorium. The income

earned from the auditorium will be used to make principal and interest

payments to bondholders. Based on this information, Oceanic’s municipal

bond is most likely an example of:

a. A Treasury bond.

b. A revenue bond.

c. A taxable bond.

d. A GO bond.

5. Oceanic’s corporate bond indenture contains a clause that prohibits the issuer

from issuing additional debt in excess of $100 million over the maturity period of

the instrument. Such a clause is often referred to as a:

a. Protective covenant.

b. Call provision.

c. Collateral agreement.

d. Sinking-fund provision.

6. The price quote for Oceanic’s corporate bond is currently BID 104:06, ASK

104:12. If the face value of the bond is $100,000, Oceanic Bank would most

likely be able to sell it in the bond market today for approximately:

a. $104,060.

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b. $104,120.

c. $104,188.

d. $104,375.

7. Which of the following bonds would most likely provide the most protection

against a decline in purchasing power during periods of high inflation?

a. Company A’s muni bond.

b. Company B’s STRIP security.

c. Company C’s junk bond.

d. Company D’s TIPS bond.

8. The yield on which of the following instruments would most likely include the

highest default risk premium?

a. Company A’s junk bond.

b. Company B’s TIPS bond.

c. Company C’s insured muni bond.

d. Company D’s Treasury note.

5.3 The Stock Market

5.3.1 Common and preferred stock

A share of stock in a firm represents ownership. A stockholder owns a percentage

interest in the firm, consistent with the percentage of outstanding stock held.

Stocks are issued by corporations who need long-term funds. Stocks are purchased by

individuals and financial institutions who wish to invest long-term funds and obtain

partial ownership in corporations.

Ownership of stock gives the stockholder certain rights regarding the firm. One is the

right of a residual claimant: stockholders have a claim on all assets and income left over

after all other claimants have been satisfied. If nothing is left over, they get nothing.

However, it is possible to earn a significant return as a stockholder if the firm does well.

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There are two classes of stock that companies offer: common and preferred. These come

with different financial terms and offer different rights in relation to the governance of

the company. Below are some of the key differences between these two types of stock

and the implications for how each type is used.

Common Stock

As discussed previously, the holders of common stock can reap two main benefits from

the issuing company: capital appreciation and dividends. Capital appreciation occurs

when a stock's value increases over the amount initially paid for it. The stockholder

makes a profit when he or she sells the stock at its current market value after capital

appreciation.

Dividends, which are taxable payments, are paid to a company's shareholders from its

retained or current earnings. Typically, dividends are paid out to stockholders on a

quarterly basis. These payments are usually made in the form of cash, but other property

or stock can also be given as dividends. Payment of dividends, however, hinges on a

company's capacity to grow — or at least maintain — its current or retained earnings.

This means that ongoing payment of dividends cannot be guaranteed.

Common stock ownership has the additional benefit of enabling its holders to vote on

company issues and in the elections of the organization's leadership team. Usually, one

share of common stock equates to one vote.

Exhibit 5.5 provides an example of a common stock certificate. Notice that the certificate

does not list many terms commonly associated with bonds, including a maturity date,

face value or an interest rate. Exhibit 5.5 – Common Stock Certificate

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Preferred Stock

Preferred stock doesn't offer the same potential for profit as common stock, but it is

generally considered a more stable investment vehicle because it guarantees a regular

dividend that isn't directly tied to the market like the price of common stock. The price of

preferred stock is tied to interest rate levels, and tends to go down if interest rates go up

and to increase if interest rates fall.

The other advantage of preferred stock is that preferred stockholders get priority when it

comes to the payment of dividends. In the event of a company's liquidation, preferred

stockholders get paid before those who own common stock. In addition, if a company

goes bankrupt, preferred stockholders enjoy priority distribution of the company's assets,

while holders of common stock don't receive corporate assets unless all preferred

stockholders have been compensated (bond investors take priority over both common and

preferred stockholders).

Like common stock, preferred stock represents ownership in a company. However,

owners of preferred stock do not get voting rights in the business.

The different types of preferred stock include:

Participating preferred stock, which entitles holders to dividend increases if, during a

given year, common stock dividends exceed those of preferred stock dividends.

Adjustable-rate preferred stock, which is tied to Treasury bill or other rates. The

dividend is augmented based on the shifts in interest rates, determined by an established

formula.

Convertible preferred stock, which has a conversion price named at its issuance so

that it can be converted to a company's common stock at the set rate.

Straight or fixed-rate perpetual stocks, which do not mature because the dividend

rate is set for the life of the issue.

5.3.2 Stock quotations

Stock quotations are provided by financial newspapers such as The Wall Street Journal,

Barrons, and Investors Business Daily. They are also widely available on many financial

websites such as Bloomberg.com and Yahoo! Finance. Stock prices are always quoted on

a per-share basis.

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Exhibit 5.6 – Stock Quotation

Exhibit 5.6 provides typical examples of stock quotations. While the format of stock

quotations varies among sources, most quotations provide the following information:

• 52-Week High & Low. Columns 1 & 2 present the stock’s highest and lowest price over

the previous 52 weeks. The high and low prices indicate the range for the stock’s price

over the last year. Some investors use this range as an indicator of how much the stock

fluctuates. Other investors compare this range to the prevailing stock price, as some

investors only purchase a stock when its prevailing price is not at its 52-week high.

• Company Name and Type of Stock. Column 3 includes the name of the issuing

company. Special symbols may be added that indicate a specific type of stock. For

example, the letters "pf" added to the company name indicates that the shares are

preferred stock. If there are no special symbols or letters following the name, the equity

instrument is common stock.

• Ticker Symbol. Column 4 includes the unique alphabetic name which identifies the

stock. If you watch financial TV, you have seen the ticker tape move across the screen,

quoting the latest prices alongside this symbol. If you are looking for stock quotes online,

you always search for a company by the ticker symbol.

• Dividend-per-share. Column 5 indicates the annual dividend payment per share. If this

space is blank, the company does not currently pay out dividends.

• Dividend Yield. Column 6 provides the percentage return on the dividend. This value is

calculated by dividing the annual dividends per share by the price per share.

• Price-Earnings Ratio (P/E Ratio). Column 7 presents the P/E ratio, which represents its

prevailing stock price per share divided by the firm’s earnings per share generated over

the last year.

• Trading Volume. Column 8 provides information on the volume of shares traded on the

previous day. The volume is normally quoted in hundreds of shares.

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• Day High & Low. Columns 9 & 10 indicate the price range at which the stock has traded

at throughout the day. In other words, these are the maximum and the minimum prices

that people have paid for the stock.

• Close. Column 11 provides the close is the last trading price recorded when the market

closed on the day.

• Net Change. Colum 12 presents the dollar value change in the stock price from the

previous day's closing price. When you hear about a stock being "up for the day," it

means the net change was positive.

5.3.3 Stock markets and exchanges

Stock markets are financial markets that facilitate the transfer of funds in exchange for

stocks. The primary market enables corporations to issue new stock to investors, while

the secondary market enables investors to sell stocks that they had previously purchased.

Thus the primary market facilitates new financing for corporations, while the secondary

market creates liquidity for investors who invest in stocks.

Literally billions of shares of stock are sold each business day in the United States. The

orderly flow of information, stock ownership, and funds through the stock markets is a

critical feature of well-developed and efficient markets. This efficiency encourages

investors to buy stocks and to provide equity capital to businesses with valuable growth

opportunities.

Stocks are generally traded through one of three mechanisms:

Organized Exchanges

Over-the-Counter Markets

Electronic Communications Networks (ECNs)

Organized Exchanges

Organized stock exchanges have historically been used to execute secondary market

transactions. The traditional definition of an organized exchange is that there is a

specified location where buyers and sellers meet on a regular basis to trade securities

using an open-outcry auction model. As more sophisticated technology has been adapted

to securities trading, this model is becoming less frequently used.

The world’s largest and most liquid exchange is the New York Stock Exchange (NYSE).

There are also other major organized stock exchanges around the world. The most active

exchange in the world is the Nikkei in Tokyo. Other major exchanges include the London

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Stock Exchange in England, the DAX in Germany, and the Toronto Stock Exchange in

Canada.

To have a stock listed for trading on one of the organized exchanges, a firm must file an

application and meet certain criteria set by the exchange designed to enhance trading. For

example, the NYSE encourages only the largest firms to list so that transaction volume

will be high. To list on the NYSE, a firm must meet the following minimum

requirements:

At least 2,200 shareholders with a monthly trading volume of 100,000 shares.

Earnings of at least $10 million for the last three years.

$100 million market value.

Over-the-Counter Markets

Stocks not traded on one of the organized exchanges trade in the over-the-counter (OTC)

market. This market is not organized in the sense of having a building where trading

takes place. Instead, trading occurs over sophisticated telecommunications networks. One

such network is called the National Association of Securities Dealers Automated

Quotation System (NASDAQ). This system, introduced in 1971, provides current bid

and ask prices on about 3,200 actively traded stocks. Dealers “make a market” in these

stocks by buying for inventory when investors want to sell and selling from inventory

when investors want to buy. These dealers provide small stocks with the liquidity that is

essential to their acceptance in the market. Total volume on the NASDAQ is usually

slightly lower than on the NYSE; however, NASDAQ volume has been growing and

occasionally exceeds NYSE volume.

Electronic Communications Networks (ECNs)

Electronic Communications Networks, or ECNs, are electronic trading systems that

automatically match buy and sell orders at specified prices. ECNs have been challenging

both NASDAQ and the organized exchanges for business in recent years.

ECNs register with the SEC as broker-dealers. Those who subscribe to ECNs – including

institutional investors, broker-dealers, and market-makers – can place trades directly with

an ECN. Individual investors must currently have an account with a broker-dealer

subscriber before their orders can be routed to an ECN for execution. When seeking to

buy or sell securities, ECN subscribers typically use limit orders. ECNs post orders on

their systems for other subscribers to view. The ECN will then automatically match

orders for execution.

If a subscriber wants to buy a stock through an ECN, but there are no sell orders to match

the buy order, the order can't be executed until a matching sell order comes in. If an ECN

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has no sell order to match with the subscriber's buy order, it may send the order to

another market center for execution. Likewise, a subscriber seeking to sell a stock

through an ECN may have its order matched with a buy order that comes into the ECN,

or the ECN may route the sell order to another market center for execution.

5.3.4 Stock indexes

Stock indexes serve as performance indicators of the stock market overall (or particular

subsets of the market). Some of the more closely monitored indexes include:

Dow Jones Industrial Average. The Dow Jones Industrial Average (DJIA) is a price-

weighted average of the stock prices of 30 large U.S. firms. Often referred to as "the

Dow", the DJIA is the oldest and single most watched index in the world. The DJIA

includes companies like General Electric, Disney, Exxon and Microsoft. When the TV

networks say "the market is up today", they are generally referring to the Dow.

Standard and Poor’s (S&P) 500. The S&P 500 is an index of 500 stocks chosen for

market size, liquidity and industry grouping, among other factors. The S&P 500 is

designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return

characteristics of the large cap universe. Companies included in the index are selected by

the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The

S&P 500 is a market value weighted index - each stock's weight is proportionate to its

market value. The S&P 500 is one of the most commonly used benchmarks for the

overall U.S. stock market. The Dow Jones Industrial Average (DJIA) was at one time the

most renowned index for U.S. stocks, but because the DJIA contains only 30 companies,

most people agree that the S&P 500 is a better representation of the U.S. market. In

fact, many consider it to be the definition of the market.

New York Stock Exchange Indexes. The NYSE provides quotations on indexes that it

created. A Composite Index represents the average of all stocks traded on the NYSE. This

is an excellent indicator of the general performance of stocks traded on the NYSE, but

because these stocks represent mostly large firms, the Composite Index is not an

appropriate measure of small stock performance. In addition to the Composite Index, the

NYSE also provides indexes for four sectors: (1) Industrial, (2) Transportation, (3) Utility

and (4) Financial. These indexes are commonly used as benchmarks for comparison to an

individual firm or portfolio in that respective sector.

Other Stock Indexes. The American Stock Exchange (one of the larger U.S. stock

exchanges) provides quotations on several indexes of stocks traded on its exchange,

including several sectors. The National Association of Securities Dealers provides

quotations on indexes of stocks traded on the NASDAQ Exchange. These indexes are

useful indicators of small stock performance, since small stocks are traded on the

NASDAQ Exchange. The firm Wilshire Associates provides quotations on an index of

5,000 stocks, called the Wilshire Index.

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9. Which of the following capital market instruments represents a percentage

ownership in the issuing company?

a. Company A’s repurchase agreement.

b. Company B’s corporate bond.

c. Company C’s common stock.


Hydra Inc. has filed for bankruptcy and is about to be liquidated.

10. Which of the following parties will most likely receive top priority upon the

liquidation of Hydra’s assets?

a. Hydra’s common stock holders.

b. Hydra’s corporate bond holders.

c. Hydra’s adjustable-rate preferred stock holders.

d. Hydra’s participating preferred stock holders.

11. Which of the following parties will most likely receive the lowest priority upon

the liquidation of Hydra’s assets?

a. Hydra’s common stock holders.

b. Hydra’s corporate bond holders.

c. Hydra’s adjustable-rate preferred stock holders.

d. Hydra’s participating preferred stock holders.

Ben, an individual investor, purchased 100 shares of Dharma Corp’s common stock

when the price was $6.00 per share. Ben sells these shares 3 years later when the

stock price is $8.00 per share. Dharma Corp.’s dividend rate per share was $0.10

during this time. Dharma Corp. reported $0.33 earnings per share in its most recent

annual financial statements.

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12. Based on this information, the total return that Ben earned on his Dharma Corp

common stock equals:

a. $10.

b. $30.

c. $200.

d. $230.

13. If the Wall Street Journal reported a closing price of $8.00 on the day after Ben

sold his Dharma Corp. common stock, it would have also reported a P/E ratio

of approximately:

a. 2.6.

b. 24.2.

c. 75.9.

d. 697.0.

The following table presents financial data for Companies A, B, C and D:

Company Shareholders (#) Trading Vol. (Mthly) 3 year net income

A 13,000 450,000 $29,000,000

B 3,500 65,000 $8,500,000

C 500 15,000 $4,000,000

D 8,800 125,000 $5,000,000

14. Based on the above information, which of the following companies most likely

qualifies for listing on the New York Stock Exchange?

a. Company A.

b. Company B.

c. Company C.

d. Company D.

15. Which of the following stock transactions most likely occurred in the OTC

market?

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a. Company A purchases stock on the NYSE.

b. Company B sells stock on the NASDAQ.

c. Company C purchases stock on the Nikkei.

d. Company D sells stock through an ECN.

16. Which of the following events would likely be the most indicative of weakness

in the U.S. stock market?

a. Trading volume on the NYSE increases 3%.

b. The DJIA decreases 3%.

c. Trading volume on the NASDAQ decreases 3%.

d. The S&P 500 increases 3%.

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Chapter 5 Summary

• A bond is a debt instrument in which an investor loans money to an entity (corporate or

governmental) that borrows the funds for a defined period of time at a specified interest

rate. The bond market is the financial market where participants buy and sell bonds.

• The U.S. Treasury commonly issues Treasury bonds and Treasury notes to finance

governmental expenditures. These instruments are considered free of default risk because

they are backed by the U.S. Government. For this reason, Treasury bonds offer very low

interest rates.

• Municipal bonds (a.k.a. “munis”) are bonds issued by states, cities, counties and various

districts to raise money to finance operations or to pay for projects. Interest income

generated on most municipal bonds is free of federal, state and local taxes, which makes

these investments very popular for individual investors. The taxable equivalent yield

formula can be used to compare the returns on a municipal bond with those of a taxable

bond. This measure is calculated using the following formula:

Taxable Equivalent Yield = Tax-free yield

1- Tax Rate

• Corporate bonds are bonds issued by corporations as a source of long-term funding.

Corporate bonds normally include a variety of unique terms, including sinking fund

provisions, protective covenants, call provisions and collateral agreements. These terms

are documented in a legal agreement known as an indenture. Bondholders are represented

by a trustee that monitors the issuing firm’s activities to ensure compliance with the terms

of the indenture. Bond yields can vary significantly based on the credit quality of the

issuer. This credit quality is independently assessed and assigned specific ratings by

ratings agencies.

• A share of stock in represents ownership in the issuing firm. There are two classes of

stock that companies offer: common and preferred. Common stock is generally

considered a riskier investment; however the owners of common stock can earn a higher

return based on both capital appreciation and dividends. The risk and return of preferred

stock is generally lower than that of common stock.

• Quotations for stock and bond prices are provided in financial newspapers and websites.

• Stock markets are financial markets that facilitate the transfer of funds in exchange for

stocks. Stocks are generally traded through one of three mechanisms: organized

exchanges, over-the-counter markets and Electronic Communications Networks (ECNs).

The world’s largest and most liquid stock market is the New York Stock Exchange.

• Stock indexes serve as performance indicators of the stock market overall (or particular

subsets of the market). Some of the more closely monitored indexes include the Dow

Jones Industrial Average, Standard and Poor’s (S&P) 500, New York Stock Exchange

Indexes, etc.

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Chapter 6 – Capital Markets (Part II)



• Identify the primary characteristics the mortgage market and recognize the various types

of mortgage loans.

• Recognize the roles that financial institutions play in the mortgage-lending process.

• Identify the criteria used by mortgage lenders in the underwriting process.

• Identify the unique attributes of mortgage-backed securities.

6.1 The Mortgage Market

6.1.1 Mortgages defined

A mortgage is a long-term loan secured by real estate. A developer may obtain a

mortgage loan to finance the construction of an office building, or a family may obtain a

mortgage loan to finance the purchase of a home. A large majority of mortgage loans

finance residential home purchases; as a result, residential mortgages will be the primary

focus of this chapter.

A mortgage is considered an amortizing loan: the borrower pays the debt off over time in

some combination of principal and interest payments that result in full payment of the

debt by maturity. Most mortgage loans are originated with 30-year original terms and

amortize on a monthly basis. Loans with stated shorter terms ranging from 10, 15, and 20

years are also used by borrowers motivated by the desire to build home equity12 more

quickly.

In a residential mortgage, a home buyer pledges his or her house to the bank. The bank

has a claim on the house should the home buyer default on paying the mortgage. In the

case of a foreclosure, the bank may evict the home's tenants and sell the house, using

the income from the sale to clear the mortgage debt.

To obtain a mortgage loan, the lender generally requires the borrower to make a down

payment on the property, which involves the borrower paying a portion of the property’s

price at initial purchase. The balance of the purchase price is paid by the loan proceeds.

Down payments are intended to make the borrower less likely to default on the mortgage

loan.

12 Home equity is the current market value of a home minus the outstanding mortgage balance. Home

equity is essentially the amount of ownership that has been built up by the holder of the mortgage through

payments and appreciation.

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6.1.2 Mortgage characteristics

When financial institutions originate residential mortgages, the mortgage contract created

should specify whether the mortgage is federally insured, the amount of the loan, whether

the interest rate if fixed or adjustable, the interest rate to be charged, the maturity, and

other special provisions that may vary among contracts.

Government Loans vs. Conventional Loans

Mortgage loans that are insured by a U.S. federal agency are generally referred to as

“government loans”. As part of housing policy considerations, the U.S. Department of

Housing and Development (HUD) oversees two agencies, the Federal Housing

Administration (FHA) and the Department of Veterans Affairs (VA). The FHA provides

loan guarantees for borrowers with very low down payments and/or relatively low levels

of income. The VA guarantees loans made to veterans, allowing such obligors to receive

favorable loan terms. Since these guarantees are backed by the U.S. Treasury, these loans

are collateralized by the “full faith and credit” of the United States government.

Conventional loans are also provided by financial institutions. Although they are not

federally insured, they can be privately insured so that the lending institutions can still

avoid exposure to default risk. This is referred to as private mortgage insurance (PMI),

which is an insurance policy that guarantees to make up any discrepancy between the

value of the property and the loan amount (should a default occur). For example, if the

balance on your mortgage loan was $120,000 at the time of default and the property was

only $100,000, PMI would pay the lending institution $20,000. The default still appears

on the credit record of the borrower, but the lender avoids sustaining a loss. PMI is

usually required on loans that have less than a 20% down payment.

Fixed-rated vs. Adjustable-rate Mortgages

One of the most important provisions in the mortgage contract is the interest rate. It can

be specified as a fixed rate or can allow for periodic rate adjustments over time.

The fixed-rate mortgage locks in the borrower’s interest rate over the life of the

mortgage. Thus, the periodic interest payment received by the lending financial

institution is constant, regardless of how markets change over time. Financial institutions

that hold fixed-rate mortgages in their asset portfolio are exposed to interest rate risk,

because the commonly use funds obtained from short-term customer deposits to make

long-term mortgage loans. Borrowers with fixed-rate mortgages do not suffer from the

effects of rising interest rates, but they also fail to benefit from declining rates (although

refinancing the mortgage is a possibility).

In contrast to the fixed-rate mortgage, the adjustable-rate mortgage (ARM) allows the

mortgage interest rate to adjust to market conditions. The periodic contractual rate is

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based on both the movement of an underlying rate (the index) and the spread over the

index (the margin) required for the particular loan program. The formula and the

frequency of adjustment can vary and is specified in the mortgage contract.

Because the interest rate of the ARM moves with prevailing interest rates, financial

institutions can stabilize their profit margin. If their cost of funds rises, so does the return

on mortgage loans. However, ARMs also create uncertainty for borrowers, whose future

mortgage payments will depend on future interest rates.

Credit Quality and Documentation

Mortgage lending traditionally has focused on borrowers of strong credit quality who

were able (or willing) to provide extensive documentation of their income and assets.

However, technological and methodological advances were made with respect to pricing

the inherent risk in loans, and as a result the mortgage industry expanded its product

offerings to consumers who had previously been outside the boundaries of the traditional

credit model. These portions of the mortgage industry became known as the subprime

and alternative-A (alt-A) sectors:

• Subprime refers to borrowers whose credit has been impaired (in some cases due to life

events such as unemployment or illness), while generally having sufficient equity in their

homes to mitigate the credit exposure. This allows the lender to place less weight on the

credit profile in making the lending decision.

• The alternative-A (alt-A) category refers to loans made to borrowers who generally have

high credit scores but who (1) have variable incomes, (2) are unable or unwilling to

document a stable income history, or (3) are buying second homes or investment

properties.

If the above sectors of the mortgage industry sound familiar, there is a good reason. The

sub-prime sector (and the alt-A sector to a lesser extent) imploded in 2007-08, resulting

in billions of dollars of losses in the U.S. financial markets. Approximately 80% of U.S.

mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages

After U.S. house prices peaked in mid-2006 and began their steep decline thereafter,

refinancing became more difficult. As adjustable-rate mortgages began to reset at higher

rates, mortgage delinquencies soared. Securities backed with subprime mortgages, widely

held by financial firms, lost most of their value. The result has been a large decline in the

capital of many banks and U.S. government sponsored enterprises, tightening credit

around the world.

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Exhibit 6.1 – 30-year Mortgage Interest Rates (Sample Data)

6.1.3 Mortgage-lending institutions

Within the mortgage market, a number of different types of financial institutions are

involved, either directly or indirectly, in the business of mortgage loans. A number of

different classification schemes can be used to distinguish businesses and functions

within the aggregate mortgage banking industry.

Direct Lender vs. Loan Broker

Consistent with terminology, a direct lender accepts and underwrites loan applications

and funds the resulting loans. In contrast, a mortgage broker represents clients and will

work with a number of different lenders in obtaining a loan. This involves taking the loan

application and (in some cases) processing it through various automated underwriting

systems. The broker does not, however, make the loan but rather serves as an agent

linking borrowers and lenders. Many large lenders classify operations in units or

channels, differentiating those divisions that work directly with borrowers (i.e. the retail

channel) from those that deal with brokers (i.e. the wholesale channel). These

distinctions are necessary partly because the different channels have differing cost

structures, necessitating alternative pricing schema.

Depository vs. Non-depository

As discussed in Section 1.4.2, depository institutions (which include banks, thrifts and

credit unions) collect deposits from both wholesale and retail sources and use those

deposits to fund lending activities. Since depositories have both loan and securities

portfolios, such institutions have the option of either holding loan production as a balance

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sheet asset or selling the securitized loans into the capital markets13. Non-depository

lenders (mainly mortgage bankers) generally do not have loan portfolios, and therefore

virtually all loan production is sold to investors through the capital markets.

Originators vs. Servicers

Both depository and non-depository loan originators underwrite and fund loan

production. However, once the loan is closed, an infrastructure is required for collecting

and accounting for principal and interest payments, remitting property taxes, dealing with

delinquent borrowers, and managing foreclosures. Entities that provide this operational

aspect of mortgage lending are referred to as servicers. As part of providing these

services, such entities receive a fee, which generally is part of the monthly interest

payment. While many originators also act as servicers, servicing as a business is both

labor- and data-intensive. As a result, large servicing operations reap the benefit of

economies of scale and may explain the significant consolidation in this industry over the

last decade.

6.1.4 Mortgage underwriting process

After the mortgage application is filed, the loan is considered to be part of the “pipeline”,

which suggests that there is a planned sequence of activities that must be completed

before the loan is funded. At application, the borrower can either lock in the rate of the

loan or let it float until some point before closing.

There are two essential and separate components of the underwriting process:

Evaluation of the ability and willingness on the part of the borrower to repay the

mortgage in a timely fashion.

Ensuring the integrity and assessing the marketability of the property such that it can be

sold in the event of a default to pay off the remaining balance of the mortgage.

There are several factors that are considered important in evaluating both the

creditworthiness of a potential borrower and the overall riskiness of a mortgage.

Credit Score

Several firms collect data on the payment histories of individuals from lending

institutions and use sophisticated models to evaluate and quantify individual

creditworthiness. The process results in a credit score, which is essentially a numerical

grade of the credit history of the borrower.

13 Mortgage securitizations are discussed in further detail in Section 6.2.

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There are three different credit-reporting firms that calculate credit scores, namely

Experian, Transunion and Equifax. While the credit scores generated by these companies

have different underlying methodologies, the scores are generically referred to as “FICO

scores”14. Lenders often get more than one score in order to minimize the impact of

variations in credit scores across providers.

Credit scores are useful in quantifying the history of the potential borrower with respect

to both ability and willingness to pay debts in a timely fashion. A general rule of thumb is

that a borrower needs a credit score of 660 or higher to qualify as a “prime” credit.

Borrowers with a credit score below this level can obtain loans either through the

government programs (mainly the FHA) or through subprime lending programs, which

involve higher rates or additional fees or both.

Loan-to-Value Ratio

The loan-to-value (LTV) ratio is an indicator of borrower leverage at the point where

the loan application if filed. The LTV calculation compares the value of the desired loan

with the market value of the property. By definition, the LTV of the loan in the purchase

transaction is function of both the down payment and the purchase price of the property.

In a refinancing, the LTV depends on the requested balance of the new loan and the

market value of the property. If the new loan is larger than the original loan, the

transaction is referred to as a “cash-out refinancing”. Otherwise, the transaction is

described as a “rate-and-term financing”.

Income Ratios

In order to ensure that a borrower’s obligations are consistent with his or her income,

lenders calculate income ratios that compare the potential monthly payment on the loan

with monthly income. The most common measures are front and back ratios. The front

ratio is calculated by dividing the total monthly payments on the home (including

principal, interest, property taxes, and homeowners insurance) by the pretax monthly

income. The back ratio is similar but adds other debt payments (including automobile

loan and credit card payments) to the total payments. Generally, the limits for front and

back ratios are 28% and 36% respectively.

Documentation

As discussed in Section 6.1.2, lenders generally require potential borrowers to provide

data on their financial status and to support the data with documentation. Loan officers

typically require applicants to report and document income, employment status, and

financial resources (including the source of the down payment). Part of the application

14 “FICO” is an acronym for the Fair Isaac Company, which created the most commonly used credit score.

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process generally involves compiling documents such as tax returns and bank statements

for use in the underwriting process.


The following table includes data on mortgage loans taken out on four

condominiums; the mortgaged condos are all located in the same complex and

therefore have the same purchase price ($150,000) and market values on 4/30/X1

($130,000).

Loan Issuer Down Pmt Interest Rate

A U.S. FHA 5% Fixed

B ABC Bank 25% Adjustable

C XYZ Bank 10% Fixed

D U.S. HUD 20% Adjustable

1. Which of the mortgage loans listed above would most likely require the

borrower to purchase private mortgage insurance?

a. Loan A.

b. Loan B.

c. Loan C.

d. Loan D.

2. The interest payments on which of the mortgage loans listed above would

most likely fluctuate with changes in market interest rates?

a. Loans A & C.

b. Loans B & D.

c. Loans A & D.

d. Loans B & C.

3. Based on the above information, the original loan proceeds for Loan C was:

a. $130,000.

b. $135,000.

c. $150,000.

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d. $165,000.

4. Based solely on the above information, ________ had the greatest amount of

home equity as of 4/30/X1.

a. Loan A.

b. Loan B.

c. Loan C.

d. Loan D.

Temple Bank, a private financial institution, recently received and approved a

mortgage application from Dogen. Dogen was unemployed until just recently, and

his credit score was relatively low as a result. Temple Bank approved Dogen’s

application because of his new found employment, extensive documentation and

favorable loan-to-value ratio. Upon approval, Temple Bank transferred the servicing

rights for Dogen’s loan to a third party.

5. Which of the following best describes the role that Temple Bank is playing in the

mortgage lending process (as it pertains to Dogen’s loan)?

a. Servicer.

b. Direct lender.

c. Guarantor.

d. Mortgage broker.

6. Given his credit background and documentation, Dogen’s loan would most

likely be associated with which of the following mortgage market sectors?

a. Prime.

b. Alt-A.

c. Government.

d. Subprime.

7. Which of the following borrowers would generally be considered the most likely

to default on a mortgage loan?

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a. Borrower A has a low front ratio.

b. Borrower B has a low LTV ratio on his loan.

c. Borrower C has a low FICO score.

d. Borrower D has a low back ratio.

6.2 Mortgage Securitization Process

6.2.1 Definition and brief history

Mortgage securitization is the structured process whereby interests in mortgage loans are

packaged, underwritten, and sold in the form of mortgage-backed securities (MBS).

From the perspective of credit originators, this market enables them to transfer some of

the risks of ownership to parties more willing or able to manage them. By doing so,

originators can access the funding markets at debt ratings higher than their overall

corporate ratings, which generally gives them access to broader funding sources at more

favorable rates. By removing the assets and supporting debt from their balance sheets,

they are able to save some of the costs of on-balance-sheet financing and manage

potential asset-liability mismatches and credit concentrations.

Mortgages are not the only financial assets that are securitized in today’s financial

markets. Many other types of loans and receivables are also securitized.

Brief History

Asset securitization began with the structured financing of mortgage pools in the 1970s.

For decades before that, banks were essentially portfolio lenders; they held loans until

they matured or were paid off. These loans were funded principally by deposits, and

sometimes by debt, which was a direct obligation of the bank (rather than a claim on

specific assets).

But after World War II, depository institutions simply could not keep pace with the rising

demand for housing credit. Banks, as well as other financial intermediaries sensing a

market opportunity, sought ways of increasing the sources of mortgage funding. To

attract investors, investment bankers eventually developed an investment vehicle that

isolated defined mortgage pools, segmented the credit risk, and structured the cash flows

from the underlying loans. Although it took several years to develop efficient mortgage

securitization structures, loan originators quickly realized the process was readily

transferable to other types of loans as well.

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Better technology and more sophisticated investors contributed to massive growth in the

securitization markets from the mid 1980’s to the mid 2000’s. However this growth came

to a screeching halt in the late 2000’s as a result of the subprime credit crisis. The

securitizations market is currently stagnant as a result of this crisis; however demand still

remains for securitized products in modern financial markets.

6.2.2 Benefits of securitization

The evolution of securitization is not surprising given the benefits that it offers to each of

the major parties in the transaction:

☺ Originators. Securitization improves returns on capital by converting an on-balance-

sheet lending business into an off-balance-sheet fee income stream that is less capital

intensive. Depending on the type of structure used, securitization may also lower

borrowing costs, release additional capital (for expansion or reinvestment purposes), and

improve asset/liability and credit risk management.

☺ Investors. Securitized mortgages offer a combination of attractive yields (compared with

other instruments of similar quality), increasing secondary market liquidity, and generally

more protection by way of collateral overages and/or guarantees by entities with high and

stable credit ratings. They also offer a measure of flexibility because their payment

streams can be structured to meet investors’ particular requirements. Most important,

structural credit enhancements and diversified asset pools free investors of the need to

obtain a detailed understanding of the underlying loans. This has been the single largest

factor in the growth of the structured finance market.

☺ Borrowers. Borrowers benefit from the increasing availability of credit on terms that

lenders may not have provided had they kept the loans on their balance sheets. For

example, because a market exists for mortgage-backed securities, lenders can now extend

fixed rate debt, which many consumers prefer over variable rate debt, without

overexposing themselves to interest rate risk.

6.2.3 Participants in the process

The securitization process redistributes risk by breaking up the traditional role of a bank

into a number of specialized roles: originator, servicer, credit enhancer, underwriter,

trustee, and investor.

• Borrower. The borrower is responsible for payment on the underlying loans and therefore

the ultimate performance of the mortgage-backed security. Because borrowers often do

not realize that their loans have been sold, the originating bank is often able to maintain

the customer relationship.

• Originator. Originators create and often service the mortgages that are sold or used as

collateral for mortgage-backed securities.

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• Servicer. The originator/lender of a pool of securitized assets usually continues to service

the securitized portfolio. In additional to customer service and payment processing,

servicing a securitized portfolio also includes providing administrative support for the

benefit of the trustee (who is duty-bound to protect the interests of the investors). For

example, a servicer prepares monthly informational reports, remits collections of

payments to the trust, and provides the trustee with monthly instructions for the

disposition of the trust’s assets. Servicing reports are usually prepared monthly, with

specific format requirements for each performance and administrative report. Reports are

distributed to the investors, the trustee, the rating agencies, and the credit enhancer.

• Trustee. The trustee is a third party retained for a fee to administer the trust that holds the

underlying assets supporting a mortgage-backed security. Acting in a fiduciary capacity,

the trustee is primarily concerned with preserving the rights of the investor. The

responsibilities of the trustee will vary from issue to issue and are delineated in a separate

trust agreement. Generally, the trustee oversees the disbursement of cash flows as

prescribed by the indenture or pooling and servicing agreement, and monitors compliance

with appropriate covenants by other parties to the agreement.

• Credit Enhancer. Credit enhancement is a method of protecting investors in the event

that cash flows from the underlying assets are insufficient to pay the interest and principal

due for the security in a timely manner. Credit enhancement is used to improve the credit

rating, and therefore the pricing and marketability of the security. As a general rule, third-

party credit enhancers must have a credit rating at least as high as the rating sought for

the security.

• Rating Agencies. The rating agencies perform a critical role in the securitization process

— evaluating the credit quality of the transactions. Such agencies are considered credible

because they possess the expertise to evaluate various underlying asset types, and

because they do not have a financial interest in a security’s cost or yield. Ratings are

important because investors generally accept ratings by the major public rating agencies

in lieu of conducting a due diligence investigation of the underlying assets and the

servicer. The rating agencies review four major areas: (1) the quality of the assets being

sold, (2) the abilities and strength of the originator/ servicer of the assets, (3) the

soundness of the transaction’s overall structure, and (4) the quality of the credit support.

From this review, the agencies assess the likelihood that the security will pay interest and

principal according to the terms of the trust agreement. The rating agencies focus solely

on the credit risk of an asset-backed security. They do not express an opinion on market

value risks arising from interest rate fluctuations or prepayments, or on the suitability of

an investment for a particular investor.

• Underwriter. The asset-backed securities underwriter is responsible for advising the

seller on how to structure the security, and for pricing and marketing it to investors.

• Investors. The largest purchasers of securitized assets are typically pension funds,

insurance companies, fund managers, and, to a lesser degree, commercial banks.

Banks may be involved in several of the roles and often specialize in a particular role or

roles to take advantage of expertise or economies of scale. The types and levels of risk to

which a particular bank is exposed will depend on the organization’s role in the

securitization process.

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Exhibit 6.2 – Mortgage Loan Securitization Process

6.2.4 Structuring the transaction

Before most loan pools can be converted into securities, they must be structured to

modify the nature of the risks and returns to the final investors. Structuring includes the

isolation and distribution of credit risk, usually through credit enhancement techniques,

and the use of trusts and special purpose entities to address tax issues and the

management of cash flows.

Generally, the structure of a transaction is governed by the terms of the pooling and

servicing agreement and, for master trusts, each series supplement. The pooling and

servicing agreement is the primary contractual document between the seller/servicer and

the trustee. This agreement documents the terms of the sale and the responsibilities of the

seller/servicer. For master trusts, the pooling and servicing agreement, including the

related series supplement, document the terms of the sale and responsibilities of the

seller/servicer for a specific issuance.

The four major stages of the structuring process include:

➢ Segregating the mortgages from the seller/originator.

➢ Creating a special-purpose entity to hold the mortgages and protect the various parties’

interests.

➢ Adding credit enhancement to improve marketability.

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➢ Issuing interests in the mortgage pool.

Stage 1: Segregating the Mortgages

Securitization allows investors to evaluate the quality of a security on its own (apart from

the credit quality of the originator/seller). To accomplish this, the seller conveys

mortgages to a trust for the benefit of certificate holders. The mortgage instruments are

subject to eligibility criteria and specific representations and warranties of the seller.

The seller designates which mortgages will be sold to a trust. The selection is carried out

with an eye to creating a portfolio whose performance is not only predictable but also

consistent with the target quality of the desired security.

Stage 2: Creating Securitization Vehicles

Banks normally structure mortgage-backed securities using trusts. These trusts are

examples of what is referred to as “special-purpose entities (SPE)”, which are legal

entities created to fulfill narrow, specific or temporary business objectives. SPE’s are

typically used by companies to isolate the firm from financial risk15. In a securitization

trust, the holders (i.e. the security investors) are treated as beneficial owners of the assets

sold (i.e. the mortgages). Principal & interest cash flows associated with the underlying

mortgages “pass through” the trust and to the holders of the beneficial interests of that

trust.

In choosing a trust structure, banks seek to ensure that the transaction insulates the

mortgage assets from the reach of the issuer’s creditors and that the issuer, securitization

vehicle, and investors receive favorable tax treatment.

Stage 3: Providing Credit Enhancement

Credit enhancement (or credit support) is a risk-reduction technique that provides

protection, in the form of financial support, to cover losses under stressed scenarios.

Think of credit enhancement as a kind of financial cushion that allows securities backed

by a pool of collateral (i.e. the mortgages) to absorb losses from defaults on the

underlying loans. Thus, it's not the case that through securitization, poor credit assets

somehow "transform" into solid investments; instead, credit enhancement helps to offset

potential losses.

There are several methods of credit enhancement, and it's not uncommon to see more

than one type in a single structured finance transaction. The most common forms include:

15 Financial risk is discussed in further detail in Section 8.1.1.

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Subordination. Subordination is the process of prioritizing the order in which mortgage

loan losses are allocated to the various layers of bonds so that the lower rated “junior”

bonds serve as credit support for the higher rated “senior” bonds. More specifically, all

principal losses on the underlying mortgages go to the most junior bonds first, resulting

in a write-down of their principal balance. Similarly, any interest shortfalls will affect the

most junior bonds first.

Over-collateralization. Under the over-collateralization method, the face value of the

underlying loan pool is larger than the par value of the issued bonds. So even if some of

the payments from the underlying loans are late or default, the transaction may still pay

principal and interest payments on the bonds. (see Exhibit 6.3 on the next page). For

example, if our analysis of a particular collateral pool's expected performance indicates

that the pool would need 40% credit enhancement to support a 'AAA' rating, that rating

could not be obtained unless the transaction had 40% more collateral above and beyond

the par value of the securities issued. So if the collateral pool was $2.0 million, it could

only issue $1.2 million in 'AAA' rated securities. If the collateral performs poorly — for

example, by incurring 30% losses — it would still leave a cushion of 10% to cover losses

from further defaults. So here, there is no "transformation" of poor credit assets into solid

investments; instead, in our example, a transaction has $2.0 million in collateral to

support $1.2 million in 'AAA' rated securities.

Excess spread. Excess spread is the additional revenue generated by the difference

between the coupon on the underlying collateral (such as a mortgage interest rate) and the

coupon payable on the securities. For example, borrowers whose mortgages are in a

given collateral pool may be paying 7% interest, while the coupon of the mortgage-

backed security may be 4%. The transaction can then use the excess spread to absorb

collateral losses or build over-collateralization to its target level. However, generally

speaking, once the transaction has used the excess spread to cover losses for that month,

whatever monthly excess spread it doesn't need to build to the over-collateralization

target is allocated to a residual certificate.

Whatever method a transaction uses, credit enhancement allows for more resources or

financial backing for a security than would be available from the underlying mortgage

assets alone. That way, if the pool ends up experiencing losses, the credit enhancement

supporting the bonds should still provide enough cushion in the transaction to allow for

payment to the bonds. Because it provides a kind of safety net, credit enhancement

increases the likelihood that bonds with a higher payment priority (senior bonds) will

receive their full repayment of principal and timely interest.

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Exhibit 6.3 – Credit Enhancement in a Securitization

Stage 4: Issuing Interests in the Mortgage Pool

On the closing date of the transaction, the mortgage loans are transferred (directly

or indirectly) from the seller to the special-purpose entity (trust). The trust issues

certificates representing beneficial interests in the trust, investor certificates, and, in the

case of revolving asset structures, a transferor (seller) certificate.

The investor certificates are sold in either public offerings or private placements, and the

proceeds, net of issuance expenses, are remitted to the seller.

6.3 Types of Mortgage-backed Securities

There are three types of mortgage-backed securities: (1) mortgage pass-through

securities, (2) collateralized mortgage obligations, and (3) stripped mortgage-backed

securities.

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6.3.1 Mortgage pass-through securities

A mortgage pass-through security (or simply “pass-through”) is created when one or

more holders of mortgages from a collection (pool) of mortgages sell shares or

participation certificates in the pool. A pool may consist of several thousand mortgages or

only a few mortgages. The cash flow of a pass-through depends on the cash flow of the

underlying mortgages, which consists of monthly mortgage payments representing

interest, the scheduled repayment of principal, and any prepayments. Payments are made

to security holders each month on a proportional (pro-rata) basis.

There are three major types of pass-through securities, guaranteed by the following U.S.

government agencies:

Government National Mortgage Association (“Ginnie Mae”)

Federal Home Loan Mortgage Corporation (“Freddie Mac”)

Federal National Mortgage Association (“Fannie Mae”)

The securities associated with these three entities are known as agency pass-through

securities. There are also non-agency pass-through securities that are issued by thrifts,

commercial banks, and private conduits that are not backed by any federal agency.

While the majority of mortgage pass-through securities are backed by one- to four-family

residential mortgages, there has been increased issuance of pass-throughs backed by other

types of mortgages. These securities are called commercial mortgage-backed securities

(CMBS). The five major property types backing such securities are office space, retail

property, industrial facilities, multifamily housing and hotels.

6.3.2 Collateralized mortgage obligations

The collateralized mortgage obligation (CMO) structure was developed to broaden the

appeal of mortgage-backed products to traditional fixed income investors. A CMO is a

security backed by a pool of pass-throughs or a pool of mortgage loans. CMOs are

structured so that there are several classes of bond holders with varying maturities. The

different bond classes are called tranches. The rules for the distribution of the principal

payments and the interest from the underlying collateral (i.e. the mortgage loans) among

the tranches are specified in the prospectus. By redirecting the cash flow (i.e. principal &

interest) from the underlying collateral, CMO issuers have created classes of bonds (i.e.

“senior” and “junior” classes) that have different degrees of prepayment risk and are

thereby more attractive to institutional investors than a pass-through security. The owners

of “senior-level” tranches are paid their principal and interest cash flows before the

owners of “junior” level tranches; therefore senior tranches generally have a lower

associated amount of prepayment risk.

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The various types of CMOs include sequential-pay bonds, planning amortization class

(PAC) bonds, accrual (“Z”) bonds, floating-rate bonds, inverse floating-rate bonds,

targeted amortization class (TAC) bonds, support bonds, and very accurately determined

maturity (VADM) bonds.

6.3.3 Stripped mortgage-backed securities

A pass-through divides the cash flow from the underlying mortgage collateral on a pro

rata basis to the security holders. Stripped mortgage-backed securities, introduced by

Fannie Mae in 1986, are created by altering the distribution of principal and interest from

a pro rata distribution to an unequal distribution.

There are two types of stripped MBS: synthetic-coupon pass-throughs and interest-

only/principal-only (“IO/PO”) securities. The first generation of stripped MBS was the

synthetic-coupon pass-throughs because the unequal distribution of principal and interest

resulted in a synthetic coupon rate that was different from the underlying mortgage

collateral. In early 1987, stripped MBS began to be issued in which all of the interest is

allocated to one class (the interest only class) and all of the principal payments to the

other class (the principal-only class). The IO class receives no principal payments, and

the PO class receives no interest.

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Eko Bank plans to securitize a $10 million of mortgage loan pool and sell the

beneficial interests in the open market. As part of the securitization process, Eko Bank

segregated the mortgage collateral from their other portfolios and transferred the

loans out of the Bank in order to protect them from the claims of creditors. The par

value of the mortgage-backed securities ultimately issued by Eko Bank totaled $8

million. Eko Bank submitted these MBS to a ratings agency prior to issuance.

8. Which of the following would Eko Bank most likely utilize in order to legally

isolate the underlying mortgage collateral to protect it from the claims of

creditors?

a. A special purpose entity.

b. A credit enhancer.

c. An underwriter.

d. An initial public offering.

9. Based on the above information, which of the following forms of credit

enhancement did Eko Bank most likely use when structuring this transaction?

a. Excess spread.

b. Over-collateralization.

c. Legal isolation.

d. Subordination.

10. Which of the following best describes the role that the ratings agency will play

in securitizing Eko Bank’s mortgage loans?

a. Protecting investors from losses in the event of borrower default.

b. Administering the trust that holds the mortgage collateral.

c. Marketing the mortgage-backed securities to investors.

d. Evaluating the credit quality of the security.

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Rousseau Corp. owns a portfolio of two asset-backed securities. Security A represents

a beneficial interest in a pool of mortgage loans issued by Eko Bank; this security

pays principal and interest to each investor on a pro-rata basis. Security B represents

the senior tranche of a FNMA security that allows Rousseau Corp. to be paid

mortgage principal and interest prior to the other (lower) tranches.

11. Security A is most likely an example of:

a. A non-agency pass-through security.

b. A non-agency IO strip.

c. An agency pass-through security.

d. An agency IO strip.

12. Security B is most likely an example of:

a. A non-agency pass-through security.

b. An agency CMO.

c. An agency pass-through security.

d. A non-agency CMO.

13. The rules for distributing the cash flows of the underlying mortgages to the

investors of Security B are most likely found in which of the following

documents?

a. The investor certificate.

b. The pooling and servicing agreement.

c. The mortgage application.

d. The prospectus.

14. Which of the following MBS positions would likely be considered the safest

investment with the least probability of default?

a. Position A is the senior tranche of a B-rated security.

b. Position B is the junior tranche of a B-rated security.

c. Position C is the senior tranche of an A-rated security.

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d. Position D is the junior tranche of an A-rated security.

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Chapter 6 Summary

• A mortgage is a long-term amortizing loan secured by real estate. Borrowers pay the debt

off over time in some combination of principal and interest payments that result in full

payment of the debt by maturity. When financial institutions originate residential

mortgages, the mortgage contract created should specify whether the mortgage is

federally insured, the amount of the loan, whether the interest rate if fixed or adjustable,

the interest rate to be charged, the maturity, and other special provisions that may vary

among contracts.

• The mortgage market is comprised of various sectors that include the prime, subprime

and alternative-A (Alt-A) sectors. Mortgages generally fall into one of these sectors based

the credit quality and documentation of the loan applicant.

• Mortgage loans may be obtained either directly from a financial institution (i.e. a direct

lender) or through a mortgage broker.

• Many financial institutions, including depository and non-depository institutions, offer

mortgage loan products. These institutions frequently contract outside servicers to

provide the operational aspects of mortgage lending (including payment processing, tax

remittance, foreclosure management, etc.).

• There are several factors that are considered important in evaluating both the

creditworthiness of a potential borrower and the overall riskiness of a mortgage,

including the borrower’s credit score, loan-to-value ratio, income ratio, and

documentation.

• Mortgage securitization is the structured process whereby interests in mortgage loans are

packaged, underwritten, and sold in the form of mortgage-backed securities (MBS).

• The securitization process redistributes risk by breaking up the traditional role of a bank

into a number of specialized roles: originator, servicer, credit enhancer, underwriter,

trustee, and investor.

• Before most loan pools can be converted into securities, they must be structured to

modify the nature of the risks and returns to the final investors. The four major stages of

the structuring process include: (1) Segregating the mortgages from the seller/originator,

(2) Creating a special-purpose entity to hold the mortgages and protect the various

parties’ interests, (3) adding credit enhancement to improve marketability, and (4) Issuing

interests in the mortgage pool.

• There are three types of mortgage-backed securities: (1) mortgage pass-through

securities, (2) collateralized mortgage obligations, and (3) stripped mortgage-backed

securities.

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Chapter 7 – Foreign Exchange Markets



• Identify the primary characteristics of the foreign exchange markets.

• Translate direct and indirect foreign exchange quotes.

• Recognize the economic factors that influence foreign exchange rates.

• Identify the differences between foreign exchange spot and forward contracts.

• Recognize how arbitrage profits are earned in foreign exchange markets.

7.1 Introduction to Foreign Exchange Markets

7.1.1 Foreign exchange defined

Almost every nation has its own national currency or monetary unit — its dollar, its

peso, its rupee — used for making and receiving payments within its own borders. But

foreign currencies are usually needed for payments across national borders. Thus, in any

nation whose residents conduct business abroad or engage in financial transactions with

persons in other countries, there must be a mechanism for providing access to foreign

currencies, so that payments can be made in a form acceptable to foreigners. In other

words, there is need for “foreign exchange” transactions — exchanges of one currency

for another.

“Foreign exchange (FX)” refers to money denominated in the currency of another nation

or group of nations. Any person who exchanges money denominated in his own nation’s

currency for money denominated in another nation’s currency acquires foreign exchange.

That holds true whether the amount of the transaction is equal to a few dollars or to

billions of dollars; whether the person involved is a tourist cashing a traveler’s check in a

restaurant abroad or an investor exchanging hundreds of millions of dollars for the

acquisition of a foreign company; and whether the form of money being acquired is

foreign currency notes, foreign currency denominated bank deposits, or other short term

claims denominated in foreign currency. A foreign exchange transaction is still a shift of

funds, or short-term financial claims, from one country and currency to another.

Thus, within the United States, any money denominated in any currency other than the

U.S. dollar is, broadly speaking, “foreign exchange.” Foreign exchange can be cash,

funds available on credit cards and debit cards, traveler’s checks, bank deposits, or other

short-term claims. It is still “foreign exchange” if it is a short-term negotiable financial

claim denominated in a currency other than the U.S. dollar.

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Whereas there are thousands of securities on the stock market, most trading in the FX

market takes place in the following currencies: the U.S. Dollar ($), Euro (€), Japanese

Yen (¥), British Pound Sterling (£), Swiss Franc (SF), Canadian Dollar (CAN$), and to a

lesser extent, the Australian and New Zealand Dollars. These major currencies are most

often traded because they represent countries with esteemed central banks, stable

governments, and relatively low inflation rates.

7.1.2 Market characteristics

The unique characteristics of the foreign exchange market include:

• It is the largest and most liquid market in the world

• It is a 24-hour market

• It is made up of an international network of dealers

• It’s most widely traded currency is the dollar

The World’s Largest Financial Market

The foreign exchange market is by far the largest and most liquid market in the world.

The estimated worldwide turnover of reporting dealers, at over $1 trillion a day, is several

times the level of turnover in the U.S. Government securities market, the world’s second

largest market. While this amount of turnover per day is a good indication of the level of

activity and liquidity in the global foreign exchange market, it is not necessarily a useful

measure of other forces in the world economy. Almost two-thirds of the total represents

transactions among the reporting dealers themselves — with only one-third accounted for

by their transactions with financial and non-financial customers. It is important to realize

that an initial dealer transaction with a customer in the foreign exchange market often

leads to multiple further transactions, sometimes over an extended period, as the dealer

institutions readjust their own positions to hedge, manage, or offset the risks involved.

The result is that the amount of trading with customers of a large dealer institution active

in the interbank market often accounts for a very small share of that institution’s total

foreign exchange activity.

The 24 Hour Market

During the past quarter century, the concept of a twenty-four hour market has become a

reality. Somewhere on the planet, financial centers are open for business, and banks and

other institutions are trading the dollar and other currencies, every hour of the day and

night, aside from possible minor gaps on weekends. In financial centers around the world,

business hours overlap; as some centers close, others open and begin to trade.

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The twenty-four hour market means that market conditions and pricing can change at any

time in response to developments that can take place at any time. It also means that

traders and other market participants must be alert to the possibility that a sharp move in

prices can occur during an off hour, elsewhere in the world. The large dealing institutions

have adapted to these conditions, and have introduced various arrangements for

monitoring markets and trading on a twenty-four hour basis. Some keep their New York

or other trading desks open twenty-four hours a day, others pass the torch from one office

to the next, and still others follow different approaches.

An International Network of Dealers

The FX market consists of a limited number of major dealer institutions that are

particularly active in foreign exchange, trading with customers and (more often) with

each other. Most, but not all, are commercial banks and investment banks. These dealer

institutions are geographically dispersed, located in numerous financial centers around

the world. Wherever located, these institutions are linked to, and in close communication

with, each other through telephones, computers, and other electronic means.

At a time when there is much talk about an integrated world economy and “the global

village,” the foreign exchange market comes closest to functioning in a truly global

fashion, linking the various foreign exchange trading centers from around the world into

a single, unified, cohesive, worldwide market. Foreign exchange trading takes place

among dealers and other market professionals in a large number of individual financial

centers — New York, Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt,

Paris, Zurich, Milan, and many, many others. But no matter in which financial center a

trade occurs, the same currencies are being bought and sold.

Each nation’s market has its own infrastructure. For foreign exchange market operations

as well as for other matters, each country enforces its own laws, banking regulations,

accounting rules, and tax code, and, as noted above, it operates its own payment and

settlement systems. Thus, even in a global foreign exchange market with currencies

traded on essentially the same terms simultaneously in many financial centers, there are

different national financial systems and infrastructures through which transactions are

executed, and within which currencies are held.

The Role of the Dollar

The dollar is by far the most widely traded currency in foreign exchange markets. The

widespread trading of the dollar reflects its use as a vehicle currency in foreign exchange

transactions, a use that reinforces, and is reinforced by, its international role in trade and

finance. For most pairs of currencies, the market practice is to trade each of the two

currencies against a common third currency as a vehicle, rather than to trade the two

currencies directly against each other. The vehicle currency used most often is the dollar.

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Thus, a trader wanting to shift funds from one currency to another, say, from Swedish

krona to Philippine pesos, will probably sell krona for U.S. dollars and then sell the U.S.

dollars for pesos. Although this approach results in two transactions rather than one, it

may be the preferred way, since the dollar/Swedish krona market, and the dollar/

Philippine peso market are much more active and liquid and have much better

information than a bilateral market for the two currencies directly against each other.

7.1.3 Payment & settlement systems

Just as each nation has its own national currency, so also does each nation have its own

payment and settlement system — that is, its own set of institutions and legally

acceptable arrangements for making payments and executing financial transactions

within that country, using its national currency. “Payment” is the transmission of an

instruction to transfer value that results from a transaction in the economy, and

“settlement” is the final and unconditional transfer of the value specified in a payment

instruction. Thus, if a customer pays a department store bill by check, “payment” occurs

when the check is placed in the hands of the department store, and “settlement” occurs

when the check clears and the department store’s bank account is credited. If the

customer pays the bill with cash, payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction,

they are agreeing on the terms of a currency exchange and committing the resources of

their respective institutions to that agreement. But the execution of that exchange—the

settlement — does not take place until later. Executing a foreign exchange transaction

requires two transfers of money value, in opposite directions, since it involves the

exchange of one national currency for another. Execution of the transaction engages the

payment and settlement systems of both nations, and those systems play a key role in the

operations of the foreign exchange market.

Payment systems have evolved and grown more sophisticated over time. At present,

various forms of payment are legally acceptable in the United States — payments can be

made, for example, by cash, check, automated clearinghouse (a mechanism developed as

a substitute for certain forms of paper payments), and electronic funds transfer (for large

value transfers between banks). Each of these accepted forms of payment has its own

settlement techniques and arrangements.

By number of transactions, most payments in the United States are still made with cash

(currency and coin) or checks. However, the electronic funds transfer systems, which

account for less than 0.1 percent of the number of all payments transactions in the United

States, account for more than 80 percent of the value of payments. Thus, electronic funds

transfer systems represent a key and indispensable component of the payment and

settlement systems. It is the electronic funds transfer systems that execute the interbank

transfers between dealers in the foreign exchange market. The two electronic funds

transfer systems operating in the United States are CHIPS (Clearing House Interbank

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Payments System), a privately owned system run by the New York Clearing House, and

Fedwire, a system run by the Federal Reserve.

7.1.4 Institutional use of foreign exchange markets

The manner by which financial institutions utilize the foreign exchange market is

summarized in Exhibit 7.1. The degree of international investment by financial

institutions is influenced by potential return, risk, and government regulations.

Commercial banks use international lending as their primary form of international

investing. Mutual funds, pension funds, and insurance companies purchase foreign

securities. In recent years, technology has reduced information costs and other transaction

costs associated with purchasing foreign securities, prompting an increase in institutional

purchases of foreign securities. Consequently, the financial institutions are increasing

their use of foreign exchange markets to exchange currencies. They are also increasing

their use of foreign exchange derivatives to hedge their investments in foreign securities

(the derivatives markets are discussed in the next chapter).

Exhibit 7.1 – Institutional Use of Foreign Exchange Markets

Financial Institution Use of FX Markets

Commercial banks • Serve as financial intermediaries by buying and selling

currencies to accommodate customers

• Speculate on FX movements by taking positions in various

currencies

• Provide forward contracts (and other FX products) to customers

International mutual funds • Exchange currencies when reconstructing their portfolios

• Use FX derivatives to hedge foreign exchange risk

Brokerage firms and investment

banking firms • Engage in foreign security transactions for their customers or for

their own accounts

Insurance companies • Exchange currencies for their international operations

• Use foreign exchange markets when purchasing foreign

securities for their investment portfolio or when selling foreign

securities.


Pension funds • Require foreign exchange of currencies when investing in

foreign securities for their stock or bond portfolios


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7.2 Foreign Exchange Rates

7.2.1 Exchange rates defined

The exchange rate is a market price — the number of units of one nation’s currency that

must be surrendered in order to acquire one unit of another nation’s currency in the FX

market. A market price is determined by the interaction of buyers and sellers in that

market, and a market exchange rate between two currencies is determined by the

interaction of the official and private participants in the foreign exchange rate market. For

a currency with an exchange rate that is fixed, or set by the monetary authorities, the

central bank or another official body is a key participant in the market, standing ready to

buy or sell the currency as necessary to maintain the authorized pegged rate or range. But

in the United States, where the authorities do not intervene in the foreign exchange

market on a continuous basis to influence the exchange rate, market participation is made

up of individuals, non-financial firms, banks, official bodies, and other private

institutions from all over the world that are buying and selling dollars at that particular

time.

The theories behind the determination of foreign currency exchange rates are discussed in

further detail in Section 7.2.3.

7.2.2 Quotes

When a currency exchange rate is quoted, it is done so in relation to another currency.

The value of one currency is therefore reflected through the value of the other currency.

For example, the foreign exchange quote between the United States Dollar (USD) and the

Japanese Yen (JPY) would appear as follows:

USD/JPY = 119.50

This relationship is referred to as a currency pair. The currency to the left of the slash is

referred to as the base currency; the currency to the right of the slash is referred to as the

quote currency.

Currency prices can be quoted either directly or indirectly. Direct quotes are currency

pairs wherein the domestic currency is listed as the base currency, while indirect quotes

are currency pairs wherein the domestic currency takes on the role of the quoted

currency. For example, if the Canadian Dollar (CAD) is the domestic currency and the

USD is the quoted currency in a currency pair, the direct quote would appear as

CAD/USD, and the indirect quote would read USD/CAD.

Customarily, the value of a foreign currency unit will vary in a direct quote, while the

domestic (or quoted) currency remains fixed as one unit. Conversely, the value of the

domestic currency will vary in an indirect quote, while the foreign currency remains fixed

as one unit. For example, if the direct quote is listed as 0.85 CAD/USD, it means that $1

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Canadian will buy $0.85 US. The indirect quote would read 1.18 USD/CAD meaning that

$1 USD will purchase $1.18 Canadian.

In order to convert a direct quote (DQ) to an indirect quote (IQ), you perform the

following calculation:

DQIQ

1=

In order to convert an indirect quote (IQ) to a direct quote (QQ), you perform the

following calculation:

IQDQ

1=

Typically, most currencies are traded against the USD and therefore the dollar is usually

listed as the base (or domestic) currency, and therefore becomes a direct quote. However,

not all currencies list the USD as the base currency. Usually, the currencies that have

historical ties with the United Kingdom --- namely the Australian Dollar and the New

Zealand Dollar --- are usually listed as the base currency against the USD. Despite the

fact that the Euro is a relative newcomer to the FX market, it is listed as the base currency

against the USD more often than not.

7.2.3 Exchange rate determination

This determination of foreign exchange rates has been extensively studied in economic

literature and widely discussed among investors, officials, academicians, traders, and

others. Still, there are no definitive answers. Views on exchange rate determination differ

and have changed over time. No single approach provides a satisfactory explanation of

exchange rate movements, particularly short- and medium-term movements.

This being said, the following are some of the principal determinants of the exchange

rate, all of which relate to the trading relationship between two countries. Note that these

factors are in no particular order; like many aspects of economics, the relative importance

of these factors is subject to much debate.

Differentials in inflation. As a rule of thumb, a country with a consistently lower

inflation rate exhibits a rising currency value, as its purchasing power increases relative

to other currencies. During the last half of the twentieth century, the countries with low

inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved

low inflation only later. Those countries with higher inflation typically see depreciation

in their currency in relation to the currencies of their trading partners. This is also usually

accompanied by higher interest rates.

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Differentials in interest rates. Interest rates, inflation and exchange rates are all highly

correlated. By manipulating interest rates, central banks exert influence over both

inflation and exchange rates, and changing interest rates impact inflation and currency

values. Higher interest rates offer lenders in an economy a higher return relative to other

countries. Therefore, higher interest rates attract foreign capital and cause the exchange

rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the

country is much higher than in others, or if additional factors serve to drive the currency

down. The opposite relationship exists for decreasing interest rates - that is, lower interest

rates tend to decrease exchange rates.

Current-account deficits. The current account is the balance of trade between a country

and its trading partners, reflecting all payments between countries for goods, services,

interest and dividends. A deficit in the current account shows the country is spending

more on foreign trade than it is earning, and that it is borrowing capital from foreign

sources to make up the deficit. In other words, the country requires more foreign currency

than it receives through sales of exports, and it supplies more of its own currency than

foreigners demand for its products. The excess demand for foreign currency lowers the

country's exchange rate until domestic goods and services are cheap enough for

foreigners, and foreign assets are too expensive to generate sales for domestic interests.

Public debt. Countries will engage in large-scale deficit financing to pay for public

sector projects and governmental funding. While such activity stimulates the domestic

economy, nations with large public deficits and debts are less attractive to foreign

investors. The reason? A large debt encourages inflation, and if inflation is high, the debt

will be serviced and ultimately paid off with cheaper real dollars in the future. In the

worst case scenario, a government may print money to pay part of a large debt, but

increasing the money supply inevitably causes inflation. Moreover, if a government is not

able to service its deficit through domestic means (selling domestic bonds, increasing the

money supply), then it must increase the supply of securities for sale to foreigners,

thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if

they believe the country risks defaulting on its obligations. Foreigners will be less willing

to own securities denominated in that currency if the risk of default is great. For this

reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for

example) is a crucial determinant of its exchange rate. Terms of trade. A ratio comparing export prices to import prices, the terms of trade is

related to current accounts and the balance of payments. If the price of a country's exports

rises by a greater rate than that of its imports, its terms of trade have favorably improved.

Increasing terms of trade shows greater demand for the country's exports. This, in turn,

results in rising revenues from exports, which provides increased demand for the

country's currency (and an increase in the currency's value). If the price of exports rises

by a smaller rate than that of its imports, the currency's value will decrease in relation to

its trading partners.

Political stability and economic performance. Foreign investors inevitably seek out

stable countries with strong economic performance in which to invest their capital. A

country with such positive attributes will draw investment funds away from other

countries perceived to have more political and economic risk. Political turmoil, for

example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.

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7.2.4 Purchasing Power Parity (PPP)

The most prominent theory for explaining the determination of exchange rates is

Purchasing Power Parity. The Purchasing Power Parity (PPP) theory holds that in the

long run, exchange rates will adjust to equalize the relative purchasing power of

currencies.

• Absolute PPP states that exchange rates will equate nations’ overall price levels. This

theory is based on the economic law of one price, which holds that in competitive

markets, identical goods will sell for identical prices when valued in the same currency.

• Relative PPP is a more commonly used version that focuses on changes in prices and

exchange rates, rather than on absolute price levels. Relative PPP holds that there will be

a change in exchange rates proportional to the change in the ratio of the two nations’

price levels, assuming no changes in structural relationships. Thus, if the U.S. price level

rose 10 percent and the Japanese price level rose 5 percent, the U.S. dollar would

depreciate 5 percent, offsetting the higher U.S. inflation and leaving the relative

purchasing power of the two currencies unchanged.

PPP is based in part on some unrealistic assumptions: that goods are identical; that all

goods are tradable; that there are no transportation costs, information gaps, taxes, tariffs,

or restrictions of trade; and — implicitly and importantly — that exchange rates are

influenced only by relative inflation rates. But contrary to the implicit PPP assumption,

exchange rates also can change for reasons other than differences in inflation rates. Real

exchange rates can and do change significantly over time, because of such things as

major shifts in productivity growth, advances in technology, shifts in factory supplies,

changes in market structure, commodity shocks, shortages, and booms.

In addition, the relative version of PPP suffers from measurement problems: What is a

good starting point, or base period? Which is the appropriate price index? How should we

account for new products, or changes in tastes and technology?

PPP is intuitively plausible and a matter of common sense, and it undoubtedly has some

validity — significantly different rates of inflation should certainly affect exchange rates.

PPP is useful in assessing long-term exchange rate trends and can provide valuable

information about long-run equilibrium. But it has not met with much success in

predicting exchange rate movements over short- and medium-term horizons for widely

traded currencies. In the short term, PPP seems to apply best to situations where a

country is experiencing very high, or even hyperinflation, in which large and continuous

price rises overwhelm other factors.

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Juliet, a trader for Swan Financial, has been asked to research the possibility of

investing the company’s capital in the foreign exchange market.

1. Which of the following statements would most likely appear in Juliet’s report to

accurately describe the characteristics of the FX market?

a. “The FX market features thousands of different currencies.”

b. “The FX market is open only during standard European business hours.”

c. “The FX market is highly liquid.”

d. “The FX market is comprised strictly of domestic and international

governmental entities.”

2. Which of the following statements would most likely appear in Juliet’s report to

accurately describe the execution of trades in the FX market?

a. “A global standard exists for the payment and settlement of foreign

currency.”

b. “Most FX trades use the Japanese yen as a vehicle currency.”

c. “The agreement of transaction terms and trade execution occur

simultaneously.”

d. “FX trading requires two distinct transfers of currency in opposite

directions.”

Juliet has received approval from the senior management of Swan Financial to

begin trading in the foreign exchange markets. Juliet receives the following British

pound quote: USD/GBP = 0.6598.

3. Given the FX quote provided above, the British pound (GBP) would be

considered the:

a. Direct currency.

b. Quote currency.

c. Indirect currency.

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d. Base currency.

4. Given the FX quote provided above, the U.S. dollar (USD) would be considered

the:

a. Direct currency.

b. Quote currency.

c. Indirect currency.

d. Base currency.

5. Given the FX quote provided above, approximately how many U.S. dollars

would Juliet be able to purchase with 100 British pounds?

a. 0.66.

b. 1.52.

c. 66.0.

d. 151.6

6. Which of the following isolated economic observations would most likely make

it more expensive for Juliet to use USD to purchase GBP is the FX market?

a. The inflation rate in Great Britain decreases.

b. A decreasing deficit in the U.S. current account.

c. The national debt of Great Britain increases significantly.

d. Interest rates in the U.S. increase.

7.3 Foreign Exchange Transactions

7.3.1 Spot transactions

A foreign exchange spot transaction is a straightforward (or “outright”) exchange of one

currency for another. The spot rate is the current market price of the foreign currency.

Spot transactions do not require immediate settlement, or payment “on the spot.” By

convention, the settlement date, or “value date,” is the second business day after the “deal

date” (or “trade date”) on which the transaction is agreed to by the two traders. The two-

day period provides ample time for the two parties to confirm the agreement and arrange

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the clearing and necessary debiting and crediting of bank accounts in various

international locations.

7.3.2 Forward transactions

A foreign exchange forward transaction (“FX forward”) is an agreement to purchase or

sell a set amount of a foreign currency at a specified price for settlement at a

predetermined future date, or within a predetermined window of time16. The contract

holders are obligated to buy or sell the currency at a specified price, at a specified

quantity and on a specified future date. Forward agreements to purchase foreign

currency are referred to as long contracts; forward contracts to sell foreign currency are

referred to as short contracts. These contracts cannot be transferred. FX forwards help

investors manage the risk inherent in currency markets by predetermining the rate and

date on which they will purchase or sell a given amount of foreign exchange.

FX forwards are traded in most major currencies, with bid-ask spreads quoted in standard

maturities of 1, 2, 3, 6, 9, and 12 months. The extent to which a currency forward is

available depends on whether exchange controls exist, the depth of alternative markets,

and a country’s monetary policy.

The forward foreign exchange markets – like the spot FX markets – are liquid, efficient

and are used by sophisticated participants. The behavior of these markets will therefore

be largely regulated by the legal contract under which they operate and the enforceability

of that contract.

The most important term included in a FX forward agreement is the forward rate (or

‘forward price’). In general terms, the forward rate is the amount that it will cost to

deliver the currency some time in the future. The pricing of a foreign exchange forward

contract is equivalent to determining the forward foreign exchange rate. In a sense, the

forward rate is the wholesale price for the forward contract. To this, the derivatives dealer

normally adds a bid-ask spread (as a profit motive).

After the two counterparties agree on the forward price for the future exchange of the

underlying currencies, the parties specify other terms of the contract:

• The amount of one currency to be exchanged for a stated amount of the other

• The date of the exchange

• The location of the exchange

If the contract is to be cash-settled, it specifies the spot rate at the maturity date as the

average of the bid-ask prices quoted by a specified bank for the spot purchase and spot

16 A “forward” contract is a form of derivative instrument. Derivatives are discussed in further detail in

Chapter 8.

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sale, respectively, of the contract currency in exchange for U.S. dollars at a prescribed

location (usually New York, London or Tokyo) at a prescribed time (usually 11:00 AM

local time).

Forward contracting requires the counterparties to agree on the forward price and

settlement date and to exchange written agreements. The settlement date of a forward

contract is the date at which a contract is actually payable. For example, if on March 1st

we agree to a three-month forward, the maturity date would be June 3, with the

settlement date two dates later. These dates, as well as the date of origination of the

contract, are stipulated in a legal document between the contracting parties. As in a loan

agreement, if one party is late in delivery of funds on contract settlement, penalty interest

is incurred on the outstanding balance.

For a forward contract, the maturity date is the only relevant date in calculating the

amount one party will owe the other on settlement date. That is, the legal agreement

stipulates that the settlement flows are based only on the deviation in contract price from

the spot price on the maturity date. According to the contract (though not necessarily

from the contractors’ perspectives), fluctuations that occur in the foreign exchange rate

between the origination date and the maturity date (when the settlement payment is

calculated) are of no consequence.

7.4 International Arbitrage

Arbitrage is the practice of taking advantage of a price differential between two or more

markets; it involves striking a combination of matching deals that capitalize upon the

imbalance; the arbitrage profit equals the difference between the market prices.

Example – The Benefits of an FX Forward

Assume that an American construction company, Jin Construction, just won a contract to

build a stretch of road in Canada. The contract is signed for $5,000,000 CAD and would be

paid for after the completion of the work. The Canadian Dollar is worth $0.90 USD at the

time the contract is signed. However, since the exchange rate could fluctuate and end with a

possible depreciation of CAD$, Jin enters into a forward agreement with the Royal Bank of

Canada to fix the exchange rate at $0.90 USD per Canadian dollar. By entering into a forward

contract Jin is guaranteed an exchange rate of $0.90 USD per Canadian dollar in the future

irrespective of what happens to the spot USD/CAD exchange rate. If Canadian dollar were to

actually depreciate, Jin would be protected. However, if it were to appreciate, then Jin would

have to forego this favorable movement and hence bear some implied losses. Even though this

favorable movement is still a potential loss, Jin proceeds with the hedging since it knows an

exchange rate of $0.90 USD per Canadian dollar is consistent with a profitable venture.

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Exchange rates in the foreign exchange market are market determined. If they become

misaligned, various forms of arbitrage will occur, forcing realignment. Common

examples of international arbitrage include:

• Locational arbitrage

• Covered interest arbitrage

7.4.1 Locational arbitrage

Suppose the exchange rates of the Canadian dollar (CAN$) quoted by two banks differ,

as shown in Exhibit 7.2:

Exhibit 7.2 – Bank Quotes (Locational Arbitrage)

Bank Bid Rate – CAN$ Ask Rate – CAN$

Los Angeles Bank $.700 $.707

Island Bank $.691 $.699

Because Island Bank is asking $.699 for Canadian dollars and Los Angeles Bank is

willing to pay (bid) $.700 for CAN$, an institution could execute locational arbitrage.

That is, it could achieve a risk-free return without tying funds up for any length of time

by buying CAN$ at one location (Island Bank) and simultaneously selling them to the

other location (Los Angeles Bank).

As locational arbitrage is executed, Island Bank will begin to raise its ask price on CAN$

in response to the strong demand. In addition, Los Angeles Bank will begin to lower its

bid price in response to its excess supply of CAN$ recently received. Once the ask price

of Island Bank is at least as high as the bid price by Los Angeles Bank, locational

arbitrage will no longer be possible. Because some financial institutions (particularly the

foreign exchange departments of commercial banks) watch for locational arbitrage

opportunities, any discrepancy in exchange rates among locations should be quickly

alleviated.

7.4.2 Covered interest arbitrage

The coexistence of international money markets and forward markets forces a special

relationship between a forward rate premium17 and the interest rate differential of two

countries, known as interest rate parity. The equation for interest rate parity can be

written as:

17 A forward premium (forward discount) is the proportion by which a country's forward exchange rate

exceeds (falls below) its spot rate.

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( )( )

11

1−

+

+=

F

H

i

ip

Where p = the forward premium of foreign currency, iH = the home country interest rate

and iF = the foreign interest rate.

For example, assume that the spot rate of the British pound is $0.50, the one-year U.S.

interest rate is 9 percent, and the one-year British interest rate is 6 percent. Under

conditions of interest rate parity, the forward premium on the pound would be:

( )1

%61

%91−

+

+=p

%8.2

This means that the forward rate of the pound would be about $.514, to reflect a 2.8

percent premium above the spot rate. When one reviewed the equation for interest rate

parity, the following relationship becomes apparent:

If the interest rate is lower in the foreign country than in the home country, the forward

rate of the foreign currency will have a premium.

If the interest rate is higher in the foreign country than in the home country, the forward

rate of the foreign currency will have a discount.

Interest rate parity suggests that the forward rate premium (or discount) should be equal

to the differential in interest rates between the countries of concern. When this condition

is not true, an investor could earn abnormally higher returns by executing covered

interest arbitrage.

To illustrate this relationship, assume that both the spot rate and one-year forward rate of

the Canadian dollar was $0.80. Also assume that the Canadian interest rate as 10 percent,

while the U.S. interest rate was 8 percent. U.S. investors could take advantage of the

higher Canadian interest rate without being exposed to exchange rate risk by executing

covered interest arbitrage. Specifically, they would exchange U.S. dollars for Canadian

dollars and invest at the rate of 10 percent. They would simultaneously sell Canadian

dollars one year forward. Because they are able to purchase and sell Canadian dollars for

the same price, their return is the 10 percent interest earned on their investment.

As the U.S. investors demand Canadian dollars in the spot market while selling Canadian

dollars forward, they place upward pressure on the spot rate and downward pressure on

the one-year forward rate of the Canadian dollar. Thus, the Canadian dollar’s forward

rate will exhibit a discount. Once the discount becomes large enough, the interest rate

advantage in Canada will be offset. The gain earned by U.S. investors on the higher

Canadian interest rate is offset by the loss incurred on the purchase and sale of

Canadian dollars at unfavorable spot and forward rates. Consequently, covered interest

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arbitrage will no longer generate a return that is any higher for U.S. investors than an

alternative investment within the United States. Once the forward discount (or premium)

offsets the interest rate differential in this manner, interest rate parity exists.


Faraday Inc. has entered into two agreements for the purchase of euros and the

sale of Canadian dollars. Under contract A, Faraday will purchase 1 million euros

today at $1.49 per euro. Under contract B, Faraday will sell 500,000 Canadian dollars

to a customer one year from now at $0.80 per CAN$. The prevailing CAN$/USD

exchange rate on the agreement date was $0.82. The prevailing CAN$/USD

exchange rate on the delivery date is $0.75.

7. Contract A is an example of which type of financial instrument?

a. A long FX forward contract.

b. A short FX forward contract.

c. A long FX spot contract.

d. A short FX spot contract.

8. Contract B is an example of which type of financial instrument?

a. A long FX forward contract.

b. A short FX forward contract.

c. A long FX spot contract.

d. A short FX spot contract.

9. Which of the following equals the “forward rate” under the terms of Faraday’s

Canadian dollar contract?

a. $0.75.

b. $0.80.

c. $0.82.

d. $1.49.

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10. Which of the following is an example of a U.S. company earning a profit as a

result of foreign exchange arbitrage?

a. Company A purchases Japanese yen from U.S. Bank for $100 and

simultaneously sells that yen to Euro Bank for $105.

b. Company B purchases long and short 6 month euro forward contracts

with the same forward rate.

c. Company C purchases a share of stock for £75 and sells it for £90 three

years later.

d. Company D issues floating rate debt denominated in Swiss francs.

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Chapter 7 Summary

• Foreign exchange (FX) refers to money denominated in the currency of another nation or

group of nations. Any person who exchanges money denominated in his own nation’s

currency for money denominated in another nation’s currency acquires foreign exchange.

• Most trading in the FX market takes place in the following currencies: the U.S. Dollar

($), Euro (€), Japanese Yen (¥), British Pound Sterling (£), Swiss Franc (SF), Canadian

Dollar (CAN$), and to a lesser extent, the Australian and New Zealand Dollars.

• The foreign exchange market is the largest and most liquid market in the world. It is a

“24-hour market” that is made up of an international network of dealers. The most widely

traded currency in FX markets is the dollar. Each FX market participant (i.e. each nation)

has its own set of institutions and legally acceptable arrangements (referred to as a

“payment and settlement system”) for making payments and executing financial

transactions within that country, using its national currency.

• An exchange rate is a market price for foreign currency. It is the number of units of one

nation’s currency that must be surrendered in order to acquire one unit of another nation’s

currency in the FX market. When a currency exchange rate is quoted, it is done so in

relation to another currency (either directly or indirectly). This relationship is referred to

as a currency pair.

• There are many factors that determine the exchange rate for a currency, including (1)

differentials in inflation and interest rates, (2) current-account deficits, (3) public debt

levels, (4) terms of export/import trading, and (5) political stability and economic

performance. The most prominent theory for explaining the determination of exchange

rates is known as Purchasing Power Parity (PPP).

• Foreign exchange transactions include spot and forward contracts:

A foreign exchange spot transaction is a straightforward (or “outright”) exchange of one

currency for another. The spot rate is the current market price, the benchmark price.

A foreign exchange forward transaction is an agreement to purchase or sell a set amount of a

foreign currency at a specified price for settlement at a predetermined future date, or within a

predetermined window of time. The forward rate is the amount that it will cost to deliver a

currency, commodity, or some other asset some time in the future.

• Arbitrage is the practice of taking advantage of a price differential between two or more

markets; it involves striking a combination of matching deals that capitalize upon the

imbalance; the arbitrage profit equals the difference between the market prices. Common

examples of foreign exchange arbitrage include (1) locational arbitrage and (2) covered

interest arbitrage.

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Chapter 8 – Derivatives Markets



• Identify the various types of risk that impact financial markets.

• Recognize the types of instruments traded in derivatives markets.

• Identify the unique characteristics of forwards, futures, swaps and options.

8.1 Financial Risk Management

Financial risk management is a process to manage the uncertainties resulting from

financial markets. It involves assessing the financial risks facing an organization and

developing management strategies consistent with internal priorities and policies.

Addressing financial risks proactively may provide an organization with a competitive

advantage. It also ensures that management, operational staff, stakeholders and the board

of directors are in agreement on key issues of risk.

8.1.1 Financial risks

When financial prices change dramatically, it can increases costs, reduce revenues, or

otherwise negatively impact the financial health of an organization. Financial fluctuations

may make it more difficult to plan and budget, price goods and services, and allocate

capital. The probability that market fluctuations will adversely impact the profitability of

an organization (or an investment) is referred to as financial risk.

Generally speaking, financial risk is the probability that the actual return on a business or

investment will be less than the expected return. Financial risk can arise through

countless transactions of a financial nature, including sales and purchases, investments

and loans, and other various business activities. It can also arise as a result of legal

transactions, new projects, mergers and acquisitions, debt financing or through the

activities of management, stakeholders, competitors, foreign governments or weather.

Financial risks are generally considered either systematic or unsystematic:

• Systematic risk is the risk inherent to the entire market or entire market segment. Interest

rates, recession and wars all represent sources of systematic risk because they affect the

entire market and cannot be avoided through diversification. It is also referred to as "un-

diversifiable risk" or "market risk."

• Unsystematic risk refers to company or industry specific risk that is inherent in each

investment. For example, news that is specific to a small number of stocks, such as a

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sudden strike by the employees of a company you have shares in, is considered to

be unsystematic risk. Unsystematic risk can be mitigated through appropriate

diversification. It is also referred to as "specific risk", "diversifiable risk" or "residual

risk".

Specific examples of financial risk include:

• Interest rate risk is the risk that changes in the levels of interest rates will adversely

impact the value of an investment or the profitability of a business. In terms of

investments, interest rate risk affects the value of bonds more directly than stocks, and it

is a major risk to all bondholders. As interest rates rise, bond prices fall and vice

versa. The rationale is that as interest rates increase, the opportunity cost of holding a

bond decreases since investors are able to realize greater yields by switching to other

investments that reflect the higher interest rate. For example, a 5% bond is worth more if

interest rates decrease since the bondholder receives a fixed rate of return relative to the

market, which is offering a lower rate of return as a result of the decrease in rates. Interest

rate risk can also impact companies and governments because interest rates are a key

ingredient in the cost of capital. Most companies and governments require debt financing

for expansion and capital projects. When interest rates increase, the impact can be

significant on borrowers.

• Credit risk (also referred to as default risk – see section 2.3.1) is one of the most

prevalent risks of finance and business. It is defined as the risk of loss of principal or loss

of a financial reward stemming from a borrower's failure to repay a loan or otherwise

meet a contractual obligation. In general, credit risk is a concern when an organization is

owed money or must rely on another organization to make a payment to it or on its

behalf. Credit risk is especially prevalent in the world of finance and investments. Credit

risk is the risk that payments on a security will not be made under the original terms.

Credit evaluation of a security assesses the likelihood of the issuer defaulting on the

obligation.

• Foreign exchange risk (also known as "currency risk" or "FX risk") is the risk of an

investment's value changing due to movements in currency exchange rates. It is also the

risk that an investor will have to close out an open position in a foreign currency at a

loss due to an adverse movement in exchange rates. Foreign currency debt can be

considered a source of translation risk. If an organization borrows in a foreign currency

but has no offsetting currency assets or cash flows, increases in the value of the foreign

currency vis-à-vis the domestic currency mean an increase in the translated market value

of the foreign currency liability.

• Liquidity risk (as discussed in section 2.3.2) is the risk stemming from the lack of

marketability of an investment that cannot be bought or sold quickly enough to prevent or

minimize a loss. Such risk is usually reflected in a wide bid-ask spread or large price

movements.

• Prepayment risk is the risk associated with the early unscheduled return of principal on

a fixed-income security. When principal is returned early, future interest payments will

not be paid on that part of the principal (thus reducing the yield-to-maturity on that

investment).

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• Inflation risk reflects the possibility that the value of assets or income will decrease as

inflation shrinks the purchasing power of a currency. Inflation causes money to decrease

in value at some rate, and does so whether the money is invested or not.

• Political risk is the risk that an investment's returns could suffer as a result of political

changes or instability in a country. Instability affecting investment returns could stem

from a change in government, legislative bodies, other foreign policy makers, or military

control.

8.1.2 Hedging financial risk

The terms ‘hedge’ and ‘hedging’ are used frequently in the world of financial risk

management. But what exactly do those terms mean?

The best way to understand hedging is to think of it as insurance. When people decide to

hedge, they are insuring themselves against a negative event. This doesn't prevent a

negative event from happening, but if it does happen and you're properly hedged, the

impact of the event is reduced. So, hedging occurs almost everywhere, and we see it

everyday. For example, if you buy house insurance, you are hedging yourself against

fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to

reduce their exposure to various financial risks. In financial markets, however, hedging

becomes more complicated than simply paying an insurance company a fee every year.

Hedging against financial risk generally involves strategically implementing various

strategies to offset the risk of any adverse price movements. The primary hedging

strategies employed by most institutions today involve the use of derivative instruments.

8.1.3 Derivative instruments

A derivative instrument is a financial product that derives its value from an underlying

asset or liability. The underlying asset or liability can be another financial instrument

(such as a debt or equity security), a currency or a commodity. The term derivative refers

to how the price of these contracts is derived from the price of the underlying security or

commodity or from some index, interest rate, exchange rate or event.

Derivatives are used primarily for hedging risk (however they may also be purchased for

speculative purposes). Their use has grown exponentially since the 1980’s. Today,

derivatives are used to hedge the risks normally associated with commerce and finance.

Farmers can use derivatives to hedge the risk that the prices of their crops fall before they

are harvested and brought to the market. Banks can use derivatives to reduce the risk that

the short-term interest rates that they pay to their depositors will increase, thus reducing

the profit they earn on fixed interest rate loans and securities. Mortgage giants Fannie

Mae and Freddie Mac – the world largest end-users of derivatives – use interest rate

swaps, options and swaptions to hedge against the prepayment risk associated with home

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mortgage financing. Electricity producers hedge against unseasonable changes in the

weather. Pension funds use derivatives to hedge against large drops in the value of their

portfolios, and insurance companies sell credit protection to banks and securities firms

through the use of credit derivatives.

Exhibit 8.1 – Derivative Categories

Derivative instruments can be traded either on various specified exchanges or “over-the-

counter”:

➢ Exchange-traded derivatives are those traded on a derivatives exchange where

individuals purchase or sell standardized derivative contracts that have been

defined by the exchange. The Chicago Board of Trade (CBOT) is an example of a

derivatives exchange.

➢ Over-the-counter (OTC) derivatives are generally customized transactions that

are traded by dealers in private transactions over the phone. The traders are

usually financial institutions, corporations and fund managers. A key advantage of

the OTC market is that the terms of a contract do not have to be those specified by

an exchange. Market participants are free to negotiate any mutually attractive

deal. A disadvantage is that there is usually some credit risk associated with an

OTC trade (i.e. there is a small risk that the contract will not be honored). Such

credit risk does not normally exist with derivatives that are traded on an exchange.

As Exhibit 8.1 illustrates, there are four basic types of derivative instruments: forwards,

futures, swaps and options.

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1. Reyes Corp. has made an investment in a small construction company that

employs several union workers. The likelihood that the company’s earnings will

be negatively impacted by a union strike would be considered _________; the

likelihood that the company’s earnings will be negatively impacted by a

downturn in the U.S. economy would be considered _________.

a. An unsystematic risk; an unsystematic risk.

b. An unsystematic risk; a systematic risk.

c. A systematic risk; an unsystematic risk.

d. A systematic risk; a systematic risk.

Companies A, B, C & D are U.S.-based reporting entities. Their customers exclusively

reside in the United States.

2. The highest amount of interest rate risk would most likely be associated with

which of the following assets?

a. Company A’s fixed rate securities portfolio.

b. Company B’s land held for sale.

c. Company C’s raw materials inventory.

d. Company D’s product inventory.

3. The highest amount of credit risk would most likely be associated with which of

the following assets?

a. Company A’s U.S. Treasuries portfolio.

b. Company B’s factory.

c. Company C’s past due accounts receivable.

d. Company D’s office equipment.

4. The highest amount of foreign exchange risk would most likely be associated

with which of the following assets?

a. Company A’s USD securities portfolio.

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b. Company B’s property & plant.

c. Company C’s cost of goods sold.

d. Company D’s Euro-denominated money market accounts.

5. Which of the following contracts represents an example of a derivative

instrument?

a. Company A’s floating rate debt security.

b. Company B’s lease agreement.

c. Company C’s pork belly futures contract.


6. The Hanso Group is a London-based public company that issued a number of

stock options to its employees as compensation. Which of the following would

most likely cause the value of these options to increase?

a. Decreases in the level of interest rates.

b. Decreases in employee turnover at Hanso.

c. Increases in Hanso’s stock price.

d. Increases in the EUR/USD exchange rate.

8.2 Forward Markets

8.2.1 Forward contracts

As briefly discussed in Chapter 7, a forward contract (also referred to as a forward) is

defined as a contract that obligates the holder to buy or sell an underlying asset for a

predetermined price at a predetermined future time. In other words, a forward is an

agreement to buy or sell an asset at a certain future time for a certain price. It can be

contrasted with a spot contract, which is an agreement to buy or sell an asset today.

Consider the following examples of contracts offered by ABC Oil Company for the

purchase of home heating oil:

▪ The first contract involves the purchase of a specified number of gallons of heating oil for

delivery today at $2.20 per gallon. This is an example of a spot contract.

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▪ The second contract involves the purchase of a specified number of gallons of heating oil

for delivery next year at $1.90 per gallon. This is an example of a forward contract.

A forward contract is traded in the over-the-counter market – usually between two

financial institutions or between a financial institution and one of its clients. The parties

that agree to the forward contract are known as counterparties. One of the counterparties

to a forward contract assumes a long position and agrees to buy the underlying asset on a

certain specified future date for a certain specified price. The other counterparty assumes

a short position and agrees to sell the asset on the same date for the same price. The

guaranteed price at which the future exchange will take place is referred to as the forward

price (a.k.a. the delivery price or contract price), and the date on which the sale will

transpire is referred to as the delivery date.

In the example above, ABC Oil Company would assume the short position in the forward

contract by agreeing to sell heating oil next year for $1.90 a gallon (i.e. the contract

price), while ABC’s customer would assume the long position in the forward contract by

agreeing to purchase the heating oil at the contract price. The value of this derivative (i.e.

the forward contract) is derived from the market price of heating oil (i.e. the underlying).

There are several different types of forward contracts, including commonly traded foreign

exchange forwards (discussed in section 7.3.2) and forward rate agreements.

8.2.2 Forward rate agreements

Forward rate agreements (“FRA”) are over-the-counter agreements in which one party

pays a fixed interest rate, and receives a floating interest rate equal to a reference rate

(the underlying rate, which is normally based on an index). These instruments are

normally transacted to hedge interest rate risk. If a firm knows that they will need to

borrow money in the future, they can lock in the interest rate with a forward rate

agreement. Forward rate agreements exist in various currencies, but the largest markets

are in U.S. dollars, pounds sterling, deutsche marks, Swiss francs and Japanese yen.

Forward rate agreements are generally used:

• By market participants who wish to hedge against future interest rate risks by locking in

an interest rate today (i.e. for hedging purposes)

• By market participants who want to make profits based on their expectations of the future

development of interest rates (i.e. for speculative purposes)

• By market participants who try to take advantage of the different prices of FRAs and

other financial instruments (i.e. for arbitrage purposes)

Forward rate agreements are considered forward contracts on interest rates, and not

forward commitments to make loans or take deposits. Therefore a forward rate

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agreement’s payoff amount is based on a notional principal that is specified in the

contract. The principal is notional in the sense that it is not paid or received upon the

maturity of the contract, but is instead used only to calculate the cash flows paid and

received.

In most cases, FRAs are written so that no money changes hands until the settlement

date. To determine the cash flows on the settlement date, the current value of the

reference rate is compared to the contract rate specified in the forward contract. The

actual dollar amount that changes hands is the present value of the dollar value of the

difference between the two rates.

FRA contracts generally contain a “normal banking practice” clause that commits the

parties to specific performance. If a party fails to perform, this clause makes the

outstanding net cash value of the contract subject to the same conditions that would apply

in the case of nonperformance on a loan. Such a clause highlights the fact that an FRA,

like a foreign exchange forward, is an instrument that is subject to credit risk.

8.3 Futures Markets

8.3.1 Futures contracts

A futures contract is a legally binding commitment to buy or sell a specified quantity of

a specified asset at a specified date in the future. Some futures contracts (notably

agricultural futures) require physical delivery of the asset, so the buy-sell activities

implied in the contracts are actually consummated. The price paid to take delivery (or

received to make delivery) of a given asset on a given date is determined by the price at

which that specific futures contract trades. Other futures contracts (notably stock index

futures and Eurodollar futures) are cash-settled. In fact, few futures contracts are held to

maturity and exercised; the majority of positions are closed through a reversing trade in

the market.

The range of available futures markets and contracts is wide. In addition to the

agricultural commodities for which the futures markets are best known (such as corn,

oats, soybeans, pork bellies), futures are traded on:

Precious metals (gold, silver, platinum, etc.)

Industrial commodities (aluminum, lead, copper, heating oil, natural gas electricity, etc.)

Foreign exchange (Swiss francs, Deutsche marks, British pounds, Japanese yen, etc.)

Interest-bearing securities (T-bills, Eurodollar deposits, T-notes and bonds, Federal

funds, etc.)

Stock indexes (S&P 500, NYSE Composite Index, etc.)

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Although futures contracts on commodities have been traded since the 1860’s, financial

futures are relatively new, dating from the introduction of foreign currency futures in

1972.

As with forward contracts, one of the parties to a futures contract assumes a long position

and agrees to buy an underlying asset on a certain specified future date for a certain

specified price. The other party assumes a short position and agrees to sell the asset on

the same date for the same price. The contract price at which the transaction will take

place is referred to as the futures price and the date on which the sale will transpire is

referred to as the delivery date.

8.3.2 Futures exchanges

Like a forward contract, a futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future for a certain price. Unlike forward contracts,

futures contracts are normally traded on an exchange. A futures exchange is a central

marketplace where people can trade futures contracts.

To make trading possible, futures exchanges specify certain standardized features of the

futures contract. The adoption of standardized contracts for delivery of grain by the

Chicago Board of Trade (the world’s first modern futures exchange) in 1865 marked the

birth of the modern futures contract. While forward contracts can be written for any

quantity of any commodity for delivery at any time the two parties desire, futures

contracts are rigidly defined.

Futures exchanges establish all the key parameters of a contract. For example, a Chicago

Board of Trade corn futures contract set terms of 5,000 bushels of U.S. No. 2 corn to be

delivered to an exchange-approved clearinghouse. Available delivery months are March,

May, July September and December.

Standardized terms of a futures contract generally include (but are not limited to):

• The underlying asset or instrument.

• The type of settlement (either cash settlement or physical settlement).

• The amount and units of the underlying asset per contract. This can be the notional

amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional

amount of the deposit over which the short term interest rate is traded, etc.

• The currency in which the futures contract is quoted.

• The grade of the deliverable. In the case of bonds, this specifies which bonds can be

delivered. In the case of physical commodities, this specifies not only the quality of the

underlying goods but also the manner and location of delivery.

• The delivery month.

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• The last trading date.

• Other details such as the commodity tick, the minimum permissible price fluctuation.

8.3.3 Market mechanics

There are two types of traders executing futures trades: commission brokers and locals.

Commission brokers are following the instructions of their clients and charge a

commission for doing so; locals are trading on their own account.

The simplest type of futures order placed with a broker is a market order. It is a request

that a trade be carried out immediately at the best price available in the market. However,

there are many other types of orders, including:

• Limit orders. A limit order specifies a particular price. This order can be executed only

at this price or at one more favorable to the investor. Thus, if the limit price is $30 for an

investor wanting to take a long position, the order will be executed only at a price of $30

or less.

• Stop orders. A stop order (or stop-loss order) also specifies a particular price. The order

is executed at the best available price once a bid or offer is made at that particular price or

a less-favorable price. For example, suppose a stop order to sell at $30 is issued when the

market price is $35. It becomes an order to sell when and if the price falls to $30. In

effect, a stop order becomes a market order as soon as the specified price has been hit.

The purpose of a stop order is usually to close out a position if unfavorable price

movements take place. It limits the loss that can be incurred.

• Stop-limit orders. A stop-limit order is a combination of a stop order and a limit order.

The order becomes a limit order as soon as a bid or offer is made at a price equal to or

less favorable than the stop price. Two prices must be specified in a stop-limit order: the

stop price and the limit price. For example, suppose that at the time the market price is

$35, a stop-limit order to buy is issued with a stop price of $40 and a limit price of $41.

As soon as there is a bid or offer at $40, the stop-limit becomes a limit order at $41.

Futures markets require its participants to post margin on their accounts. Margin is a

deposit - usually specified percentage of a futures contract contract's value - required by a

futures exchange from both the buyer and the seller of the contract. Margin helps to

ensure that both buyer and seller will perform as specified in the futures contract. To

illustrate how margins work, consider an investor who contacts his or her broker to buy

two futures contracts on an exchange. Prior to the execution of the futures trade, the

broker will require the investor to deposit funds in a margin account. The amount that

must be deposited at the time the contract is entered into is known as the initial margin.

This security deposit serves as a buffer in case the futures trades executed by the broker

(on behalf of the investor) incur losses.

At the end of each trading day, the margin account is adjusted to reflect the investor’s

gain or loss based on market movements that occurred during that day. This practice is

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referred to as marking-to-market the account. A trade is first marked-to-market at the

close of the day on which it takes place. It is then marked-to-market at the close of

trading on each subsequent day.

The investor is entitled to withdraw any balance in the margin account in excess of the

initial margin. A maintenance margin is set to ensure that the balance in the margin

account never becomes negative. The maintenance margin is normally lower than the

initial margin amount. If the balance in the margin account falls below the maintenance

margin threshold due to mark-to-market (MTM) losses, the investor will receive a

“margin call” and will be expected to deposit additional funds into the account to bring

the balance back up to the initial margin amount. The additional funds deposited are

known as variation margin.


7. Which of the following financial instruments would most likely be traded in the

over-the-counter derivatives market?

a. Company A’s forward rate agreement.

b. Company B’s mortgage-backed security.

c. Company C’s foreign exchange spot contract.

d. Company D’s commodity futures contract.

8. Which of the following scenarios would most likely be associated with a typical

forward contract?

a. Bank A purchases British pounds in the market at today’s market price.

b. Bank B locks in a price today for the future purchase of an asset.

c. Bank C purchases funds today to meet expected future reserve

requirements.

d. Bank D issues securities backed by pools of mortgage loans.

9. Which of the following futures transactions is an example of a limit order?

a. Company A places a short order that will be executed whenever the

market price falls below a specified threshold.

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b. Company B places a long order to be carried out immediately at the

best price available.

c. Company C places a long order than can only be executed at a

specific price (or a price more favorable to the company).

d. Company D places a short order to be carried out during off-market

hours.

10. Which of the following practices effectively minimizes the credit risk associated

with futures contracts?

a. Company A strictly places only stop-limit orders.

b. Company B maintains its margin account on a daily basis.

c. Company C matches the purchase and sale dates of their assets with

the delivery dates of their futures contracts.

d. Company D purchases futures contracts for speculative purposes.

8.4 Swap Markets

8.4.1 Swap contracts

A swap is an agreement between two counterparties to exchange cash flows in the future.

The agreement defines the dates when the cash flows are to be paid and the way in which

they are to be calculated. Usually the calculation of cash flows involves the future value

of an interest rate, an exchange rate, or other market variable.

Unlike standardized futures contracts, swaps are not exchange-traded instruments.

Instead, swaps are customized contracts that are traded in the over-the-counter market

between private parties. Firms and financial institutions dominate the swaps market, with

few (if any) individuals ever participating.

A forward contract can be viewed as a simple example of a swap. However whereas a

forward contract is equivalent to the exchange of cash flows on just one future date,

swaps typically lead to cash flow exchanges taking place on several future dates.

8.4.2 Interest rate swaps

One of the most commonly traded swap contracts is the interest rate swap. An interest

rate swap is an agreement between two parties to exchange one stream of interest

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payments for another stream with different features. Interest payment calculations are

based on a notional principal for an agreed-upon period of time. These payments are

exchanged at regular intervals on either a fixed or floating basis.

Fixed-rate payments are based on a predetermined fixed interest rate that is applied

throughout the term of the swap.

Floating rate payments are based on a rate of interest that is periodically reset, with

reference to a floating rate index (plus or minus a spread). The amount of each swap

payment varies with the change in the floating rate index since the previous payment.

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap,

Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional

principal on specific dates for a specified period of time. Concurrently, Party B agrees to

make payments based on a floating interest rate to Party A on that same notional

principal on the same specified dates for the same specified time period. In a plain vanilla

swap, the two cash flows are paid in the same currency. The specified payment dates are

called settlement dates, and the time between are called settlement periods. Because

swaps are customized contracts, interest payments may be made annually, quarterly,

monthly, or at any other interval determined by the parties.

For example, on December 31, 2006, Jack Corp. enters into a five-year interest rate swap

with Sawyer Inc.. The swap contains the following terms:

• Jack Corp. pays Sawyer Inc. an amount equal to 6% per annum on a notional principal of

$20 million.

• Sawyer Inc. pays Jack Corp. an amount equal to one-year LIBOR plus a 1% spread per

annum on a notional principal of $20 million.

LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks

on deposits made by other banks in the Eurodollar markets. The market for interest rate

swaps frequently (but not always) uses LIBOR as the base for the floating rate. For

simplicity, let's assume the two parties exchange payments annually on December 31,

beginning in 2007 and concluding in 2011.

At the end of 2007, Jack Corp. will pay Sawyer Inc. $20,000,000 * 6% = $1,200,000.

On December 31, 2006, one-year LIBOR was 5.33%; therefore, Sawyer Inc. will pay

Jack Corp. $20,000,000 * (5.33% + 1%) = $1,266,000.

Normally, swap contracts allow for payments to be netted against each other to avoid

unnecessary payments. Therefore in this case, Sawyer Inc. would pay $66,000, and Jack

Corp. would pay nothing. As with forward rate agreements, the notional principal

amounts associated with interest rate swaps are not exchanged between counterparties.

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Usually two non-financial entities such as Jack Corp. and Sawyer Inc. do not get in touch

directly to arrange a swap such as our previous example. Instead, they would each deal

with a financial intermediary when conducting the transaction.

Exhibit 8.2 – Interest Rate Swap

Swap agreements are normally formalized in a confirmation. A confirmation is the legal

agreement underlying a swap and is signed by representatives of the two parties. The

drafting of confirmations has been facilitated by the work of the International Swaps and

Derivatives Association (ISDA) in New York. This organization has produced a number

of Master Agreements that consist of clauses defining in some detail the terminology

used in swap agreements (including default terms, payment conventions, etc.).

8.4.3 Other types of swaps

Other popular types of swap contracts include:

• A currency swap (in its simplest form) involves exchanging principal and

interest payments in one currency for principal and interest payments in another.

Unlike an interest rate swap, the parties to a currency swap will exchange

principal amounts at the beginning and end of the swap. The two specified

principal amounts are set so as to be approximately equal to one another, given

the exchange rate at the time the swap is initiated.

• A credit default swap is similar to an insurance contract because it provides the

buyer, who often owns the underlying asset, with protection against default, a

credit rating downgrade, or another "credit event." CDS documentation will

identify the reference entity (or the reference obligation). The reference entity is

the issuer of the debt instrument that is being hedged. It could be a corporation, a

sovereign government, or a bank loan. The seller of the contract assumes the

credit risk associated with the reference entity in exchange for a periodic

protection fee similar to an insurance premium. The buyer of the CDS remits

these payments to the seller until the end of the life of the CDS or until a credit

event occurs. Generally, a seller is obligated to pay only if the reference entity

experiences a credit event.

Jack Corp.

Sawyer Inc.

6%

LIBOR + 1%

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• An equity swap is an agreement to exchange the total return (dividends and

capital gains) realized on an equity index for either a fixed or a floating rate of

interest. For example, the total return on the S&P 500 in successive 6-month

periods might be exchanged for LIBOR, with both being applied to the same

principal. Equity swaps can be used by portfolio managers to convert returns from

a fixed or floating investment to the returns from investing in an equity index, and

vice versa.

8.5 Options Markets

8.5.1 Options contracts

In contrast to forward, futures and swaps contract, which impose obligations on the

counterparties, an option contract conveys from one contracting party to another a right.

Where a forward, futures or swap contract obliges one party to buy a specific asset at a

specified price on a specified date and obliges the other party to make the corresponding

sale, an option gives its purchaser the right to buy or sell a specified asset at a specified

price on (or before) a specified date.

In an option contract, one party grants to the other the right to buy or to sell an asset. The

party granting the right is referred to as the option seller (or the option writer or the

option maker). The counterparty, the party purchasing the right, is referred to as the

option buyer. As with forwards and futures contracts, the buyer of an option contract is

said to be long the option position. It follows that the option seller is said to be short the

option position.

There are two basic types of options:

➢ A call option gives the holder the right to buy an asset by a certain date for a certain

price.

➢ A put option gives the holder the right to sell an asset by a certain date for a certain

price.

The date specified in the contract is known as the expiration date or the maturity date.

The price specified in the contract is known is the exercise price or the strike price.

Options can be either American or European, a distinction that has nothing to do with

geography. American options can be exercised at any time before the expiration date,

whereas European options can be exercised only on the expiration date itself.

Options are referred to as in-the-money, out-of-the-money or at-the-money based on their

current value:

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➢ When the current value of an option contract is positive, the option is considered “in-the-

money”.

➢ When the current value of an option contract is negative, the option is considered “out-

of-the-money”.

➢ When the current value of an option contract is zero, the option is considered “at-the-

money”.

8.5.2 Options trading

As with futures contracts, options are traded on exchanges that specify the terms of the

contracts it trades. Options exchanges generally specify the size of the contract, the

precise expiration time, and the strike price.

Most option exchanges use market makers. A market maker is an institution that is

prepared to quote both a bid price (at which it is prepared to buy) and an offer price (at

which it is prepared to sell). Market makers improve the liquidity of the market to ensure

that there is never any delay in executing market orders. They themselves make a profit

from the difference between their bid and offer prices (known as their bid-offer spread).

Option exchanges generally have rules specifying upper limits for the bid-offer spread.

Not all options trade on exchanges; there is also a large over-the-counter (OTC) market

for these instruments. Participants in the OTC market include banks, investment banks,

insurance companies, large corporations, and other parties. OTC options differ somewhat

from their exchange-traded counterparts. Whereas exchange-traded options are

standardized contracts, OTC options are usually tailored to a particular risk. If a

corporation wants to hedge a stream of foreign currency cash flows for five years, but

exchange-traded options are available only out to six months, the corporation can

purchase an option contract in the OTC market. An insurance company or bank can

design and price a five-year option on the currency in question, giving the company the

right to buy or sell at a particular price during the five-year period.

8.5.3 The Options Clearing Corporation (OCC)

The Options Clearing Corporation (OCC) performs much the same function for options

markets as the clearinghouse does for futures markets (see section 3.2.5). It guarantees

that options writers will fulfill their obligations under the terms of options contracts and

keeps a record of all long and short positions. The OCC has a number of members, and

all options trades must be cleared through a member. If a brokerage house is not itself a

member of an exchange’s OCC, it must arrange to clear its trades with a member.

Members are required to have a certain minimum amount of capital and to contribute to a

special fund that can be used if any member defaults on an option obligation.

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The writer of the option maintains a margin account with a broker, as described earlier.

The broker maintains a margin account with the OCC member that clears its trades. The

OCC member in turn maintains a margin account with the OCC.

When an investor notifies a broker to exercise an option, the broker in turn notifies the

OCC member that clears the trades. This member then places an exercise order with the

OCC. The OCC randomly selects a member with an outstanding short position in the

same option and processes the transaction.


Eko Investments is a European-based hedge fund that frequently invests in countries

all over the world. Eko’s financial statements are reported in euros. Eko recently

entered into a swap agreement to pay ABC Bank a stream of U.S. dollar cash flows

based on a 5% fixed rate in exchange for another stream of U.S. dollar cash flows

based on 1 year LIBOR. The annual swap settlements are based on a $10 million

notional principal.

11. The swap agreement between Eko and its counterparty is considered

_____________.

a. A currency swap.

b. An interest rate swap.

c. An equity swap.

d. A credit default swap.

12. If the value of 1 year LIBOR equals 3.5% on the first observation date, a net

settlement amount would be remitted by __________ in the amount of

___________ (in accordance with the swap agreement).

a. Eko Investments; $10,150,000.

b. ABC Bank; $10,150,000.

c. Eko Investments; $150,000.

d. ABC Bank; $150,000.

13. Which of the following agreements is the most consistent with the terms of a

typical option contract?

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a. Company A will pay 6% fixed interest to ABC Bank in exchange for

interest based on a floating index.

b. Company B is obligated to purchase $5 million of corporate bonds at a

specified price in 3 years.

c. Company C will receive payment from NYC Bank in the event of

default by its primary bond issuer.

d. Company D has paid a fee for the right to buy 1,000 shares of Proctor &

Gamble stock for a specified price.

14. Jin Inc. currently owns a fixed income security that it anticipates selling in the

near future. Jin sells the right for a counterparty to purchase this security from

them for a predetermined price at any time over the next 6 months. From the

perspective of Jin Inc., this contract is considered a:

a. Long call option contract.

b. Long put option contract.

c. Short call option contract.

d. Short put option contract.

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Chapter 8 Summary

• Financial risk is the likelihood that market fluctuations will adversely impact the

profitability of an organization or an investment. Financial risks are generally considered

either systematic or unsystematic. Types of financial risk include:

Interest rate risk

Credit risk

Foreign exchange risk

Liquidity risk

Prepayment risk

Inflation risk

Political risk

• A derivative instrument is a financial product that derives its value from an underlying

asset or liability. The underlying asset or liability can be another financial instrument

(such as a debt or equity security), a currency or a commodity. The term derivative refers

to how the price of these contracts is derived from the price of the underlying item. There

are four basic types of derivative instruments: forwards, futures, swaps and options.

Derivative instruments can be traded either on various specified exchanges or “over-the-

counter”.

• A forward is a contract that obligates the holder to buy or sell an underlying asset for a

predetermined price (i.e. the forward price) at a predetermined future time (i.e. the

delivery date). Forward contracts are executed by counterparties in the over-the-counter

market. The counterparty that agrees to buy the underlying asset assumes a long position

in the forward contract. The counterparty that agrees to sell the underlying asset assumes

a short position in the forward contract.

• A futures contract is similar to a forward contract in that it is a legally binding

commitment to buy or sell a specified quantity of a specified asset at a specified date in

the future. However unlike forward contracts, futures contracts have standardized terms

and are traded on organized exchanges. Futures trades can be executed using various

order types, including market orders, limit orders, stop orders and stop-limit orders.

Entities that trade futures contracts generally must maintain a margin account with the

futures exchange.

• A swap is an agreement between two counterparties to exchange cash flows in the future.

The agreement defines the dates when the cash flows are to be paid and the way in which

they are to be calculated. Usually the calculation of cash flows involves the future value

of an interest rate, an exchange rate, or other market variable. The most commonly traded

swaps include interest rate swaps, currency swaps and credit default swaps.

• An option is a contract that grants the buyer the right to buy or sell an asset at a specified

price on (or before) a specified date. Where a forward, futures or swap contract obliges

one party to buy a specific asset under the terms of the contract and obliges the other

party to make the corresponding sale, an option gives its purchaser the right to buy or sell

a specified asset under the terms of the contract. A call option gives the holder the right

to buy an asset by a certain date for a certain price. A put option given the holder the right

to sell an asset by a certain date for a certain price.

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Review Answers

Chapter 1

1. Jack is drafting an article on the role of financial markets in the global

economy. Which of the following statements would Jack include in his article

to best describe the primary purpose of financial markets?

➢ Answer A is incorrect. The primary purpose of the tax system (not financial

markets) is to provide the means for governments to levy taxes to pay for

public services.

➢ Answer B is correct. The primary purpose of financial markets is to provide a

mechanism for participants to obtain financing (such as home mortgages,

automobile loans, and other forms of short- and long-term financing).

➢ Answer C is incorrect. The primary purpose of Generally Accepted Accounting

Principles (not financial markets) provide a consistent set of accounting

principles used by businesses when preparing financial statements.

➢ Answer D is incorrect. The primary purpose of the bank regulatory system (not

financial markets) is to protect depositors from risky or improper investing by

banks and other financial institutions.

2. Which of the following financial market participants would most likely be

considered an example of a deficit unit?

➢ Answer A is incorrect. Company A would be considered a ‘surplus unit’ because

it has $2 million excess funds that are currently in a money market account.

➢ Answer B is correct. Company B is considered a ‘deficit unit’ because it has

entered the financial market to obtain funds (i.e. the $2 million loan).

➢ Answer C is incorrect. Company C would most likely be considered a ‘surplus

unit’ because it recently realized $2 million of positive cash flow from

operations.

➢ Answer D is incorrect. Company D would be considered a ‘surplus unit’

because it has $2 million of excess funds that it is looking to invest in the bond

market.

Lost Corp. has issued a financial instrument by which it will remit principal and 5%

interest payments to the holder until a stated maturity date (10 years from

the issue date).

3. Lost Corp.’s financial instrument is most likely an example of:

➢ Answer A is incorrect. Equity instruments represent a percentage ownership of

the company. The features of Lost Corp.’s instrument are not consistent with

those of an equity instrument.

153

➢ Answer B is incorrect. Lost Corp.’s financial instrument is not an equity

instrument because it does not represent a percentage ownership of the

company. (Note – equity instruments are not delineated between short-term

and long-term).

➢ Answer C is incorrect. Lost Corp.’s financial instrument is a not short-term

debt instrument because its maturity period is greater than one year’s time.

➢ Answer D is correct. Lost Corp.’s financial instrument is a long-term debt

instrument because it is a contractual agreement by Lost to pay the holder

fixed dollar amounts at regular intervals (interest and principal payments)

over 10 years.

4. Lost Corp. most likely sold their financial instrument to an investor in a:

➢ Answer A is incorrect. The over-the-counter market is a secondary market;

new debt issuances (such as this example) are sold to investors in the primary

market.

➢ Answer B is incorrect. The money market is a financial market for short-term

debt instruments; Lost Corp.’s financial instrument is a long-term debt

instrument.

➢ Answer C is correct. Lost Corp’s financial instrument is a new debt issuance,

which are sold to investors in the primary market.

➢ Answer D is incorrect. An exchange is an example of a secondary market; new

debt issuances (such as this example) are sold to investors in the primary

market.

5. Which of the following financial transactions would most likely take place in a

money market?

➢ Answer A is correct. The money market is a financial market in which only

short-term debt instruments are traded. A U.S. Government Treasury bill is an

example of such an instrument that is traded in the money market.

➢ Answer B is incorrect. Only short-term debt instruments are traded in the

money market.

➢ Answer C is incorrect. Equity shares are traded in equity (i.e. stock) markets,

not the money market.

➢ Answer D is incorrect. Such mortgages are normally obtained in the capital

market.

6. Under which of the following scenarios would the exchange of a financial

instrument most likely take place automatically?

➢ Answer A is incorrect. The underwriting process does not normally occur

automatically; it involves an investment bank pricing and finding buyers for an

issuer’s securities buyers, which can be a lengthy process.

➢ Answer B is incorrect. The terms of OTC contracts are generally negotiated

between counterparties; the transactions do not occur automatically.

➢ Answer C is correct. When the bid and ask prices for a financial instrument

are compatible, a financial market transaction generally occurs automatically.

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➢ Answer D is incorrect. Security sales that occur in an inactive market generally

do not occur automatically because there is an imbalance between the supply

of and demand for the investments.

7. Ben is a mutual fund manager that frequently invests in equity securities.

Which one of the following is the lowest form of market efficiency that would

be violated if Ben is able to earn excess return by buying stocks of firms with

historically higher-than-average share price appreciation?

➢ Answer A is correct. This scenario violates the weak form of market

efficiency because the investor is able to earn abnormal returns based on a

trading strategy that is solely based on past price movements. This strategy

also violates the other forms of market efficiency; however the weak form is

the lowest form of efficiency under the hypothesis.

➢ Answer B is incorrect. The efficient market hypothesis states that efficient

markets can be classified into three forms: weak-form, semi-strong form, and

strong-form. The semi-weak form is not a valid form of market efficiency

under the hypothesis.

➢ Answer C is incorrect. Semi-strong-form efficiency suggests that financial

instrument prices fully reflect all public information (including market-related

information and other economic and political information). This strategy

violates the semi-strong form of market efficiency; however the weak form is

the lowest form of efficiency that is violated.

➢ Answer D is incorrect. This strategy violates the strong form of market

efficiency; however the weak form is the lowest form of efficiency under the

hypothesis.

8. Which of the following is an example of a borrower borrowing funds through

the use of direct finance?

➢ Answer A is incorrect. A bank loan is an example of indirect finance, as

Borrower A is receiving its funds from a financial intermediary (rather than

directly from the bank’s depositors).

➢ Answer B is correct. In direct finance, borrowers borrow funds directly from

lenders in financial markets by selling them financial instruments. An example

of direct finance includes the bond issuance by Borrower B.

➢ Answer C is incorrect. Borrower C is lending (not borrowing) funds to the

corporation through the purchase of its debt security.

➢ Answer D is incorrect. Borrower D is receiving its funds from a financial

intermediary (i.e. the finance company), which is a form of indirect finance.

Institution A invests in stocks and bonds and secures funds by selling shares in these

investments to outside investors. Institution B makes consumer loans (including mortgages) and funds them by taking in deposits. Institution C uses the premiums

that they receive on their annuity products to purchase mortgages and other investments.

155

9. Institution A is an example of a:

➢ Answer A is incorrect. Institution A is not an example of a pension fund, which

provides retirement income in the form of annuities to employees who are

covered by a pension plan.

➢ Answer B is incorrect. Institution A is not an example of a credit union, which

are small depository institutions generally organized for a particular group.

➢ Answer C is incorrect. Institution A is not an example of a life insurance

company, which insures people against financial hazards following a death.

➢ Answer D is correct. Institution A is an example of a mutual fund, which

acquire funds by selling shares to many individuals and use the proceeds to

purchase diversified portfolios of stocks and bonds.

10. Institution B is an example of a/an:

➢ Answer A is correct. Institution B is an example of a commercial bank, which

raise funds primarily by issuing deposits and making loans.

➢ Answer B is incorrect. Institution B is not an example of a investment bank,

which do not take in deposits and make loans.

➢ Answer C is incorrect. Institution B is not an example of a fire and casualty

insurance company, which insures their policy holders against loss from theft,

fire and accidents.

➢ Answer D is incorrect. Institution B is not an example of a pension fund, which

provides retirement income in the form of annuities to employees who are

covered by a pension plan.

11. Institution C is an example of a:

➢ Answer A is incorrect. Institution C is not an example of a savings and loan

association, which is a depository institution.

➢ Answer B is incorrect. Institution C is not an example of a money market

mutual fund, which sell shares of highly liquid investments to shareholders.

➢ Answer C is correct. Institution C is an example of a life insurance company,

which insures people against financial hazards following a death and sell

annuities to fund their investment purchases.

➢ Answer D is incorrect. Institution C is not an example of a credit union, which

are small depository institutions generally organized for a particular group.

Chapter 2

Linus Corp. has issued two debt instruments in order to raise funds. Bond #1 accrues 6% simple interest based on a $3,000,000 principal amount with a three year

maturity. Bond #2 accrues 3% compound interest based on a $10,000,000 principal amount with a five year maturity. Both instruments accrue interest on an annual

basis.

1. What is the amount of the annual interest that will accrue on Bond #1 during

its second year?

156

➢ Answer A is incorrect. The bond has a stated interest rate of 6% (not 0%).

➢ Answer B is correct. The bond will accrue $180,000 simple interest during

its second year. This equals the $3,000,000 principal amount multiplied by the

6% interest rate.

➢ Answer C is incorrect. This amount equals the cumulative interest accrued on

the bond for years 1 and 2 (i.e. $3,000,000 principal amount X 6% X 2).

➢ Answer D is incorrect. This amount equals the cumulative interest accrued on

the bond throughout its 3 year term (i.e. $3,000,000 principal amount X 6% X

3).

2. Assuming that no debt extinguishments take place, what is the principal

balance of Bond #2 at the end of its second year:

➢ Answer A is incorrect. This amount is the original principal balance of the

instrument. The compounded interest amounts from years 1 & 2 are not

correctly added to the balance.

➢ Answer B is incorrect. This amount is the principal balance of the instrument at

the end of year 1. The compounded interest amount from year 2 is not

correctly added to the balance.

➢ Answer C is incorrect. This amount incorrectly doubles the interest amount

from year 1 and adds it to the original principal balance. The correct

calculation is illustrated below.

➢ Answer D is correct. The bond accrues interest on a compound basis, which

means that the interest accrued for a particular compounding period is added

to the principal balance of the instrument. In this case, the principal balance of

the bond at the end of year 2 would be calculated as follows:

Year Beg. Principal Interest (3%) End Principal

1 10,000,000 300,000 10,300,000

2 10,300,000 309,000 10,609,000

3. Which of the following bonds was most likely purchased at a discount?

➢ Answer A is incorrect. Bond A would be traded at par because its stated

coupon rate (8%) equals its yield-to-maturity (8%).

➢ Answer B is correct. The comparison of a bond’s YTM with its stated coupon

rate determines the price at which the instrument is traded. Bond B would be

traded at a discount because its stated coupon rate (5%) is less than its yield-

to-maturity (7%).

➢ Answer C is incorrect. Bond C would trade at a premium because the stated

coupon rate (6%) is more than its yield-to-maturity (5%).

➢ Answer D is incorrect. Bond D would be traded at par because its stated


4. Which of the following bonds was most likely purchased at par?

157

➢ Answer A is incorrect. Bond A would be traded at a discount because its stated

coupon rate (6%) is less than its yield-to-maturity (8%).

➢ Answer B is incorrect. Bond B would be traded at a discount because its stated


➢ Answer C is incorrect. Bond C would be traded at a premium because its

stated coupon rate (6%) is more than its yield-to-maturity (5%).

➢ Answer D is correct. Bonds trade at par if their yield-to-maturity equals the

stated coupon rate. Bond D would be traded at par because its stated coupon

rate (7%) is equal to its yield-to-maturity (7%).

5. Which of the following bonds was most likely purchased at a premium?

➢ Answer A is incorrect. Bond A would be traded at a discount because its stated


➢ Answer B is incorrect. Bond B would be traded at par because its stated


➢ Answer C is incorrect. Bond B would be traded at par because its stated

coupon rate (5%) equals its yield-to-maturity 5%).

➢ Answer D is correct. The comparison of a bond’s YTM with its stated coupon

rate determines the price at which the instrument is traded. Bond D would be

traded at a premium because its stated coupon rate (9%) is more than its

yield-to-maturity (7%).

6. Hurley, a market analyst, is attempting to predict market interest rate

movements. Which of the following economic indicators would most likely be

necessary in order for Hurley to make this prediction using the concepts of

the loanable funds theory?

➢ Answer A is correct. The supply and demand for money (or ‘loanable funds’)

are the key components to determining interest rates under the loanable funds

theory. The ability to predict changes in the money supply would be necessary

in order to predict changes in interest rates under this theory.

➢ Answer B is incorrect. The DJIA is a price-weighted average of 30 significant

stocks traded on the New York Stock Exchange and the Nasdaq. It is not a

component for determining interest rates under the loanable funds theory.

➢ Answer C is incorrect. A foreign exchange (FX) rate is the price of one

country's currency expressed in another country's currency. The loanable

funds theory explain interest rate movements, not FX rate movements.

➢ Answer D is incorrect. The unemployment rate is not a component for

determining interest rates under the loanable funds theory.

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7. Dharma Corp. recently issued debt instruments to finance an expansion of

their foreign operations. Dharma has reported material net losses in their

income statements for the past three years. Under the risk structure of

interest rates, which of the following interest rate characteristics would be

most likely be adjusted to compensate Dharma’s bond investors for the

increased risk of loss?

➢ Answer A is incorrect. The liquidity risk premium compensates bond holders if

the debt instrument cannot be quickly converted to cash in a secondary

market. Such risk does not apply in this example.

➢ Answer B is incorrect. While interest rate is often associated with bonds, the

yields on these instruments are not adjusted for interest rate risk under the

risk structure of interest rates.

➢ Answer C is correct. Under the risk structure of interest rates, the primary

characteristics that affect the yields on debt instruments are default risk,

liquidity risk and income taxes. Premiums are added to a bond’s yield when

such risks exist. The interest rate on Dharma Corp.’s debt instrument would

likely include a default risk premium to compensate investors for assuming the

default risk associated with the instrument.

➢ Answer D is incorrect. Bond yields are not adjusted for foreign exchange risk

under the risk structure of interest rates.

8. Which of the following debt instruments would most likely have the highest

default risk premium?

➢ Answer A is incorrect. AAA-rated bonds are generally considered very safe

investments with little-to-no default risk and default risk premiums.

➢ Answer B is incorrect. A-rated bonds have less default risk (and consequently

lower default risk premiums) than B-rated bonds.

➢ Answer C is correct. Bonds with lower credit ratings generally have higher

default risk premiums (and as a result, higher yields). Bond C would most

likely feature the highest default risk premium because it is has the lowest

credit risk rating (B).

➢ Answer D is incorrect. AA-rated bonds have less default risk (and consequently

lower default risk premiums) than B-rated bonds.

9. Which of the following investors would most likely seek the highest degree of

liquidity when making investment decisions?

➢ Answer A is correct. Liquidity is a term used to describe the relative ease

and speed with which an asset can be converted to cash. A “liquid” asset is

one that can be quickly and cheaply converted to cash if the need arises.

Investor A will need cash to settle his/her short-term liabilities, and therefore

would most likely seek out highly liquid investments.

159

➢ Answer B is incorrect. The cash conversion cycle is the length of time between

the purchase of raw materials and the collection of accounts receivable

generated in the sale of the final product. A short cycle implies that the

investor will have relatively easy access to cash if necessary. In such a case,

longer-term (and less liquid) investments might be preferable.

➢ Answer C is incorrect. A small amount of short-term liabilities wouldn’t

consume a large amount of cash, and therefore longer-term (and less liquid)

investments might be preferable.

➢ Answer D is incorrect. An investor with a large amount of excess cash would

have less of a need for liquid investments than someone with a large amount

of short-term liabilities.

10. Based on the risk structure of interest rates, which of the following

investments would likely have the lowest yield-to-maturity?

➢ Answer A is incorrect. U.S. Treasuries normally have lower yields-to-maturity

because they are highly liquid instruments with no default risk. A long-term

corporate bond would have a higher YTM than a short-term U.S. Treasury

bond due to the inherent default and liquidity risks associated with the

instrument.

➢ Answer B is incorrect. A long-term Fannie Mae bond would have a higher YTM

than a short-term U.S. Treasury bond due to the inherent liquidity risk

associated with the instrument.

➢ Answer C is incorrect. A short-term corporate bond would have a higher YTM

than a short-term U.S. Treasury bond due to the inherent default (and

possibly liquidity) risk associated with the instrument.

➢ Answer D is correct. Under the risk structure of interest rates, less risky

instruments normally have lower yields-to-maturity. A short-term U.S.

Treasury bond is a highly liquid instrument with no default risk. Therefore its

YTM would be the lowest given its risk-free nature.

11. Sawyer, Inc. has recently issued corporate bonds to fund an expansion of

their operations. The default risk premium and liquidity risk premium

associated with these bonds is 0.8% and 1.3%, respectively. The tax adjusted

risk free rate equals 4.6%. The implied yield on these bonds most likely

equals:

➢ Answer A is incorrect. This implied yield incorrectly subtracts the 0.8% default

risk premium and 1.3& liquidity risk premium from the 4.6% risk free rate.

These three amounts should instead be added together.

➢ Answer B is incorrect. This implied yield represents the risk free rate.

Corporate bonds are not considered risk free, and therefore their associated

yields should include a default risk premium and a liquidity risk premium.

➢ Answer C is incorrect. This implied yield incorrect multiples the 4.6% risk free

rate by the 0.8% default risk premium and 1.3% liquidity risk premium. These

three amounts should instead be added together.

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➢ Answer D is correct. The implied yield on these bonds would be 6.7%, which

equals the 4.6% risk free rate plus the 0.8% default risk premium plus the

1.3% liquidity risk premium.

12. On 5/1/201X, bonds A, B & C are being offered in the market under the

following terms: Bond A pays 3% interest with a 5 year term-to-maturity;

Bond B pays 5.5% interest with an 8 year term-to-maturity; Bond C pays

8.5% interest with a 12 year term-to-maturity. The risk, liquidity and tax

profiles of the three bonds are identical. Under this scenario, the bond yield

curve on 5/1/201X is most likely:

➢ Answer A is incorrect. The yield curve would slope downward if interest rates

on longer-term bonds were lower than interest rates on shorter-term bonds.

However in this scenario, the longer-term bonds have higher yields than the

shorter-term bonds, and therefore the yield curve is upward sloping.

➢ Answer B is incorrect. The yield curve would be flat if interest rates on longer-

term bonds were the same as interest rates on shorter-term bonds. However

this is not true in this scenario.

➢ Answer C is correct. A yield curve is a graphical depiction of bond yields

based on their terms-to-maturity. A yield curve slopes upward when interest

rates on longer-term bonds are higher than interest rates on shorter-term

bonds (as is the case in this scenario).

➢ Answer D is incorrect. The yield curve would be inverted (i.e. slope downward)

if interest rates on longer-term bonds were lower than interest rates on

shorter-term bonds.

13. Which of the following practices would provide support for the liquidity

premium theory that explains the term structure of interest rates?

➢ Answer A is incorrect. Investing exclusively in short-term debt instruments due

to their liquidity requirements would provide support for this theory, not the

liquidity premium theory. According to the segmented markets theory,

investors and borrowers choose securities with maturities that satisfy their

forecasted needs.

➢ Answer B is correct. The liquidity premium theory states that many

investors prefer short-term investments with higher liquidity and require

additional compensation (in the form of a higher yield) on longer-term

investments. Scenario B provides the most support for this theory.

➢ Answer C is incorrect. Investing in floating rate debt instruments whenever

possible does not provide support for the liquidity premium theory.

➢ Answer D is incorrect. The practice of accepting lower yields on debt

instruments does not provide support for the liquidity premium theory. Rather,

it is related to the risk structure of interest rates.

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Chapter 3

1. Jack, a market analyst, is researching U.S. central banking practices and their

impact on interest rates. Which of the following institutions would likely have

the greatest impact on market interest rates in the United States?

➢ Answer A is incorrect. The Internal Revenue Service is the United States

federal government agency that collects taxes and enforces the internal

revenue laws. Its actions do not directly impact interest rates.

➢ Answer B is incorrect. The Securities and Exchange Commission is an

independent agency of the United States government which holds primary

responsibility for enforcing the federal securities laws and regulating the

securities industry. Its actions do not directly impact interest rates.

➢ Answer C is correct. The Federal Reserve System is the central bank of the

United States. Its monetary policies significantly influence interest rates.

➢ Answer D is incorrect. The Financial Accounting Standards Board is a private,

not-for-profit organization whose primary purpose is to develop generally

accepted accounting principles (GAAP) within the United States in the public's

interest. Its actions do not directly impact interest rates.

2. Which of the following scenarios most accurately depicts a central banking

practice in the United States?

➢ Answer A is incorrect. The Federal Reserve Board of Governors does not have

the ability to modify tax rates.

➢ Answer B is correct. The evaluation of proposed bank mergers is a function

performed by the 12 Federal Reserve banks.

➢ Answer C is incorrect. The Federal Reserve Board of Governors authorizes

changes in the discount rate for primary credit (not the SEC).

➢ Answer D is incorrect. The Federal Reserve Board of Governors establishes

reserve requirements (not the Comptroller of the Currency).

On 12/31/1X, the Federal Reserve reports having the following asset & liability

balances: Securities $1.2 trillion; Currency in circulation $1.5 trillion; Discount

loans $0.8 trillion.

3. Given the information above, the balance of Reserves reported on the Fed’s

12/31/1X balance sheet must have equaled:

➢ Answer A is incorrect. The Federal Reserve’s balance sheet must balance, and

in this example the total reserves must equal $0.5 trillion in order for this to

be true.

162

➢ Answer B is correct. The Federal Reserve’s total assets (i.e. securities +

discount loans) equals $2.0 trillion in this scenario; therefore their total

reserves must equal $0.5 trillion ($2.0 trillion total assets – $1.5 trillion

currency liability) in order to balance.

➢ Answer C is incorrect. This answer incorrectly assumes that the Fed’s reserves

are an asset and their discount loans are a liability. The opposite is true.

➢ Answer D is incorrect. Government securities represent an asset on the

Federal Reserve’s balance sheet. Bank reserves represent a liability on the

Fed’s balance sheet. Therefore The Federal Reserve’s total assets (i.e.

securities + discount loans) equals $2.0 trillion in this scenario; therefore their

total reserves must equal $0.5 trillion ($2.0 trillion total assets – $1.5 trillion

currency liability) in order to balance.

4. Given the information above, the total assets reported on the Fed’s 12/31/1X

balance sheet must have equaled:

➢ Answer A is incorrect. A calculation of $0.8 trillion incorrectly includes only

discount loans and excludes the $1.2 trillion of government securities (assets).

➢ Answer B is incorrect. $1.2 trillion represents the securities, which are assets

of the Federal Reserve. However this answer incorrectly excludes the $0.8

trillion of discount loans (assets) from the calculation of Total Assets.

➢ Answer C is incorrect. This answer incorrectly excludes the $1.2 trillion of

government securities and $0.8 trillion of discount loans (assets) from the

calculation and incorrectly includes the $1.5 trillion of currency in circulation

(liability) in the calculation.

➢ Answer D is correct. The Federal Reserve’s total assets (i.e. $1.2 securities

+ $0.8 discount loans) equals $2.0 trillion in this scenario.

5. Which of the following actions would most likely increase the U.S. money

supply?

➢ Answer A is correct. The Federal Reserve increases the U.S. money supply

when it purchases U.S. government securities in the open market. Funds

previously held by the Fed are placed into circulation when they are

transferred to the securities’ sellers.

➢ Answer B is incorrect. The Fed reduces (not increases) the U.S. money supply

when it sells U.S. government securities in the open market.

➢ Answer C is incorrect. The U.S. money supply is not affected when commercial

banks purchase corporate bonds. The funds are still considered in circulation

when securities transactions are conducted by private parties.

➢ Answer D is incorrect. The U.S. money supply is only affected when the

Federal Reserve buys or sells its securities in the open market. Securities

transactions conducted by private parties have no effect on the money supply.

6. Hurley Bank currently has insufficient reserves in their Federal Reserve

account. Which of the following actions would the Bank most likely take in

order to increase their reserves balance?

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➢ Answer A is incorrect. While borrowing funds directly from a Federal Reserve

Bank would increase Hurley Bank’s reserves, such an action would normally be

taken only as a last resort.

➢ Answer B is incorrect. Purchasing government securities in the open market

would lower Hurley Bank’s reserves (not increase them).

➢ Answer C is incorrect. Hurley Bank would not have the ability to lower their

reserve requirement ratio (this ratio is established by the Federal Reserve).

➢ Answer D is correct. The federal funds market is the most commonly used

outlet for purchasing funds to eliminate reserve deficiencies. Hurley Bank

would most likely purchase federal funds to increase their reserves balance.


money supply is decreased?

➢ Answer A is incorrect. The money supply would not increase or decrease if the

Fed were to replace damaged currency with new currency.

➢ Answer B is incorrect. The money supply would increase (not decrease) if the

FOMC were to purchase government securities in the open market.

➢ Answer C is correct. The discount rate is the interest rate charged to

commercial banks and other depository institutions on loans they receive from

their regional Federal Reserve Bank’s discount window. To decrease money

supply, the Fed could authorize an increase in the discount rate for primary

credit.

➢ Answer D is incorrect. A member bank would not be able to modify its own

reserve requirement ratio (this ratio is established by the Federal Reserve).


money supply is increased?

➢ Answer A is incorrect. The money supply would decrease (not increase) if the

Fed were increase the reserve requirement ratio, as banks would be required

to hold higher levels of reserves (rather than circulating that money in the

market through lending activity).

➢ Answer B is incorrect. Foreign exchange rates are market driven and cannot

be directly increased or decreased by the Federal Reserve Bank.

➢ Answer C is incorrect. Increasing the discount rate would decrease the money

supply, as depository institutions would be discouraged from borrowing money

directly from the Fed.

➢ Answer D is correct. To increase money supply, the Fed could authorize an

increase in the outright purchases of government securities in the market. The

money paid for these securities would be placed into circulation upon purchase

by the Fed.

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Kate, an analyst at the Federal Reserve Bank, calculated the following balances of U.S.

money supply as of 12/31/1X:

Currency in circulation $4.2 trillion

Demand deposits $1.7 trillion

Money market funds (retail) $0.2 trillion

Savings accounts $2.2 trillion

Short-term repos $1.6 trillion

Traveler’s checks $0.6 trillion

9. Based on the above balances, M1 equals.

➢ Answer A is incorrect. A calculation of $2.3 trillion incorrectly excludes the

$4.2 trillion currency in circulation from the M1 calculation.

➢ Answer B is incorrect. A calculation of $4.2 trillion incorrectly excludes the

$1.7 trillion demand deposits and $0.6 trillion travelers’ checks from the M1

calculation.

➢ Answer C is correct. The M1 money measure is restricted to the most liquid

form of money; it consists of currency in the hands of the public, travelers’

checks, demand deposits and other checkable deposits. In this example, M1

would equal $6.5 trillion, or the sum of the $4.2 trillion currency in circulation,

$1.7 trillion demand deposits and $0.6 trillion travelers’ checks.

➢ Answer D is incorrect. A calculation of $8.9 trillion incorrectly includes the $0.2

trillion money market funds and $2.2 trillion savings accounts in the M1

calculation. These amounts would be included in the calculation of M2, but not

M1.


➢ Answer A is incorrect. A calculation of $6.5 trillion equals the M1 money

measure (not M2). It incorrectly excludes the $0.2 trillion money market funds

and $2.2 trillion savings accounts in the calculation.

➢ Answer B is incorrect. A calculation of $8.7 trillion incorrectly excludes the

$0.2 trillion money market funds, which is included in the definition of M2.

➢ Answer C is correct. The M2 money measure includes M1 plus savings

accounts, time deposits under $100,000 and retail money market mutual

funds. In this example, M2 would equal $8.9 trillion, or the sum of M1 ($6.5

trillion), the $0.2 trillion money market funds and the $2.2 trillion savings

accounts.

➢ Answer D is incorrect. A calculation of $10.5 trillion incorrectly includes $1.6

trillion short-term repos, which is not included in definitions of either M1 or

M2.

11. Which of the following actions would most likely result in a theoretical

reduction of the M2 money measure?

165

➢ Answer A is correct. This transaction would theoretically reduce the M2

money measure because the proceeds used to purchase the security would be

transferred from a checking account (included in M2) to a Federal Reserve

account (effectively taking the funds out of circulation).

➢ Answer B is incorrect. Such a transfer would have no net impact on M2, as

both checking and saving accounts are included in the calculation.

➢ Answer C is incorrect. Both checking accounts and travelers’ checks are

included in the calculation of M2. Therefore transferring money between the

two would have no net impact on M2.

➢ Answer D is incorrect. Transfers of money between checking accounts and

retail money market mutual funds would have no net impact on the measure

of M2, as both are included in the definition.

Chapter 4

An auditor for Sawyer Bank observes that the institution executed several transactions in the money markets during the current reporting period.

1. Which of the following most likely summarizes the terms of these

transactions?

➢ Answer A is incorrect. Money market instruments have short terms-to-

maturity (i.e. one year or less), not long terms-to-maturity.

➢ Answer B is incorrect. A characteristic of the money markets is that they are

wholesale markets. This means that most money market instruments

generally have large (not small) denominations, which prevents most

individual investors from participating directly in the market.

➢ Answer C is incorrect. Money market instruments have short terms-to-

maturity (i.e. one year or less), not long terms-to-maturity. Money market

instruments also have large (not small) denominations, which prevents most

individual investors from participating directly in the market.

➢ Answer D is correct. The money market is traditionally defined as the

market for financial assets that have original maturities of one year or less.

Financial instruments purchased in the money market have short-term

maturity periods (i.e. one year or less) and generally large denominations (i.e.

$1 million or more).

2. Which of the following statements best describes Sawyer Bank’s ability to sell

their money market instruments to meet short-term cash needs?

➢ Answer A is correct. Money market instruments have an active secondary

market. This means that they can quickly be sold to a third party at any point.

➢ Answer B is incorrect. Money market instruments are not illiquid, which means

that have an inactive secondary market (or no secondary market at all).

Rather, money market instruments are frequently traded in secondary

markets.

166

➢ Answer C is incorrect. Money market instruments have short terms-to-

maturity and relatively simple terms, thus making them easy to sell in a

secondary market.

➢ Answer D is incorrect. Money market instruments are those with traded with

maturities of one year or less. Money (as in actual currency) is not traded in

the money markets.

3. Which of the following statements best summarizes the U.S. Treasury’s

participation in the money markets?

➢ Answer A is incorrect. The U.S. Treasury’s participation in the money markets

is limited to the issuance of T-bills; it does not purchase commercial paper.

➢ Answer B is incorrect. Long-term securities are issued in the capital markets,

not the money markets.

➢ Answer C is correct. The U.S. Treasury’s participation in the money market

is through the issuance of Treasury bills (T-bills); the U.S. Treasury is never

the purchaser of money market instruments.

➢ Answer D is incorrect. Common stocks are purchased in the capital markets,

not the money markets.

4. Default risk would least likely be associated with which of the following

financial assets?

➢ Answer A is incorrect. Long-term corporate bonds generally have varying

levels of default risk; Treasury bills are considered free of default risk.

➢ Answer B is incorrect. Mortgage loans inherently have default risk, as banks

regularly incur credit losses when bowers default. Treasury bills are considered

free of default risk.

➢ Answer C is correct. A U.S. Treasury bill is considered a default-risk free

investment because it is short-term and is backed by U.S. Government.

Treasury bills are sold at auctions to refinance maturing issues and to help

finance current federal deficits.

➢ Answer D is incorrect. Non-agency debt securities are privately issued and

therefore have varying levels of default risk; Treasury bills are considered free

of default risk.

5. Which of the following scenarios depicts the most likely use of federal funds

purchased in the money market?

➢ Answer A is incorrect. Federal funds do not earn interest income for the

purchaser. Rather, federal funds incur an interest expense as they are

considered short term liabilities to the purchasers.

➢ Answer B is correct. The main purpose for purchasing federal funds is to

meet the reserve requirements established by the Federal Reserve. Fed funds

are not normally used for other purposes.

➢ Answer C is incorrect. Federal funds are considered borrowings to the

purchaser. They are not purchased as speculative investments.

167

➢ Answer D is incorrect. Federal funds are purchased to meet the reserve

requirements established by the Federal Reserve; they are not normally

purchased to fund capital projects.

Kwon Corp. is planning to issue commercial paper on January 1st to meet certain

financing requirements. They wish to avoid the costs associated with registering

this issuance with the SEC. They plan to place their commercial paper through a

dealer.

6. Which of the following scenarios would disqualify Kwon Corp.’s commercial

paper issuance from the registration exemption provided in the Securities Act

of 1933?

➢ Answer A is incorrect. A fixed interest payment term would not necessarily

disqualify a commercial paper issuance from the SEC registration exemption.

➢ Answer B is incorrect. Proceeds from a commercial paper issuance must be

used to finance “current transactions” to qualify for the registration exemption.

➢ Answer C is correct. A commercial paper’s term-to-maturity must be less

than 270 days in order to qualify for the SEC registration exemption. Kwon

Corp.’s issuance has a maturity period of approximately 300 days.

➢ Answer D is incorrect. Commercial paper is normally issued at a discount; this

term would not necessarily disqualify a commercial paper issuance from the

SEC registration exemption.

7. Which of the following best describes the role that the dealer would most

likely play in the issuance of Kwon Corp.’s commercial paper?

➢ Answer A is correct. Most firms place their commercial paper through

dealers who, acting as principals, purchase commercial paper from issuers and

resell it to the public.

➢ Answer B is incorrect. Kwon Corp. (not the dealer) would determine the

commercial paper issuance amount and maturity.

➢ Answer C is incorrect. Kwon Corp. would distribute the proceeds received from

the issuance. The dealer would not likely be involved in such decisions.

➢ Answer D is incorrect. The dealer would purchase the commercial paper

directly from Kwon Corp. and resell it to the public. It generally would not

purchase the paper in the secondary market.

Shephard Bank has issued a new $100,000 time deposit product. The instrument

has a 4% annual interest rate; interest is paid at the end of ninety days based on

an actual/360 basis. The holder is able to sell the instrument to a third party under

the terms of the instrument.

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8. Shephard Bank’s financial product is most likely an example of:

➢ Answer A is incorrect. This instrument is not a repurchase agreement as it

does not involve the purchasing and subsequent selling of a security for a

specified rate of return.

➢ Answer B is incorrect. This instrument is not a nonnegotiable CD because the

holder is able to sell this instrument to a third party.

➢ Answer C is incorrect. This instrument is not a reverse repurchase agreement

as it does not involve the selling and subsequent purchasing of a security for a

specified rate of return.

➢ Answer D is correct. The instrument described is an example of a negotiable

certificate of deposit, as it is a time deposit that can be sold to third parties.

9. The interest due to the holder of Shephard Bank’s financial product upon

maturity equals:

➢ Answer A is incorrect. Shephard Bank’s CD is an interest-bearing financial

instrument. Therefore the interest due to the holder is not $0.

➢ Answer B is correct. Certificates of deposit are interest-bearing instruments.

The interest due to the CD holder in this example totals $1,000, which equals

$100,000 * 4% * (90/360).

➢ Answer C is incorrect. This interest amount incorrectly excludes the basis

portion (90/360) of the calculation, which reflects the instrument’s 90 day

maturity.

➢ Answer D is incorrect. This amount incorrect multiplies the 4% interest by a

basis of (360/90). The correct basis is (90/360), which reflects the

instrument’s 90 day maturity.

Libby Bank has entered into a contract wherein they will (1) purchase a fixed income

security with a $10,000,000 par value from Hurley Bank today at a specified price and (2) sell the same security back to Hurley Bank tomorrow at the same price. This

transaction has a 3.5% rate of return that is calculated on an actual/360 basis.

10. Libby Bank’s transaction with Hurley Bank is most likely an example of:

➢ Answer A is correct. This transaction is considered a reverse repurchase

agreement from Libby Bank’s perspective. This is because they are

simultaneously agreeing to purchase and re-sell a security at a specified price.

➢ Answer B is incorrect. This transaction is not an example of a variable rate CD,

as it not a time deposit product.

➢ Answer C is incorrect. This transaction would be considered a repurchase

agreement from Libby Bank’s perspective if they simultaneously agreed to sell

and re-purchase a security at a specified price.

➢ Answer D is incorrect. This transaction is not an example of a fixed coupon CD,

as it not a time deposit product.

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11. Under the specified terms, __________ will be paid approximately

_________ of interest at the conclusion of this transaction.

➢ Answer A is incorrect. Hurley Bank would pay interest as compensation for the

short-term repo financing received from Libby Bank. Also, this amount

incorrectly uses an actual/365 basis (i.e. 1/365) when performing the

calculation.

➢ Answer B is incorrect. Hurley Bank would pay interest as compensation for the

short-term repo financing received from Libby Bank.

➢ Answer C is incorrect. This amount incorrectly uses an actual/365 basis when

performing the calculation (i.e. 1/365).

➢ Answer D is correct. Under the specified terms, Libby Bank will be paid

approximately $972 of interest at the conclusion of this reverse repo

transaction. This amount equals $10,000,000 * 3.5% * (1/360).

Chapter 5

1. Which of the following transactions would most likely occur in the bond

market?

➢ Answer A is incorrect. Equity shares are generally exchanged in the stock

market.

➢ Answer B is incorrect. Funds used by banks to meet U.S. reserve requirements

are purchased in the federal funds market.

➢ Answer C is correct. Bonds are long-term debt instruments that are

generally issued to finance a variety of projects and activities. The primary

bond market is where new issues of bonds are introduced.

➢ Answer D is incorrect. Short-term financial instruments issued to finance

current expenses (such as commercial paper) are generally traded in the

money markets.

Oceanic Bank has purchased a bond portfolio that includes one U.S. Treasury bond,

one municipal bond and one corporate bond.

2. Which of the following characteristics could apply to all three instruments

included in Oceanic’s portfolio?

➢ Answer A is incorrect. U.S. Treasury securities are not rated by ratings

agencies. Regardless, these bonds have an implied ‘AAA’ rating because they

are backed by the U.S. government.

➢ Answer B is incorrect. Interest income on U.S. Treasury and corporate bonds is

generally taxable for federal income tax purposes.

➢ Answer C is correct. Most bonds (including many types of Treasury,

municipal and corporate bonds) pay the par value to the investor upon

maturity of the instrument. This is a common term.

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➢ Answer D is incorrect. This assumption applies to U.S. Treasury bonds (only)

because these instruments are backed by the U.S. government. This

assumption does not apply to municipal or corporate bonds (which do not

carry such a guarantee).

3. The municipal bond included in Oceanic’s portfolio earns 4% interest. Oceanic

Bank’s federal tax rate is 32%. Based on this information, the taxable

equivalent yield on their municipal bond investment is approximately:

➢ Answer A is incorrect. A 1.3% calculation incorrectly multiplies the tax-free

yield (4%) by Oceanic’s tax rate (32%).

➢ Answer B is incorrect. This calculation incorrectly multiplies the tax-free yield

by (1 – Oceanic’s tax rate).

➢ Answer C is incorrect. 4.0% represents the tax-free yield on the bond, not the

tax equivalent yield.

➢ Answer D is correct. The taxable equivalent yield of this bond is 5.9%; this

equals the tax-free yield (4%) divided by (1 – 0.32).

4. The municipal bond included in Oceanic’s portfolio is a secured instrument

that was issued to finance the construction of a new public auditorium. The

income earned from the auditorium will be used to make principal and

interest payments to bondholders. Based on this information, Oceanic’s

municipal bond is most likely an example of:

➢ Answer A is incorrect. Treasury bonds are debt instruments issued by the U.S.

Federal government (not municipalities).

➢ Answer B is correct. A revenue bond is a secured instrument that was issued

to finance a specific project. Oceanic’s municipal bond is an example of a

revenue bond.

➢ Answer C is incorrect. Municipal bonds are generally not taxable.

➢ Answer D is incorrect. A general obligation (GO) bond is an unsecured

instrument issued to finance municipal operations (not specific projects).

5. Oceanic’s corporate bond indenture contains a clause that prohibits the issuer

from issuing additional debt in excess of $100 million over the maturity period

of the instrument. Such a clause is often referred to as a:

➢ Answer A is correct. Protective covenants are restrictions placed on the

issuing firm that are designed to protect the bondholders from being exposed

to increasing risk during the investment period. These terms frequently limit

the amount of dividends and corporate officers’ salaries the firm can pay and

also restrict the amount of additional debt the firm can issue.

➢ Answer B is incorrect. A call provision is one that allows the issuing firm to

“buy back” the bonds it has previously “sold” (issued).

➢ Answer C is incorrect. A collateral agreement governs the amount and type of

collateral that secures a bond.

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➢ Answer D is incorrect. A sinking-fund provision is a requirement that the

issuing firm retire a certain amount of the bond issue each year.

6. The price quote for Oceanic’s corporate bond is currently BID 104:06, ASK

104:12. If the face value of the bond is $100,000, Oceanic Bank would most

likely be able to sell it in the bond market today for approximately:

➢ Answer A is incorrect. This amount incorrectly multiplies the bond face value

by the bid price (not the ask price). Also, the bond quote fraction (to the right

of the colon) represents 12/32 of a dollar (not 12%). Therefore this fraction

must be converted to a decimal (0.375) in order to properly complete the

calculation.

➢ Answer B is incorrect. This amount incorrectly multiplies the bond face value

by the converted bid price (not the converted ask price).

➢ Answer C is incorrect. The bond quote fraction (to the right of the colon)

represents 12/32 of a dollar (not 12%). Therefore this fraction must be

converted to a decimal (0.375) in order to properly complete the calculation.

➢ Answer D is correct. Oceanic Bank would most likely be able to sell its

corporate bond in the market for $104,375. This amount equals the face value

($100,000) multiplied by the converted ask price ($104 + (12/32)).

7. Which of the following bonds would most likely provide the most protection

against a decline in purchasing power during periods of high inflation?

➢ Answer A is incorrect. The rate of return on a municipal bond does not

normally include an inflation adjustment.

➢ Answer B is incorrect. Treasury STRIPs are fixed income securities sold at a

significant discount to face value and offer no interest payments because they

mature at par. They do not provide protection against inflation risk.

➢ Answer C is incorrect. Junk bonds do not normally offer protection against

inflation risk.

➢ Answer D is correct. A TIPS bond is a special type of Treasury bond that

offers protection from inflation (by linking its rate of return to an inflation

index (normally the consumer price index). The coupon payments and

underlying principal of TIPS are automatically increased by an adjustment for

inflation.

8. The yield on which of the following instruments would most likely include the

highest default risk premium:

➢ Answer A is correct. Bond yields increase as the risk of default increases, as

investors require compensation for the assumption of this risk. Junk bonds are

speculative investments with a very high degree of default risk.

➢ Answer B is incorrect. A TIPS bond is a special type of Treasury bond;

Treasury bonds have no default risk because they are backed by the U.S.

government.

172

➢ Answer C is incorrect. A municipal bond that is insured by an outside agency

are generally well-rated and would likely be considered a lower default risk

than a junk bond.

➢ Answer D is incorrect. Treasury notes have no default risk because they are

backed by the U.S. government.

9. Which of the following capital market instruments represents a percentage

ownership in the issuing company?

➢ Answer A is incorrect. A repurchase agreement involves the purchasing and

subsequent selling of a security for a specified rate of return. It does not

represent a percentage ownership in an issuing company.

➢ Answer B is correct. Common stock is a financial instrument that represents

a percentage ownership in the issuing company. A stockholder owns a

percentage interest in the firm, consistent with the percentage of outstanding

stock held.

➢ Answer B is incorrect. A bond represents debt (i.e. an obligation) of the issuing

entity; it does not represent a percentage ownership.

➢ Answer D is incorrect. A Treasury note is a debt instrument issued by the

United States government. Common stocks are instruments issued by

companies in the private sector.

Hydra Inc. has filed for bankruptcy and is about to be liquidated.

10. Which of the following parties will most likely receive top priority upon the

liquidation of Hydra’s assets?

➢ Answer A is incorrect. Common stock holders generally have the lowest level

of claim on a issuing company’s assets and income.

➢ Answer B is correct. The claims of bond holders generally receive higher

priority than the claims of common and preferred stock holders upon

liquidation of a bankrupt issuer. Stock ownership generally includes the right

of residual claimant, which means they have claim only on the residual assets

and income left over after the bondholders have been paid.

➢ Answer C is incorrect. The claims of bond holders are generally higher than

those of adjustable-rate preferred stock holders.

➢ Answer D is incorrect. The claims of participating preferred stock holders are

normally lower than bond holders.

11. Which of the following parties will most likely receive the lowest priority upon

the liquidation of Hydra’s assets?

173

➢ Answer A is correct. The claims of common stock holders generally receive

lower priority than the claims of bond holders and preferred stock holders

upon liquidation of a bankrupt issuer. Common stock ownership generally

includes the right of residual claimant, which means they have claim only on

the residual assets and income left over after the bondholders and preferred

stockholders have been paid.

➢ Answer B is incorrect. The claims of common stock holders are normally lower

than those of bond holders.

➢ Answer C is incorrect. The claims of bond holders and adjustable-rate

preferred stock holders would normally be higher than those of common stock

holders.

➢ Answer D is incorrect. Common stock holders (not preferred stock holders)

normally have the lowest priority upon liquidation.

Ben, an individual investor, purchased 100 shares of Dharma Corp’s common stock

when the price was $6.00 per share. Ben sells these shares 3 years later when the

stock price is $8.00 per share. Dharma Corp.’s dividend rate per share was $0.10

during this time. Dharma Corp. reported $0.33 earnings per share in its most

recent annual financial statements.

12. Based on this information, the total return that Ben earned on his Dharma

Corp common stock equals:

➢ Answer A is incorrect. This amount represents Ben’s dividend income for one

year; it excludes his dividend income for years 2-3 and the capital appreciation

on the stock.

➢ Answer B is incorrect. This amount represents Ben’s dividend income years 1-

3; it excludes the capital appreciation on the stock.

➢ Answer C is incorrect. This amount represents the capital appreciation on the

stock; it excludes Ben’s dividend income for years 1-3.

➢ Answer D is correct. The total return on a common stock investment is

comprised of (1) capital appreciation and (2) dividend income. The capital

appreciation on Ben’s investment in Dharma Corp. equals $200, or ($8.00 -

$6.00) * 100 shares. During the three years that Ben owned this stock,

Dharma Corp. paid him $30 in dividend income, or (100 shares * 0.10

dividend rate per share * 3 years). Therefore, Ben’s total return on his

common stock investment equals $200 + $30 = $230.

13. If the Wall Street Journal reported a closing price of $8.00 on the day after

Ben sold his Dharma Corp. common stock, it would have also reported a P/E

ratio of approximately:

➢ Answer A is incorrect. This value incorrectly equals the Dharma stock price

multiplied by their reported earnings per share.

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➢ Answer B is correct. The P/E ratio equals the prevailing stock price divided

by a firm’s reported earnings per share. In this case, the P/E ratio for Dharma

Corp.’s stock would equal $8.00 per share / 0.33 EPS = 24.2.

➢ Answer C is incorrect. This value incorrectly equals Ben’s total return on his

investment in Dharma stock price ($230) multiplied by their reported earnings

per share.

➢ Answer D is incorrect. This value incorrectly equals Ben’s total return on his

investment in Dharma stock price ($230) divided by their reported earnings

per share.

The following table presents financial data for Companies A, B, C and D:

Company Shareholders (#) Trading Vol. (Mthly) 3 year net income

A 13,000 450,000 $29,000,000

B 3,500 65,000 $8,500,000

C 500 15,000 $4,000,000

D 8,800 125,000 $5,000,000

14. Based on the above information, which of the following companies most likely

qualifies for listing on the New York Stock Exchange?

➢ Answer A is correct. To list on the NYSE, a firm must have (1) at least 2,200

shareholders with a monthly trading volume of 100,000 shares and (2)

earnings of at least $10 million for the last three years18. Company A meets

these requirements.

➢ Answer B is incorrect. Company B does not meet the trading volume and

earnings requirements necessary for listing on the NYSE.

➢ Answer C is incorrect. Company C does not meet the shareholder, trading

volume and earnings requirements necessary for listing on the NYSE.

➢ Answer D is incorrect. Company D does not meet the earnings requirements

necessary for listing on the NYSE.

15. Which of the following stock transactions most likely occurred in the OTC

market?

➢ Answer A is incorrect. The New York Stock Exchange is an example of an

organized exchange (not an OTC market), as buyers and sellers meet regularly

in New York City to trade stocks.

➢ Answer B is correct. The NASDAQ is an example of an over-the-counter

(OTC) stock market. Trading on NASDAQ occurs over telecommunications

networks, rather than in specific locations.

➢ Answer C is incorrect. The Nikkei is an organized exchange located in Japan. It

is not an OTC market.

18 Note – the third requirement (a $100 million market value) is disregarded in this example.

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➢ Answer D is incorrect. An ECN is an electronic trading system that is neither an

organized exchange not an OTC market.

16. Which of the following events would likely be the most indicative of weakness

in the U.S. stock market?

➢ Answer A is incorrect. Trading volume is not necessarily an indicator of stock

market weakness, as the trades being executed could be either buys or sells.

Changes in the DJIA provide a better performance indicator of the stock

market.

➢ Answer B is correct. The Dow Jones Industrial Average (DJIA) serves as a

performance indicator for the U.S. stock market overall. A decrease in the

DJIA would likely be the most indicative of weakness in the stock market (of

the choices provided).

➢ Answer C is incorrect. Trades executed on NASDAQ could be either buys or

sells. Therefore such trading activity would not necessarily an indicator of

stock market weakness.

➢ Answer D is incorrect. An increase in the S&P 500 would be indicative of

strength (not weakness) in the U.S. stock market.

Chapter 6

The following table includes data on mortgage loans taken out on four condominiums;

the mortgaged condos are all located in the same complex and therefore have the

same purchase price ($150,000) and market values on 4/30/X1 ($130,000).

Loan Issuer Down Pmt Interest Rate

A U.S. FHA 5% Fixed

B ABC Bank 25% Adjustable

C XYZ Bank 10% Fixed

D U.S. HUD 20% Adjustable

1. Which of the mortgage loans listed above would most likely require the

borrower to purchase private mortgage insurance?

➢ Answer A is incorrect. Loan A would not require PMI because it is issued (and

guaranteed) by a U.S. government agency.

➢ Answer B is incorrect. Loan B would not likely require PMI because the down

payment made by the borrower exceeds the 20% threshold.

➢ Answer C is correct. Private mortgage insurance generally applies to

conventional mortgages (issued by private financial institutions) where the

down payment made by the borrower is less than 20% of the property value.

Loan C meets these criteria.

➢ Answer D is incorrect. Loan D issued (and guaranteed) by a U.S. government

agency and therefore would not require PMI.

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2. The interest payments on which of the mortgage loans listed above would

most likely fluctuate with changes in market interest rates?

➢ Answer A is incorrect. The interest rates on Loans A & C are fixed and will not

fluctuate based on changes in market interest rates.

➢ Answer B is correct. Interest payments on adjustable rate mortgages (such

as Loans B & D) fluctuate based on changes in the underlying interest rate

index. Such indices move with prevailing market interest rates.

➢ Answer C is incorrect. The interest rate on Loan A is fixed and will not fluctuate

based on changes in market interest rates.

➢ Answer D is incorrect. The interest rate on Loan C is fixed and will remain

constant over the life of the loan.

3. Based on the above information, the original loan proceeds for Loan C was:

➢ Answer A is incorrect. $130,000 is the current market value of the condo on

4/30/X1; it is not the original loan proceeds.

➢ Answer B is correct. To obtain a mortgage loan, lenders generally require

the borrower to make a down payment on the property. The purchase price of

the property less this down payment equals the mortgage loan proceeds. Loan

C’s original loan proceeds was $135,000, which equals the purchase price of

the condo ($150,000) minus the down payment ($150,000 * 10%).

➢ Answer C is incorrect. $150,000 is the original purchase price of the condo

(not the proceeds); this answer fails to reflect the down payment made on the

property.

➢ Answer D is incorrect. This answer incorrectly adds the down payment made

on the property to the purchase price; the down payment should be subtracted

when calculating the loan proceeds.

4. Based solely on the above information, ________ had the greatest amount of

home equity as of 4/30/X1.

➢ Answer A is incorrect. Loan A does not have any home equity on 4/30/X1, as

the market value of the condo ($130,000) is less than the current loan balance

($142,500).

➢ Answer B is correct. Home equity exists if a positive difference exists

between the current market value of a home and the outstanding mortgage

balance. The home equity on Loan B equals $17,500 on 4/30/X1, which is the

highest amount of the four loans; this amount equals the market value of the

home ($130,000) minus the loan balance ($112,500). Note that principal

repayments would also be included in a typical home equity calculation;

however this information was ignored for this example.

➢ Answer C is incorrect. Loan C does not have any home equity on 4/30/X1, as

the market value of the condo ($130,000) is less than the current loan balance

($135,000).

➢ Answer D is incorrect. Loan D has $10,000 of home equity on 4/30/X1, which

is less than Loan B.

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Temple Bank, a private financial institution, recently received and approved a

mortgage application from Dogen. Dogen was unemployed until just recently, and

his credit score was relatively low as a result. Temple Bank approved Dogen’s

application because of his new found employment, extensive documentation and

favorable loan-to-value ratio. Upon approval, Temple Bank transferred the

servicing rights for Dogen’s loan to a third party.

5. Which of the following best describes the role that Temple Bank is playing in

the mortgage lending process (as it pertains to Dogen’s loan)?

➢ Answer A is incorrect. Temple Bank is not acting as servicer of Dogen’s loan; it

has transferred that responsibility to a third party.

➢ Answer B is correct. A direct lender accepts and underwrites loan

applications and funds the resulting loans. Temple Bank is acting as a direct

lender in this scenario.

➢ Answer C is incorrect. Temple Bank is not acting as a guarantor of Dogen’s

loan. Dogen would purchase private mortgage insurance from a third party (if

necessary).

➢ Answer D is incorrect. A mortgage broker represents clients and will work with

a number of different lenders in obtaining a loan. Temple Bank would not

serve as a mortgage broker in any likely circumstance, as it originates

mortgages on its own.

6. Given his credit background and documentation, Dogen’s loan would most

likely be associated with which of the following mortgage market sectors?

➢ Answer A is incorrect. Prime loans are standard mortgages made to borrowers

with acceptable credit scores. Dogen’s mortgage would not likely be

considered a prime loan because of his low credit score.

➢ Answer B is incorrect. The Alt-A category refers to loans made ti borrowers

who generally have high credit scores but have variable income or no income

documentation. Dogen’s mortgage would not likely be considered an Alt-A loan

because of his low credit score.

➢ Answer C is incorrect. Dogen’s mortgage is through a private financial

institution, not a governmental entity.

➢ Answer D is correct. Dogen’s mortgage would likely be considered a

subprime loan because of his low credit score.

7. Which of the following borrowers would generally be considered the most

likely to default on a mortgage loan?

➢ Answer A is incorrect. A mortgage borrower with a low front ratio generally

has lower monthly expenses and therefore can afford their mortgage payment

and is less likely to default.

178

➢ Answer B is incorrect. A low LTV ratio is indicative of a lower balance on a

mortgage loan and a lower risk of default.

➢ Answer C is correct. A mortgage borrower that has a low FICO score (i.e.

credit score) most likely has a poor credit history and is generally considered

to be at a higher risk of default.

➢ Answer D is incorrect. A mortgage borrower with a back front ratio generally

has lower monthly expenses and therefore can afford their mortgage payment

and is less likely to default.

Eko Bank plans to securitize a $10 million of mortgage loan pool and sell the

beneficial interests in the open market. As part of the securitization process, Eko

Bank segregated the mortgage collateral from their other portfolios and transferred

the loans out of the Bank in order to protect them from the claims of creditors. The

par value of the mortgage-backed securities ultimately issued by Eko Bank totaled

$8 million. Eko Bank submitted these MBS to a ratings agency prior to issuance.

8. Which of the following would Eko Bank most likely utilize in order to legally

isolate the underlying mortgage collateral to protect it from the claims of

creditors?

➢ Answer A is correct. A trust (or other form of “special purpose entity”) is

often used to legally isolate the underlying mortgage collateral to protect it

from the claims of creditors.

➢ Answer B is incorrect. Credit enhancement is a method of protecting investors

in the event that cash flows from the underlying assets are insufficient to pay

the interest and principal due for the security in a timely manner. It does not

involve the legal isolation of MBS collateral.

➢ Answer C is incorrect. An underwriter prices MBS and markets them to

investors. This person is generally not involved with the legal isolation of

mortgage collateral.

➢ Answer D is incorrect. An initial public offering of a security issuance does not

involve the legal isolation of MBS collateral. Special purpose entities are used

for this purpose.

9. Based on the above information, which of the following forms of credit

enhancement did Eko Bank most likely use when structuring this transaction?

➢ Answer A is incorrect. Excess spread is the additional revenue generated by

the coupon receivable on the underlying mortgage loans and the coupon

payable on the securities. Based on the evidence provided, Eko Bank utilized

the over-collateralization method of credit enhancement. There is no evidence

available suggesting that the excess spread method was used.

179

➢ Answer B is correct. Under the over-collateralization method of credit

enhancement, the face value of the underlying loan pool is larger than the par

value of the issued bonds. So even if some of the payments from the

underlying loans are late or default, the transaction may still pay principal and

interest payments on the bonds. Eko Bank utilized this method by issuing $8

million of securities based on $10 million of underlying mortgage collateral.

➢ Answer C is incorrect. “Legal isolation” is not a form of credit enhancement.

➢ Answer D is incorrect. Subordination is the process of prioritizing the order in

which mortgage loan losses are allocated to the various tranches. Based on

the evidence provided, Eko Bank utilized the over-collateralization method of

credit enhancement. There is no evidence available suggesting that the

subordination method was used.

10. Which of the following best describes the role that the ratings agency will play

in securitizing Eko Bank’s mortgage loans?

➢ Answer A is incorrect. Credit enhancement (not ratings agencies) Protecting

investors from losses in the event of borrower default.

➢ Answer B is incorrect. The trustee administers the trust that holds the

mortgage collateral (not the ratings agencies).

➢ Answer C is incorrect. The underwriter markets the mortgage-backed

securities to investors (not the rating agencies).

➢ Answer D is correct. Rating agencies evaluate the credit quality of a

mortgage-backed security and assign each issuance a letter grade (e.g. AAA)

based on this evaluation.

Rousseau Corp. owns a portfolio of two asset-backed securities. Security A

represents a beneficial interest in a pool of mortgage loans issued by Eko Bank;

this security pays principal and interest to each investor on a pro-rata basis.

Security B represents the senior tranche of a FNMA security that allows Rousseau

Corp. to be paid mortgage principal and interest prior to the other (lower)

tranches.

11. Security A is most likely an example of:

➢ Answer A is correct. Security A is a non-agency pass-through security

because it was issued by a private (non-governmental) institution and its cash

flows are paid to investors on a proportional (pro-rata) basis.

➢ Answer B is incorrect. An IO (“interest only”) strip is a security that pays only

interest to the investor. Security A pays both principal and interest to

investors; therefore it is not a IO strip.

➢ Answer C is incorrect. Security A is not an agency pass-through security

because it was not issued by an agency of the U.S. government.

180

➢ Answer D is incorrect. Security A pays both principal and interest to investors;

therefore it is not an IO strip. It is also not an agency pass-through security

because it was not issued by an agency of the U.S. government.

12. Security B is most likely an example of:

➢ Answer A is incorrect. Security B is not a non-agency pass-through security

because it was issued by a U.S. government agency (not a private institution)

and its cash flows are paid to investors on a priority-level (not pro-rata) basis.

➢ Answer B is correct. Security B is an agency collateralized mortgage

obligation (CMO) because it was issued by a government agency (Fannie Mae)

and its cash flows are paid to investors on a priority-level (i.e. tranche-level)

basis.

➢ Answer C is incorrect. Security B is not an agency pass-through security

because its cash flows are paid to investors on a priority-level (not pro-rata)

basis.

➢ Answer D is incorrect. Security B is not a non-agency CMO because it was

issued by a U.S. government agency (not a private institution).

13. The rules for distributing the cash flows of the underlying mortgages to the

investors of Security B are most likely found in which of the following

documents?

➢ Answer A is incorrect. The term ‘investor certificate’ refers to securities issued

by a trust (or other SPE) and sold in either public offerings or private

placements. These certificates do not govern the distribution of cash flows in

an MBS structure.

➢ Answer B is incorrect. The pooling and servicing agreement documents the

terms of the sale of MBS and the responsibilities of the servicer/seller. It does

not contain the rules for distributing cash flow amongst various MBS tranches.

➢ Answer C is incorrect. The mortgage application does not contain the rules for

distributing cash flow amongst various MBS tranches. In fact, this document

has no relevance in the structuring process.

➢ Answer D is correct. The rules for the distribution of the principal payments

and the interest from the underlying collateral (i.e. the mortgage loans)

among the tranches are specified in the prospectus.

14. Which of the following MBS positions would likely be considered the safest

investment with the least probability of default?

➢ Answer A is incorrect. Position A would not be considered a safer investment

than Position C because the security has a “B” rating, which is considered

“below investment grade”.

➢ Answer B is incorrect. Position B would not be considered a safer investment

than Position C because (1) the security has a rating that is “below investment

grade” and (2) the position is a junior tranche and will receive cash flows only

after the senior level tranches receive them.

181

➢ Answer C is correct. Position C would likely be considered the safest

investment because (1) the security is rated investment grade and (2) the

senior tranche position receives cash flows prior to the lower, junior level

tranches. This results in the lowest probability of default fort he examples

given.

➢ Answer D is incorrect. Position D would not be considered a safer investment

than Position C because it is a junior tranche that will receive cash flows only

after the senior level tranches receive them.

Chapter 7

Juliet, a trader for Swan Financial, has been asked to research the possibility of

investing the company’s capital in the foreign exchange market.

1. Which of the following statements would most likely appear in Juliet’s report

to accurately describe the characteristics of the FX market?

➢ Answer A is incorrect. There are only eight currencies in the FX market that

are commonly traded, including the U.S. Dollar, Euro, Japanese Yen, British

Pound Sterling, Swiss Franc, Canadian Dollar, and others.

➢ Answer B is incorrect. The FX market is a global market that is generally open

24 hours a day.

➢ Answer C is correct. The foreign exchange market is one of the largest and

most liquid financial markets in the world. It is several times larger than the

U.S. Government securities market (the second largest market in the world).

➢ Answer D is incorrect. The FX market consists of a limited number of major

dealer institutions that are particularly active in foreign exchange, trading with

customers and (more often) with each other. Most, but not all, are commercial

banks and investment banks.

2. Which of the following statements would most likely appear in Juliet’s report

to accurately describe the execution of trades in the FX market?

➢ Answer A is incorrect. Each nation has its own payment and settlement

system. There is no global standard.

➢ Answer B is incorrect. Most FX trades use the U.S. dollar (not the yen) as a

vehicle currency.

➢ Answer C is incorrect. When two traders enter a deal and agree to undertake a

foreign exchange transaction, they are agreeing on the terms of a currency

exchange and committing the resources of their respective institutions to that

agreement. But the execution of that exchange—the settlement — does not

take place until later.

182

➢ Answer D is correct. Executing a foreign exchange transaction requires two

transfers of money value, in opposite directions, since it involves the exchange

of one national currency for another. Juliet would therefore include this

statement in her report.

Juliet has received approval from the senior management of Swan Financial to begin

trading in the foreign exchange markets. Juliet receives the following British pound

quote: USD/GBP = 0.6598.

3. Given the FX quote provided above, the British pound (GBP) would be

considered the:

➢ Answer A is incorrect. FX quotes are considered direct or indirect; a direct

quote is a currency pair wherein the domestic currency is being listed as the

base currency. However the currencies being quoted are not referred to as

“direct” or “indirect”.

➢ Answer B is correct. GBP is considered the “quote” currency in this example.

This is because it is being quoted and its symbol appears to the right of the

slash in the exchange quote.

➢ Answer C is incorrect. FX quotes are considered direct or indirect; an indirect


quoted currency. However the currencies being quoted are not referred to as


➢ Answer D is incorrect. USD (not GBP) is the base currency in this example, as

it appears to the left of the slash in the exchange quote.

4. Given the FX quote provided above, the U.S. dollar (USD) would be

considered the:

➢ Answer A is incorrect. FX quotes are considered direct or indirect; a direct


base currency. However the currencies being quoted are not referred to as


➢ Answer B is incorrect. GBP (not USD) is the base currency in this example, as

it appears to the right of the slash in the exchange quote.

➢ Answer C is incorrect. FX quotes are considered direct or indirect; an indirect


quoted currency. However the currencies being quoted are not referred to as


➢ Answer D is correct. The U.S. Dollar is considered the “base” currency in this

example as it is the currency being converted and its symbol appears to the

left of the slash in the exchange quote.

5. Given the FX quote provided above, approximately how many U.S. dollars

would Juliet be able to purchase with 100 British pounds:

183

➢ Answer A is incorrect. This amount (0.66) incorrectly represents the direct

USD/GBP quote.

➢ Answer B is incorrect. This amount (1.52) incorrectly represents the indirect

GBP/USD quote.

➢ Answer C is incorrect. This amount (66.0) incorrectly multiplies the 100 GBP

funds by the direct USD/GBP quote.

➢ Answer D is correct. The FX quote provided in the example is a direct quote

(1 USD = 0.6598 GBP). This rate must be converted to an indirect quote in

order to complete the calculation. The GBP/USD indirect rate equals

(1/0.6598) = 1.5156. Therefore, 100 GBP of funds would purchase

approximately 151.6 USD.

6. Which of the following isolated economic observations would most likely make it

more expensive for Juliet to use USD to purchase GBP is the FX market?

➢ Answer A is correct. As a rule of thumb, a country with a consistently lower

inflation rate exhibits a rising currency value, as its purchasing power

increases relative to other currencies. If the inflation rate in Great Britain

decreases (relative to the Untied States), then the exchange rate for GBP

would most likely increase, making it more expensive for holders of USD (such

as Juliet).

➢ Answer B is incorrect. A decreasing deficit in the U.S. current account would

likely increase the purchasing power of the U.S. dollar. Thus, the GBP would

likely be less expensive for Juliet to purchase in this scenario.

➢ Answer C is incorrect. Large amounts of public debt generally lead to inflation,

which would lower the exchange rate for the GBP. Thus, the GBP would likely

be less expensive for Juliet to purchase in this scenario.

➢ Answer D is incorrect. Higher interest rates in the U.S. would attract foreign

capital and cause the value of the USD to rise. Thus, the GBP would likely be

less expensive for Juliet to purchase in this scenario.

Faraday Inc. has entered into two agreements for the purchase of euros and the

sale of Canadian dollars. Under contract A, Faraday will purchase 1 million euros

today at $1.49 per euro. Under contract B, Faraday will sell 500,000 Canadian

dollars to a customer one year from now at $0.80 per CAN$. The prevailing

CAN$/USD exchange rate on the agreement date was $0.82. The prevailing

CAN$/USD exchange rate on the delivery date is $0.75.

7. Contract A is an example of which type of financial instrument:

➢ Answer A is incorrect. Contract A is not a forward contract, as the exchange

will occur today (not in the future).

➢ Answer B is incorrect. Contract A is not a forward contract, as the exchange

will occur today (not in the future). Also, contract A is not a short transaction

as Faraday Inc. will be purchasing (not selling) the foreign currency.

184

➢ Answer C is correct. Contract A is an example of a long FX spot contract.

This is because it involves the purchase of foreign currency today at the

current market price.

➢ Answer D is incorrect. Contract A is not a short transaction as Faraday Inc. will

be purchasing (not selling) the foreign currency.

8. Contract B is an example of which type of financial instrument?

➢ Answer A is incorrect. Contract B is not a long transaction as Faraday Inc. will

be selling (not purchasing) the foreign currency.

➢ Answer B is correct. Contract B is an example of a short forward contract.

This is because it involves the sale of foreign currency in the future at a price

agreed upon today.

➢ Answer C is incorrect. Contract B is not a spot contract, as the exchange will

occur in the future (not today). Also, contract B is not a long transaction as

Faraday Inc. will be selling (not purchasing) the foreign currency.

➢ Answer D is incorrect. Contract B is not a spot contract, as the exchange will

occur in the future (not today).

9. Which of the following equals the “forward rate” under the terms of Faraday’s

Canadian dollar contract?

➢ Answer A is incorrect. This amount ($0.75) represents the market price of

CAN$ on the delivery date (not the forward price).

➢ Answer B is correct. The forward rate (or forward/delivery price) associated

with this contract equals $0.80. This represents the guaranteed price at which

the future exchange will take place.

➢ Answer C is incorrect. This amount ($0.82) represents the market price of

CAN$ on the agreement date (not the forward price).

➢ Answer D is incorrect. This amount ($1.49) represents the spot price for

contract A.

10. Which of the following is an example of a U.S. company earning a profit as a

result of foreign exchange arbitrage?

➢ Answer A is correct. This scenario is an example of locational arbitrage,

which generally involves buying an asset (e.g. foreign currency) in one

location and selling that same market for a different (and higher) in another

location.

➢ Answer B is incorrect. Purchasing long and short forward contracts with the

same forward rate is not a form of arbitrage.

➢ Answer C is incorrect. Purchasing and selling international stock over a period

of three years is not a form of arbitrage. Arbitrage purchases and sales

generally happen simultaneously.

➢ Answer D is incorrect. Issuing foreign denominated debt is not a form of

arbitrage.

185

Chapter 8

1. Reyes Corp. has made an investment in a small construction company that

employs several union workers. The likelihood that the company’s earnings

will be negatively impacted by a union strike would be considered

_________; the likelihood that the company’s earnings will be negatively

impacted by a downturn in the U.S. economy would be considered

_________.

➢ Answer A is incorrect. The likelihood that the company’s earnings will be

negatively impacted by a downturn in the U.S. economy would not be

considered an unsystematic risk, as that term refers to company or industry

specific risk.

➢ Answer B is correct. The likelihood that the company’s earnings will be

negatively impacted by a union strike would be considered an unsystematic

risk, as it is a company-specific risk. The likelihood that the company’s

earnings will be negatively impacted by a downturn in the U.S. economy would

be considered a systematic risk, as it is inherent to the entire market.

➢ Answer C is incorrect. The likelihood that the company’s earnings will be

negatively impacted by a downturn in the U.S. economy would not be

considered an unsystematic (company-specific) risk. Also, the likelihood that

the company’s earnings will be negatively impacted by a union strike would

not be considered a systematic risk, as such an event would likely affect only

this company.

➢ Answer D is incorrect. The likelihood that the company’s earnings will be

negatively impacted by a union strike would not be considered a systematic

risk, as such an event would likely affect only this company and therefore

would be categorized as a systematic risk.

Companies A, B, C & D are U.S.-based reporting entities. Their customers

exclusively reside in the United States.

2. The highest amount of interest rate risk would most likely be associated with

which of the following assets?

➢ Answer A is correct. Interest rate risk is the risk that changes in the levels of

interest rates will adversely impact the value of an investment. Such risk

would have the most impact the value on a fixed rate security. As interest

rates rise, security prices fall and vice versa.

➢ Answer B is incorrect. Interest rate risk is not associated with property, plant

& equipment, as such assets do not normally earn interest.

186

➢ Answer C is incorrect. Interest rate risk affects the value of debt securities

because they are interest-earning assets. Raw materials and other inventories

are generally not interest-earning assets, and therefore their values would not

be impacted by movements in interest rates.

➢ Answer D is incorrect. Office equipment is less likely to be subject to interest

rate risk than debt securities.

3. The highest amount of credit risk would most likely be associated with which

of the following assets?

➢ Answer A is incorrect. U.S. Treasuries are generally considered credit risk free

because they are backed by the “full faith and credit of the U.S. Government”.

➢ Answer B is incorrect. Credit risk is the risk that a borrower will fail to repay a

loan or otherwise meet a contractual obligation. Such risk is not normally

associated with physical assets.

➢ Answer C is correct. The highest amount of credit risk would most likely be

associated with the past due accounts receivable. This is because there is a

higher probability that a loss will be incurred from the customer’s failure to

meet their contractual obligation.

➢ Answer D is incorrect. Credit risk is not normally associated with equipment.

4. The highest amount of foreign exchange risk would most likely be associated

with which of the following assets?

➢ Answer A is incorrect. Company A is a U.S. based company, and their

securities are denominated in USD. Therefore, there would be no FX risk

associated with these instruments.

➢ Answer B is incorrect. Company B is a U.S.-based company with physical

assets located in the U.S. Therefore, therefore it is unlikely that any FX risk

would be associated with their property, plant and equipment.

➢ Answer C is incorrect. Company C’s cost of goods sold would be denominated

in USD, as their customers exclusively reside in the United States. Therefore,

there would be no FX risk associated with them. Furthermore, the cost of

goods sold is an expense, not an asset.

➢ Answer D is correct. Foreign currency risk would be associated with the

Euro-denominated money market accounts. The company would be subject to

adverse changes in the value of these accounts should the USD/EUR exchange

rate move unfavorably.

5. Which of the following contracts represents an example of a derivative

instrument?

➢ Answer A is incorrect. A debt security is an example of an investment, not a

derivative. A derivative is a contract that derives its value from an underlying

asset or liability.

➢ Answer B is incorrect. A lease agreement is a contract that generally pertains

to the rental of equipment, office space or other property. It is not an example

of a derivative instrument.

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➢ Answer C is correct. A futures contract is a type of derivative instrument. It

is a legally binding commitment to buy or sell a specified quantity of a

specified asset (e.g. pork bellies) at a specified date in the future.

➢ Answer D is incorrect. A Treasury note is an example of an investment, not a

derivative.

6. The Hanso Group is a London-based public company that issued a number of

stock options to its employees as compensation. Which of the following would

most likely cause the value of these options to increase?

➢ Answer A is incorrect. The value of interest rate options (not stock options)

would fluctuate with movements in interest rates.

➢ Answer B is incorrect. Decreases in employee turnover at Penguin would have

no effect on the value of their stock options.

➢ Answer C is correct. The underlying item associated with these stock options

would be Penguin’s equity shares. The value of the stock options would

therefore increase as Penguin’s stock price increases.

➢ Answer D is incorrect. The value of FX options (not stock options) would

fluctuate with movements in foreign currency rates.

7. Which of the following financial instruments would most likely be traded in the

over-the-counter derivatives market?

➢ Answer A is correct. Forward contracts are an instrument normally traded in

the over-the-counter derivatives market. This is because the terms of forward

contracts are normally customized via private negotiations to meet the specific

needs of the buyer.

➢ Answer B is incorrect. Mortgage-backed securities are not considered

derivative instruments; such instruments are traded in capital markets.

➢ Answer C is incorrect. FX spot contracts are contracts to purchase foreign

exchange at current market prices. Such instruments are not considered

derivative instruments.

➢ Answer D is incorrect. Futures are exchange-traded derivative instruments;

they are not normally traded in OTC derivative markets.

8. Which of the following scenarios would most likely be associated with a typical

forward contract?

➢ Answer A is incorrect. Bank A’s contract to purchase foreign currency at

current market prices is an example of an FX spot contract (not a FX forward

contract, which would involve the future purchase of currency).

➢ Answer B is correct. A forward contract is one that allows a buyer to lock in

the price of an underlying asset that will be purchased at a future date. Bank

B’s contract is an example of a forward contract.

➢ Answer C is incorrect. Bank C’s federal funds purchase is not a derivative

contract.

➢ Answer D is incorrect. This is an example of a mortgage securitization.

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9. C. A limit order specifies a particular price. This order can be executed only at

this price or at one more favorable to the investor.

➢ Answer A is incorrect. Company A’s order is an example of a stop order. Stop

orders are often used by investors to limit losses that can be incurred when

selling their positions. Limit orders specify maximum prices for investors

wishing to purchase positions.

➢ Answer B is incorrect. Company B’s order is an example of a market order, as

the order will be executed immediately at current market prices. Limit orders

allow investors to specify prices in which they are willing to execute their

trades.

➢ Answer C is correct. A limit order specifies a particular price. Company C’s

order can be executed only at this price or at one more favorable to the

investor.

➢ Answer D is incorrect. Company D’s order is not an example of a valid futures

order.

10. Which of the following practices effectively minimizes the credit risk

associated with futures contracts?

➢ Answer A is incorrect. The type of futures order placed generally does not

impact the credit risk associated with the contract.

➢ Answer B is correct. The margin requirement associated with futures

contracts minimizes the credit risk associated with these instruments. This is

because the traders are required by the exchange to deposit funds in a margin

account on a daily basis to prevent contract defaults.

➢ Answer C is incorrect. This practice would minimize the basis risk associated

with the hedge, not the credit risk associated with the futures contract.

➢ Answer D is incorrect. The specific usage of a futures contract (hedging vs.

speculating) generally does not affect the credit risk associated with the

instrument.

Eko Investments is a European-based hedge fund that frequently invests in countries all over the world. Eko’s financial statements are reported in euros. Eko recently

entered into a swap agreement to pay ABC Bank a stream of U.S. dollar cash flows based on a 5% fixed rate in exchange for another stream of U.S. dollar cash flows

based on 1 year LIBOR. The annual swap settlements are based on a $10 million notional principal.

11. The swap agreement between Eko and its counterparty is considered

_____________.

➢ Answer A is incorrect. This swap agreement is not a currency swap. A currency

swap involves exchanging principal and interest payments in one currency for

principal and interest payments in another. Unlike an interest rate swap, the

parties to a currency swap will exchange principal amounts at the beginning

and end of the swap.

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➢ Answer B is correct. The swap agreement between Eko and its counterparty

is an interest rate swap. The transaction is an agreement to exchange one set

of cash flows based on a fixed (5%) rate for another set based on a floating

index (1 year LIBOR).

➢ Answer C is incorrect. This contract is not an equity swap. An equity swap is

an agreement to exchange the total return (dividends and capital gains) on an

equity index for either a fixed or floating rate of return.

➢ Answer D is incorrect. This contract is not a credit default swap. A credit

default swap is a contract that provides the buyer with protection against

default, a credit rating downgrade, or another credit event.

12. If the value of 1 year LIBOR equals 3.5% on the first observation date, a net

settlement amount would be remitted by __________ in the amount of

___________ (in accordance with the swap agreement).

➢ Answer A is incorrect. The $10mm notional principal in an interest rate swap

agreement is not exchanged between counterparties.

➢ Answer B is incorrect. Eko would owe ABC Bank for the difference in interest

rates, as the fixed rate it is paying under the contract (5%) is higher than the

floating rate it is receiving (3.5%). Also, the $10mm notional principal in an

interest rate swap agreement is not exchanged between counterparties.

➢ Answer C is correct. A net settlement amount of $150,000 would be paid by

Eko Investments; this amount equals $10,000,000 notional principal * (3.5%

receive rate – 5% pay rate). The $10mm notional principal in an interest rate

swap agreement is not exchanged between counterparties.

➢ Answer D is incorrect. Eko would owe ABC Bank for the difference in interest

rates, as the fixed rate it is paying under the contract (5%) is higher than the

floating rate it is receiving (3.5%).

13. Which of the following agreements is the most consistent with the terms of a

typical option contract?

➢ Answer A is incorrect. Company A’s contract is consistent with the terms of an

interest rate swap, as it involves the exchange of cash flows based on fixed

and floating interest rates.

➢ Answer B is incorrect. Company B’s contract is consistent with the terms of a

forward contract. A forward contract obliges one party to buy a specific asset

for a specified price, while an option contract grants a party the right to do so.

➢ Answer C is incorrect. Company’s C contract is consistent with the terms of a

credit default swap, which insures the purchaser against credit losses incurred

on an underlying asset.

➢ Answer D is correct. In an option contract, one party grants to the other the

right to buy or sell an asset at a specific price at some point in the future.

Company D’s contract would be considered an option.

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14. Jin Inc. currently owns a fixed income security that it anticipates selling in the

near future. Jin sells the right for a counterparty to purchase this security

from them for a predetermined price at any time over the next 6 months.

From the perspective of Jin Inc., this contract is considered a:

➢ Answer A is incorrect. Jin’s contract would be long call option if it were

purchasing the right to buy an underlying instrument at a specified price until

the expiration date.

➢ Answer B is incorrect. Jin’s contract would be long put option if it were

purchasing the right to sell an underlying instrument at a specified price until

the expiration date.

➢ Answer C is correct. Jin’s contract is a short call option, in which they are

selling the right for their counterparty to buy the underlying fixed income

security at a specified price until the expiration date (6 months from now).

➢ Answer D is incorrect. Jin’s contract would be short put option if it were selling

the right to sell an underlying instrument at a specified price until the

expiration date.

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Glossary

Alternative-A (alt-A) – A sector of the mortgage market; the term refers to loans made to borrowers who generally have high credit scores but who (1) have variable incomes, (2) are unable or unwilling to document a stable income history, or (3) are buying second homes or investment properties. Annual percentage rate (APR) – A yearly rate of interest that includes fees and costs paid to acquire a loan. Annuity – A financial product that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time. Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years.

Arbitrage – A trading strategy that takes advantage of price differentials between two or more financial markets.

Ask price – The price that the seller of a financial instrument is willing to accept in the market. Asset-Liability Management (ALM) – The practice of managing risks that arise due to mismatches between the assets and liabilities. Financial institutions commonly employ an ALM strategy of matching interest-sensitive assets with interest sensitive liabilities in order to eliminate exposure to interest rate fluctuations. At-the-money – A term used to denote an option contract with a value of zero. Banker’s acceptance – A time draft drawn on and accepted by a bank. Bank reserves – Funds that banks maintain in a non-interest earning account at a Federal Reserve Bank (plus vault cash). Base currency – The first currency quoted in a currency pair on foreign exchange. It is also typically considered the domestic currency or accounting currency.

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Beneficial interest – Right to enjoy and use a property, and to otherwise benefit from its possession. Beneficial interest usually accrues to the legal owner but may be vested in some other party, such as the beneficiary of a trust.

Bid-ask spread – The difference between the “bid price” and “ask price” for a particular financial instrument. Bid price – The price that the buyer of a financial instrument is willing to pay in the market. Bond – A debt instrument in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a specified interest rate.

Bond market – The financial market where participants buy and sell bonds. Capital appreciation – The return on an investment that is based on increases of the asset’s value over the amount initially paid for it. Capital market – A financial market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded. Call option – An option contract that gives the holder the right to buy an asset by a certain date for a certain price. Call provision – A bond term that allows the issuing firm to “call” (i.e. buy back) the debt instruments at a specific price (normally above par). Certificate of deposit (CD) – A time deposit placed with a depository institution. The certificate states the amount of the deposit, the maturity date, the interest rate and the method under which the interest is calculated. Checkable deposits – Deposits on which checks are written. CMBS – Commercial mortgage-backed securities; securities secured by mortgages of office space, retail property, industrial facilities, multifamily housing and hotels.

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Collateral agreement – A term that specifies the amount and type of collateral that secures a bond issuance.

Collateralized mortgage obligation (CMO) – A security backed by a pool of pass-throughs or a pool of mortgage loans. CMOs are structured so that there are several classes of bond holders with varying maturities (called tranches). Commercial bank – A depository institution that raises funds primarily by issuing deposits and uses these funds to make commercial, consumer and mortgage loans and to buy U.S. government securities and municipal bonds. Commercial paper – A short-term unsecured promissory note issued by corporations and foreign governments. Compound interest – Interest that is calculated based on the both the principal of the financial instrument and the previously accrued interest; it may be computed daily, monthly, quarterly, semiannually, or annually.

Confirmation – The legal agreement underlying a swap contract that is signed by representatives of the two counterparties.

Contractual savings institutions – Financial intermediaries that acquire funds at periodic intervals on a contractual basis. They have generally long-term liabilities and stable cash flows and are providers of term finance.

Corporate bond – Long-term debt instrument issued by a corporation. Covered interest arbitrage – An arbitrage strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency.

Coupon rate – The rate of interest that a bond issuer must pay the instrument holder.

Credit default swap – A derivative contract that allows the transfer of third party

credit risk from one party to the other. One party in the swap is a lender and

faces credit risk from a third party, and the counterparty in the credit default

swap agrees to insure this risk in exchange of regular periodic payments.

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Credit enhancement – A method of protecting security investors in the event that cash flows from the underlying assets are insufficient to pay the interest and principal due for the security in a timely manner.

Credit event – A pre-determined event (such as a bankruptcy credit rating downgrade) whose occurrence triggers the settlement of a credit derivative.

Credit risk – See “default risk”. Credit union – Depository institutions that are typically very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth.

Currency swap – A swap agreement that involves exchanging principal and interest payments in one currency for principal and interest payments in another.

Current account – The balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends.

Debt instrument – A contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. Examples include bonds and mortgages. Default risk – The risk that the issuer of a financial instrument will be unable or unwilling to make payment as promised under the terms of the contract. Default risk premium – The additional amount of interest investors must earn to be willing to hold a debt instrument that is subject to a certain level of default risk. Deficit units – Participants that enter financial markets to obtain funds.

Depository institution – A financial intermediary that accepts deposits from individuals and institutions and makes loans.

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Derivative – a financial product that derives its value from an underlying asset or liability. The term derivative refers to how the price of these contracts is derived from the price of an underlying security or commodity or from some index, interest rate, exchange rate or event. Direct finance – A form of borrowing in which borrowers receive funds directly from lenders by selling them financial instruments. Direct (mortgage) lender – A mortgage-lending institution that accepts and underwrites loan applications directly from applicants and funds the resulting loans.

Direct quote – A currency quote wherein the domestic currency is listed as the base currency.

Discount rate – The interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's discount window.

Discount window – Credit facilities in which financial institutions go to borrow funds from the Federal Reserve.

Dividends – Taxable payments paid to a company's shareholders from its retained or current earnings.

Efficient market hypothesis – A theory used to explain movements in prices in the financial markets.

Electronic Communications Network (ECN) – An electronic stock-trading system that automatically matches buy and sell orders at specified prices.

Equilibrium interest rate – A rate that theoretically exists when the demand for money and supply of money are equal.

Equity instrument – A claim to share in the net income and the assets of a business. Examples include common and preferred stock.

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Equity swap – A derivative contract to exchange the total return (dividends and capital gains) realized on an equity index for either a fixed or a floating rate of interest.

Excess spread – A method of security credit enhancement; it refers to the additional revenue generated by the difference between the coupon on the underlying collateral (such as a mortgage interest rate) and the coupon payable on the securities.

Exchange (market) – An organized financial market where buyers and sellers of financial instruments (or their agents or brokers) meet in one central location to conduct trades. The New York and American Stock Exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver and other raw materials) are examples of organized exchanges. Exchange rate – The number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency in the FX market. Expectations theory – A theory that explains the term structure of interest rates (as reflected in the shape of the yield curve); its states that the term structure of interest rates is determined solely by expectations of future interest rate.

Federal Advisory Council – A council within the Federal Reserve System that consults with and advises the Federal Reserve Board of Governors.

Federal funds market – The financial market where banks and other depository institutions trade their non-interest-bearing reserve balances held at the Federal Reserve with each other, usually on an overnight basis.

Federal funds (fed funds) – Funds deposited to regional Federal Reserve Banks by commercial banks, including funds in excess of reserve requirements. These non-interest bearing deposits are lent out at the Fed funds rate to other banks unable to meet overnight reserve requirements. Federal funds rate – The interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.

Federal Open Market Committee (FOMC) – A committee within the Federal Reserve System that conducts open market operations.

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Federal Reserve Banks – The 12 district banks of the Federal Reserve System.

Federal Reserve Board of Governors – Appointed officials that oversee the actions of the Federal Reserve Banks; their primary roles include regulating commercial banks and controlling monetary policy. Federal Reserve System – The central bank of the United States; it has the responsibility of conducting national monetary policy. FICO score – A numerical grade of the credit history of a mortgage borrower; also referred to as a credit score.

Finance company – An investment intermediary that raises funds by selling commercial paper and by issuing stocks and bonds.

Financial intermediary – A third-party financial institution that stands between financial market participants (i.e. the lender-savers and the borrower-spenders) and helps transfer funds from one party to another.

Financial intermediation – See “indirect finance”. Financial instrument – A claim on a borrower’s future income that is sold by the borrower to the lender. Financial market – A market in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial risk – The probability that the actual return on a business or investment will be less than the expected return.

Financial risk management – The process of evaluating and managing current and possible financial risk at a firm as a method of decreasing the firm's exposure to the risk. Financial risk managers must identify the risk, evaluate all possible remedies, and then implement the steps necessary to alleviate the risk.

Fire and Casualty insurance company – A company that insures their policy holders against loss from theft, fire and accidents.

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Fixed interest rate – An interest rate that is established upon purchase (or issuance) of a financial instrument and remains at that predetermined rate for the entire term of the instrument.

Floating interest rate – An interest rate that adjusts up and down with the rest of the market or along with a specified index; also known as a “variable” or “adjustable” interest rate. Foreign exchange (FX) – Money denominated in the currency of another nation or group of nations. Foreign exchange risk – The risk of an investment’s value changing due to changes in foreign exchange rates. FX risk generally comes in two forms: transaction risk and translation risk. Forward contract – An over-the-counter derivative contract that obligates the holder to buy or sell an underlying asset for a predetermined price at a predetermined future time.

Forward price – The guaranteed price (or rate) at which a future exchange will take place under the terms of a forward contract. Forward rate agreement (FRA) – Derivative contract in which one party pays a fixed rate of interest to a counterparty (at one point in time) in exchange for a floating rate of interest.

Futures contract – An exchange-traded derivative contract to buy or sell a specified quantity of a specified asset at a specified date in the future.

Futures exchange – A central marketplace where people can trade futures contracts.

General Obligation (GO) bond – An unsecured financial instrument that finances municipal operations.

Haircut – The reduction of value to securities used as collateral in a secured borrowing (e.g. repurchase agreement). That is, when one places securities as

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collateral, the recipient brokerage treats them as being worth less than they actually are, so as to give itself a cushion in case its market price decreases.

Hedge – An action taken in order to reduce exposure to financial risk.

Income ratios – Calculations that compare a potential monthly payment on a mortgage loan with the borrower’s monthly income. The most common measures are front and back ratios.

Indenture – A legal document specifying the rights and obligations of both a bond issuer and the bondholders.

Indirect finance – A form of borrowing in which a financial intermediary stands between the market participants (i.e. the lender-savers and the borrower-spenders) and helps transfer from one to another. This process is also referred to as financial intermediation. Indirect quote – A FX quote wherein the domestic currency takes on the role of quoted currency.

Inflation – A rise in the general level of prices of goods and services in an economy over a period of time. Inflation risk – The risk that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Initial public offering (IPO) – The first sale of securities by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

Interest rate – The cost of borrowing money that is expressed as a percentage of the amount of the borrowed funds.

Interest rate parity – Concept that any disparity in the interest rates of two countries is equalized by the movement in their currency exchange rates.

Interest rate risk – The risk that changes in the levels of interest rates will adversely impact the value of an investment or the profitability of a business.

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Interest rate swap – A swap agreement between two parties to exchange one stream of interest payments for another stream with different features. Interest payment calculations are based on a notional principal for an agreed-upon period of time. These payments are exchanged at regular intervals on either a fixed or floating basis. In-the-money – A term used to denote an option contract with a positive value.

Investment bank – A financial intermediary that helps corporations issue securities.

Junk bond – A low-rated (speculative grade) debt instrument.

Law of one price – An economic theory stating that in competitive markets, identical goods will sell for identical prices when valued in the same currency.

Letter of credit – A letter from a bank guaranteeing that a buyer's payment to a seller will be received. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. LIBOR – The London Interbank Offer Rate, i.e. the interest rate offered by London banks on deposits made by other banks in the Eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. Life insurance company – A financial intermediary that insures people against financial hazards following a death and sells annuities. Limit order – An order placed on an exchange that can be executed only at a specific price (or at one more favorable to the investor). Liquidity – A term used to describe the relative ease and speed with which an asset can be converted to cash. A “liquid” asset is one that can be quickly and cheaply converted to cash if the need arises.

Liquidity premium theory – A theory that explains the term structure of interest rates (as reflected in the shape of the yield curve); its states that the interest rate

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on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond.

Liquidity risk premium – The additional return received by investors on relatively illiquid financial instruments. Loanable funds theory – A theory commonly used to explain interest rate movements; it suggests that the market interest rate is determined by the factors that control the supply and the demand for loanable funds. Loan-to-value (LTV) ratio – An indicator of borrower leverage at the point where the loan application if filed. The LTV calculation compares the value of the desired loan with the market value of the property. Locational arbitrage – Arbitrage strategy that allows investors to achieve a risk-free return by buying foreign currencies (or other financial asset) at one location and simultaneously selling them to the another location for a higher price.

Long position – A position involving the purchase of an asset.

Margin – A deposit required by a futures exchange from both the buyer and the seller of a contract. The amount that must be deposited at the time the contract is entered into is known as the initial margin. A maintenance margin is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin threshold due to mark-to-market (MTM) losses, the investor will receive a “margin call” and will be expected to deposit additional funds into the account to bring the balance back up to the initial margin amount. The additional funds deposited fare known as variation margin. Market maker – An institution that is prepared to quote both a bid price (at which it is prepared to buy) and an offer price (at which it is prepared to sell). Maturity - The number of years (term) until a debt instrument’s expiration date.

M1 – A money supply measure that is restricted to the most liquid forms of money; it consists of currency in the hands of the public; travelers’ checks; demand deposits, and other deposits against which checks can be written.

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M2 – A money supply measure that includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.

Member banks – Commercial banks that a part of the Federal Reserve System.

Monetary policy – Actions that impact economic conditions; the formulation of monetary policy involves developing a plan aimed at pursuing the goals of stable prices, full employment and, more generally, a stable financial environment for the economy. Money center bank – A large bank in a major financial center which borrows from and lends to governments, corporations, and other banks, rather than consumers. Money market – A financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded. Money supply – Currency (i.e. dollar bills and coins issued by the Federal Reserve System and the U.S. Treasury) and various kinds of deposits held by the public at commercial banks and other depository institutions such as thrifts and credit unions.

Mortgage – A long-term amortizing loan secured by real estate. Mortgage-backed security (MBS) – A type of financial instrument that is secured by a mortgage or collection of mortgages. Mortgage broker – A third party in the mortgage market that represents clients and will work with a number of different lenders in obtaining a loan. Municipal bond – Bonds issued by states, cities, counties and various districts to raise money to finance operations or to pay for projects. Mutual fund – A financial intermediary that acquires funds by selling shares to many individuals and uses the proceeds to purchase diversified portfolios of stocks and bonds.

Mutual Savings Bank – A depository institution that obtain funds through savings deposits (often called shares) and time and checkable deposits.

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NASDAQ – The National Association of Securities Dealers Automated Quotation System; an over-the-counter stock market.

Nominal interest rate – An interest rate that is not adjusted for inflation.

Notional principal - The predetermined dollar amount on which exchanged interest payments are based in an interest rate swap and forward rate agreement. Each period's rates are multiplied by the notional principal amount to determine the value of each counterparty's payment. Open market operations – The primary tool used by the Federal Reserve to implement its monetary policy; open market operations by the Federal Reserve involve the buying and selling of government securities in the secondary market in which previously issued securities are traded.

Option contract – A derivative that gives its purchaser the right to buy or sell a specified asset at a specified price on (or before) a specified date.

Options Clearing Corporation – The organization that handles clearing of the options trades for the various options exchanges and regulates the listing of new options. Out-of-the-money – A term used to denote an option contract with a negative value. Over collateralization – A method of security credit enhancement in which the face value of the underlying loan pool is larger than the par value of the issued bonds. Over-the-counter (OTC) market – A decentralized market of financial instruments not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. Par value – The amount that the issuer of a bond must pay the instrument holder at maturity; also referred to as the “face value” or “maturity value”.

Pass-through – A security created when one or more holders of mortgages from a collection (pool) of mortgages and sell shares or participation certificates in the pool.

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Pass-through payments are made to security holders each month on a proportional (pro-rata) basis.

Payment and settlement system – A country’s set of institutions and legally acceptable arrangements for making payments and executing financial transactions within that country, using its national currency. Pension fund – A fund established by an employer to facilitate and organize the investment of employees' retirement funds contributed by the employer and employees. The pension fund is a common asset pool meant to generate stable growth over the long term, and provide pensions for employees when they reach the end of their working years and commence retirement.

Pooling and servicing agreement – The primary contractual document that governs the structure of a securitization.

Prepayment risk - The risk associated with the early unscheduled return of principal on a fixed-income security. When principal is returned early, future interest payments will not be paid on that part of the principal (thus reducing the yield-to-maturity on that investment).

Price mechanism – A system used to match up buyers and sellers of a particular item. Primary market – A financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or governmental agency borrowing the funds. Private mortgage insurance (PMI) – An insurance policy linked to a mortgage loan that guarantees to make up any discrepancy between the value of the mortgaged property and the loan amount (should a default occur). Prospectus – Legally mandated document published by every firm offering its securities to public for purchase. A prospectus must disclose essential information such as (1) firm's objectives, (2) primary business activity, (3) background and qualification of principal officers, (4) current financial position, (5) projected financial statements, (6) assumptions underlying the projections, (7) foreseeable risks to the firm, (8) offering price on the stock (shares), and (9) (in case of bonds and notes) how the interest and principal will be paid.

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Protective covenant – A restriction placed on a bond-issuing firm that is designed to protect bondholders from being exposed to increasing risk during the investment period.

Purchasing Power Parity (PPP) – A theory for explaining the determination of exchange rates; it holds that in the long run, exchange rates will adjust to equalize the relative purchasing power of currencies. Put option – An option contract that gives the holder the right to sell an asset by a certain date for a certain price. Quote currency – The second currency quoted in a currency pair in foreign exchange. In a direct quote, the quote currency is the foreign currency. In an indirect quote, the quote currency is the domestic currency. It is also known as the "secondary currency" or "counter currency".

Ratings agency – Private firms that rate corporate and municipal bonds (and other securities) on the basis of the associated degree of default risk, and sell the ratings for publication in the financial press and daily newspapers. Examples include Moody’s Investors Service and Standard & Poor’s Corp. Real interest rate – An interest rate that has been adjusted to account for changes in inflation.

Reference entity – The issuer of a debt instrument that is being hedged by a credit derivative. Repurchase agreement (repo) – A type of transaction in which a money market participant acquires immediately available funds by selling securities and simultaneously agreeing to repurchase the same or similar securities after a specified time at a given price, which typically includes interest at an agreed-upon repo rate of return.

Reserve requirements – Requirements set by the Federal Reserve Board under which depository institutions must hold a fraction of their deposits as reserves.

Revenue bond – Secured financial instruments issued by municipalities to finance specific projects. The revenues generated by these projects are used to secure the bonds.

206

Risk-free rate – The theoretical rate of return of an investment with no risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. The interest rate on a three-month U.S. Treasury bill is often used as a proxy for the risk-free rate. Risk structure of interest rates – A concept that links the varying yields on financial instruments to changes in default risk, liquidity and tax consideration. Savings and Loan Association (S&L) – A depository institution that obtain funds through savings deposits (often called shares) and time and checkable deposits.

Savings deposits – Deposits that are payable on demand but do not allow their owner to write checks.

Secondary market – A financial market in which securities that have been previously issued can be resold. The New York Stock Exchange and NASDAQ are the best-known examples of secondary markets.

Securitization – The structured process whereby interests in loans (or other receivables) are packaged, underwritten, and sold in the form of securities.

Security – See “financial instrument”.

Segmented markets theory – A theory that explains the term structure of interest rates (as reflected in the shape of the yield curve); it states that the choice of long-term versus short-term maturities is predetermined according to need rather than expectations of future interest rates. Servicer – Entities that provide certain operational services related to mortgage lending in exchange for fees; these services include collecting and accounting for principal and interest payments, remitting property taxes, dealing with delinquent borrowers, and managing foreclosures. Short position – A position involving the sale of an asset. Simple interest – A type of interest that is calculated based solely on the principal of the financial instrument.

207

Sinking-fund provision – A bond term that requires the issuer to retire a certain amount of the bond issuance each year.

Special-purpose entity (SPE) – Legal entities (such as trusts) created to fulfill narrow, specific or temporary business objectives. Spot contract – An agreement to buy or sell an asset today at the current market price. Spot price – The current price of an asset for immediate delivery.

Stripped MBS – A form of mortgage-backed security that alters the distribution of principal and interest from a pro rata distribution to an unequal distribution. There are two types of stripped MBS: synthetic-coupon pass-throughs and interest-only/principal-only (“IO/PO”) securities. STRIPS – An acronym for 'separate trading of registered interest and principal securities'; Treasury STRIPS are fixed-income securities sold at a significant discount to face value and offer no interest payments because they mature at par.

Stock – A financial instrument that represents a percentage ownership in the issuing firm. The two types of stock offered include common stock and preferred stock.

Stock index – A performance indicator of the stock market. Stock market – A financial market that facilitates the transfer of funds in exchange for stocks. Stop order – An order placed on an exchange that is executed at the best available price once a bid or offer is made at that particular price or a less-favorable price. Stop-limit order – An order placed on an exchange that is a combination of a stop order and a limit order. The order becomes a limit order as soon as a bid or offer is made at a price equal to or less favorable than the stop price.

Strike price – The purchase or sale price specified in an option contract.

208

Structuring – The process of modifying the risks and returns of a loan pool prior to securitization; this includes the isolation and distribution of credit risk, usually through credit enhancement techniques, and the use of trusts and special purpose entities to address tax issues and the management of cash flows. Swap – An agreement between two counterparties to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of cash flows involves the future value of an interest rate, an exchange rate, or other market variable. Subordination – A method of security credit enhancement; the process of prioritizing the order in which mortgage loan losses are allocated to the various layers of MBS so that the lower rated “junior” securities serve as credit support for the higher rated “senior” securities. Subprime – A sector of the mortgage market; the term refers to borrowers whose credit has been impaired (in some cases due to life events such as unemployment or illness), while generally having sufficient equity in their homes to mitigate the credit exposure.

Surplus units – Those participants that provide funds in financial markets.

Sweeps – A practice that banks have adopted of shifting funds out of checking accounts that are subject to reserve requirements into savings accounts that are not subject to reserve requirements.

Systematic risk – The risk inherent to an entire market or market segment.

Taxable equivalent yield – A formula used to compare the returns on a non-taxable municipal bond with those of a taxable bond.

Term structure of interest rates – A concept that states that bonds with identical risk, liquidity and tax characteristics may have different interest rates because the time remaining to maturity is different.

Time deposits – Deposits with fixed terms to maturity.

TIPS – Treasury Inflation Protected Securities, which are a special type of Treasury note or bond that offers protection from inflation.

209

Tranche – Issuance class of a debt security; each class (tranche) is characterized by a unique set of features such as maturity, interest (coupon) rate, interest payment date, to suit the needs of different investors.

Transaction costs – The time and money spent in carrying out financial transactions.

Treasury bills (T-bills) – Short-term money market securities issued by the U.S. Treasury.

Treasury bonds – Long-term debt issued by the U.S. Treasury. Trustee – A third party retained for a fee to administer the trust that holds the underlying assets supporting a security. Underlying – A variable on which the value of a derivative depends. Examples include interest rates, exchange rates and stock prices.

Underwriter – Person or firm that buys a new issue of bonds or an initial public offering (usually as a syndicate with other underwriters) for reselling it to the public at a profit.

Unsystematic risk – Company or industry specific risk that is inherent in each investment.

Yield curve – A plot of yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations; the yield curve describes the term structure of interest rates.

Yield-to-maturity (YTM) – The interest rate that equates the present value of cash flows received from a debt instrument with its value today.

Zero-coupon bond – A bond that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

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Index

A

accrual (“Z”) bonds ................................................. 110 adjustable-rate mortgage ........................................ 95 adjustable-rate preferred stock ............................... 85 alternative-A (alt-A) .................................................. 96 annual percentage rate ............................................ 23 annuities ........................................... 16, 155, 200, 215 Anticipation notes ..................................................... 79 arbitrage ................................................................. 127 ask price ................................ 11, 18, 77, 128, 171, 192 at-the-money .................................................. 147, 148

B

bank notes ................................................................ 67 bank reserves ....................................... 44, 45, 47, 220 banker’s acceptance ........................................... 69, 72 Barrons ................................................................ 76, 85 base currency ......................... 120, 121, 182, 193, 195 beneficial interests ......................... 106, 108, 111, 178 bid price ................ 11, 18, 77, 128, 148, 171, 192, 201 Bloomberg.com ......................................................... 85 Board of Governors .................................................. 41 bond .......................................................................... 73 bond collateral agreements ...................................... 80 bond market ............................................................. 73 bond ratings .............................................................. 28 brokers .................................................................. 9, 62

C

call option ............................................................... 147 call premium (bonds) ................................................ 80 call provision (bonds) ................................................ 80 capital appreciation ................................................. 84 capital market . 9, 73, 90, 153, 172, 215, 216, 220, 224 cash management bills ............................................. 59 certificate of deposit ...... 65, 70, 71, 72, 168, 214, 226 checkable deposits .............................. 15, 45, 202, 206 CHIPS (Clearing House Interbank Payments System)

........................................................................... 119 collateralized mortgage obligation (CMO) .... 109, 180 commercial banks . 15, 34, 41, 45, 56, 57, 75, 119, 202 commercial mortgage-backed securities (CMBS) . 109,

192 commercial paper .......... 7, 62, 72, 167, 193, 222, 223 common stock... 8, 58, 84, 85, 86, 90, 91, 93, 173, 207,

214, 236

compound interest .......................................... 22, 193 confirmation (swap) .............................................. 146 consumer price index ................................................ 77 continuing contract federal funds ........................... 62 contractual savings institutions ...................... 16, 193 conventional loans .................................................. 95 convertible preferred stock ..................................... 85 corporate bonds .. 16, 32, 49, 56, 67, 73, 79, 150, 159,

166, 169, 170 coupon payments ..................................................... 23 coupon rate . 23, 38, 68, 74, 76, 77, 110, 156, 157, 224 covered interest arbitrage ............................. 128, 193 credit default swap ................. 146, 149, 189, 193, 239 credit enhancement ....... 104, 106, 178, 179, 194, 230 credit risk ............................................. See default risk credit score ................. 98, 99, 101, 114, 177, 178, 197 credit unions ............................................................ 15 currency pair .......................................................... 120 currency swap ................................. 146, 149, 188, 239 current account ...................................................... 122

D

DAX ........................................................................... 88 dealers . 9, 45, 55, 56, 61, 62, 64, 68, 88, 116, 117, 118,

132, 136, 167 debt instrument ... 8, 11, 16, 20, 23, 28, 29, 37, 38, 73,

93, 146, 153, 158, 172, 192, 193, 194, 200, 201, 205, 209, 216

default risk ... 28, 29, 30, 31, 32, 38, 59, 75, 79, 80, 82, 83, 93, 95, 134, 158, 159, 160, 166, 171, 172, 194, 205, 206, 219, 225, 229

deficit units .......................................... 7, 14, 15, 20, 56 Demand for loanable funds ...................................... 24 deposit notes ........................................................... 67 depository institutions .... 7, 14, 15, 16, 20, 42, 44, 45,

46, 47, 48, 50, 54, 60, 61, 65, 97, 102, 114, 155, 194, 195, 196, 202, 205

derivative instrument ............................................ 135 direct lender ............................................ 97, 114, 177 direct quote ............................ 120, 121, 183, 205, 232 discount .................................................................... 23 discount window ..................................................... 47 dividend yield .......................................................... 86 dividend-per-share .................................................. 86 dividends .................................................................. 84 Double-barreled bonds ............................................. 79 Dow Jones Industrial Average .............. 27, 89, 93, 175

E

efficient market hypothesis ............. 6, 12, 13, 20, 215

211

Electronic Communications Networks ......... 87, 88, 93 Equifax ...................................................................... 99 equilibrium interest rate .......................................... 25 equity instruments ................................. 8, 9, 153, 192 equity swap ............................................................ 147 excess spread ................................. 107, 111, 196, 230 exchange rate .. 49, 120, 121, 122, 123, 126, 127, 128,

129, 130, 132, 135, 138, 144, 146, 151, 183, 186, 195, 208, 233, 236, 239

exchanges ..... 9, 20, 87, 88, 89, 93, 115, 132, 136, 141, 144, 148, 151, 196, 203, 232, 233

exchange-traded derivatives ................................. 136 expectations theory ................. 33, 34, 35, 36, 38, 219 Experian .................................................................... 99

F

Fannie Mae ....................... 32, 109, 110, 135, 159, 180 fed funds ..................................................... 60, 72, 196 Federal Advisory Council .......................................... 42 federal funds market . 44, 48, 49, 60, 61, 72, 163, 169,

220 Federal Housing Administration (FHA)...................... 95 Federal Open Market Committee ............................ 42 Federal Reserve .... 7, 39, 40, 41, 42, 43, 44, 45, 46, 47,

48, 49, 50, 51, 52, 54, 56, 57, 60, 61, 72, 119, 161, 162, 163, 164, 165, 166, 167, 191, 195, 196, 197, 202, 203, 205, 220, 221, 235

Fedwire ............................................................. 61, 119 FICO score ............................... 102, 178, 197, 224, 228 finance companies ................................. 16, 56, 57, 75 financial instrument .......6, 10, 11, 12, 18, 22, 38, 130,

135, 151, 152, 153, 154, 168, 172, 191, 192, 193, 194, 198, 202, 206, 207, 215, 234

financial intermediary . 13, 17, 20, 146, 154, 194, 199, 200, 202, 214

financial market ... 2, 6, 8, 9, 10, 11, 13, 14, 20, 38, 56, 73, 93, 152, 153, 192, 196, 197, 202, 204, 206, 207, 214

financial risk ........................................................... 133 financial risk management ..................................... 133 fire and casualty insurance companies .................... 16 Fisher effect ........................................................ 26, 38 fixed interest rate ..................................................... 22 fixed-rate mortgage ................................................. 95 floating interest rate .......................... 22, 38, 139, 145 foreign exchange (FX) ............................................. 115 foreign exchange risk ............................................. 134 forward contract .................................................... 138 forward price .......................................................... 139 forward rate agreements ....................................... 139 Freddie Mac .................................................... 109, 135 futures contract ...................................................... 140 futures exchange .................................................... 141 FX forward .............................................. 126, 130, 234

G

General Obligation bonds........................................ 78 Ginnie Mae ............................................................. 109 government loans (mortgages) ................................ 95 government retirement funds ................................. 16

H

hedging .................................................................. 135

I

income ratios ........................................................... 99 indenture ................................................................. 80 indirect finance .............................. 13, 14, 20, 154, 197 indirect quotes ....................................................... 120 Industrial revenue bonds .......................................... 79 inflation .................................................................... 26 inflation risk ........................................................... 135 initial public offering ................ 74, 111, 178, 209, 224 inside information .................................................... 12 interest rate . 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31,

32, 33, 34, 35, 36, 38, 42, 44, 47, 54, 61, 62, 65, 66, 67, 68, 70, 72, 73, 75, 80, 84, 85, 93, 95, 96, 103, 104, 107, 114, 129, 135, 137, 139, 141, 144, 145, 149, 151, 155, 156, 157, 158, 167, 176, 185, 186, 187, 188, 189, 191, 192, 195, 196, 198, 200, 201, 203, 205, 206, 208, 209, 216, 217, 218, 219, 223, 228, 231, 236, 238, 239

interest rate parity ................................................ 128 interest rate risk ...................................... 95, 134, 139 interest rate swap .................................................. 144 interest-only/principal-only (“IO/PO”) securities .... 110 International Swaps and Derivatives Association

(ISDA) ................................................................ 146 in-the-money .................................................. 147, 148 inverse floating-rate bonds .................................... 110 inverted yield curve ......................................... 33, 219 investment banks .................................................... 17 Investors Business Daily ...................................... 76, 85

J

junk bonds ............................................................... 81

L

letter of credit .......................................................... 70 LIBOR . 66, 145, 147, 149, 188, 189, 200, 231, 236, 238 life insurance companies ......................................... 16 limit order ........................................ 142, 143, 188, 207 liquidity .................................................................... 29

212

liquidity premium theory ......... 33, 35, 36, 37, 38, 160 liquidity risk premium ............ 29, 30, 31, 32, 158, 159 loanable funds theory 21, 24, 25, 26, 27, 38, 157, 217 loan-to-value (LTV) ratio . 99, 102, 178, 201, 224, 228 locational arbitrage ................................ 128, 132, 184 London Stock Exchange ............................................ 88 long position ........................................................... 139

M

M1 ............................................................................. 50 M2 ............................................................................. 50 M3 ............................................................................. 51 maintenance margin ....................................... 143, 201 margin (futures) ..................................................... 142 market order .......................................................... 142 market participants ....... 7, 9, 12, 13, 20, 55, 56, 59, 61,

117, 139, 199, 203 marking-to-market.................................................. 143 maturity .. 7, 8, 9, 10, 15, 21, 23, 26, 28, 30, 31, 32, 34,

35, 36, 37, 38, 58, 59, 61, 62, 63, 64, 65, 66, 67, 68, 70, 71, 72, 74, 75, 76, 77, 78, 79, 81, 82, 84, 94, 95, 114, 126, 127, 134, 140, 147, 152, 153, 155, 156, 157, 160, 165, 166, 167, 168, 169, 170, 192,194, 202, 203, 204, 208, 209, 214, 216, 217, 219, 223, 224, 225, 238

member banks .......................................................... 41 monetary policy ... 2, 39, 42, 43, 44, 45, 47, 50, 51, 52,

54, 60, 126, 197, 202, 203, 220 money market 9, 10, 11, 17, 46, 50, 53, 55, 56, 57, 58,

59, 60, 64, 65, 67, 69, 70, 72, 138, 152, 153, 155, 164, 165, 166, 186, 202, 205, 209, 214, 215, 216, 222, 223, 224

money market mutual funds ........................... 17, 221 Moody’s Investor Service .......................................... 28 mortgage .................................................................. 94 mortgage broker ...................................... 97, 114, 177 mortgage loan servicers ................................... 98, 114 mortgage pass-through security ............................ 109 mortgage-backed securities .... 94, 102, 103, 106, 108,

109, 110, 111, 114, 178, 179, 192, 231 municipal bonds .... 15, 16, 24, 30, 75, 78, 93, 193, 205 mutual funds .............................................. 17, 75, 119 mutual savings banks ............................................... 15

N

NASDAQ .................... 8, 88, 89, 92, 174, 203, 206, 227 national currency .................................................... 115 New Housing Authority bonds .................................. 79 New York Stock Exchange ... 8, 87, 89, 91, 93, 174, 206 Nikkei .......................................................... 87, 92, 174 non-depository lenders ............................................. 98 notional principal ... 140, 145, 149, 188, 189, 200, 203,

236, 237, 238

O

open market operations . 42, 44, 45, 54, 196, 203, 220 opportunity cost ............................................... 21, 134 option contract ...................................................... 147 Options Clearing Corporation (OCC) ....................... 148 out-of-the-money ........................................... 147, 148 over-collateralization ............................ 107, 111, 231 over-the-counter (OTC) derivatives ...................... 136 over-the-counter (OTC) market ................... 9, 88, 148

P

par value .................................................................. 74 participating preferred stock ................................... 85 payment and settlement system .......... 118, 132, 181 pension funds ............................... 16, 57, 75, 119, 136 perpetual stocks ...................................................... 85 plain vanilla swap ................................................... 145 planning amortization class (PAC) bonds ............... 110 political risk ............................................................ 135 pooling and servicing agreement .......................... 105 preferred stock ........................................................ 85 premium ................................................................... 23 prepayment risk ..................................................... 134 price mechanism ................................................ 11, 20 Price-Earnings Ratio ................................................. 86 primary credit .......................................................... 47 primary market ................................. 8, 20, 74, 87, 153 principal .................................................................... 22 private mortgage insurance .................... 95, 100, 177 Project notes............................................................. 79 protective covenants ........................................ 80, 170 Purchasing Power Parity (PPP) .............. 123, 132, 205 put option .............................................................. 147

Q

quote currency ............................................... 120, 205

R

reference entity ...................................................... 146 repo rate of return ................................................... 68 repurchase agreements .............. 7, 45, 67, 68, 72, 221 reserve requirements ........................... 44, 45, 54, 205 residual claimant ...................................................... 83 Revenue bonds ........................................................ 79 risk structure of interest rates ..... 28, 31, 38, 158, 159,

160 risk-free rate .............................................. 30, 31, 206

213

S

S&P 500 ............................... 89, 92, 140, 147, 175, 239 savings and loan associations .................................. 15 savings deposits ............................ 13, 15, 51, 202, 206 seasonal credit ......................................................... 47 secondary credit ....................................................... 47 secondary market ... 8, 9, 18, 20, 35, 44, 54, 55, 58, 64,

65, 66, 70, 72, 74, 75, 79, 87, 103, 153, 158, 165, 166, 167, 203, 217, 218, 222

securitization .......................................................... 102 segmented markets theory ...... 33, 34, 35, 36, 38, 160 semi-strong-form efficiency .............................. 12, 154 sequential-pay bonds .............................................. 110 settlement date ................................. 68, 125, 127, 140 short position ......................................................... 139 simple interest .................................................. 22, 206 sinking-fund provision ....................................... 79, 171 special purpose entities (SPE) 106, 180, 207, 229, 231 Special tax bonds ...................................................... 79 spot (FX).................................................................. 125 spot contract .......................................................... 138 spot rate (FX) .......................................................... 125 Standard and Poor’s Corporation .............................. 28 stock ......................................................................... 83 stock indexes .............................................. 89, 93, 140 stock markets ........................................................... 87 stock quotations ....................................................... 85 stop order ................................................ 142, 188, 207 stop-limit order ....................................................... 142 stripped mortgage-backed securities .................... 110 strong-form efficiency............................................... 12 structuring .............................................................. 105 Subordination ................................. 107, 111, 208, 230 subprime ............................. 96, 99, 103, 114, 177, 229 Supply of loanable funds ........................................... 24 support bonds ......................................................... 110 surplus units .............................................. 7, 15, 20, 56 swap ....................................................................... 144 sweeps ...................................................................... 52 synthetic-coupon pass-throughs ............................. 110 systematic risk ................................ 133, 137, 185, 235

T

targeted amortization class (TAC) bonds ................ 110 taxable equivalent yield ......... 73, 78, 82, 93, 170, 226 term federal funds ................................................... 62 term structure of interest rates 21, 32, 33, 34, 36, 37,

38, 196, 200, 206, 209

ticker symbol ........................................................... 86 time deposits ................................... 15, 50, 51, 67, 202 Toronto Stock Exchange ........................................... 88 tranches .................. 109, 112, 179, 180, 181, 193, 229 transaction costs ............................. 14, 17, 45, 62, 119 Transunion................................................................ 99 Treasury bills ..... 7, 11, 45, 56, 59, 60, 63, 72, 166, 209 Treasury bonds ............... 75, 76, 77, 93, 170, 171, 209 Treasury Inflation Protected Securities ................... 77 Treasury notes .................................. 7, 75, 76, 93, 172 Treasury STRIPS ....................................................... 77 trustee .............................................................. 80, 104

U

U.S. Department of Housing and Development ....... 95 U.S. Treasury ...7, 13, 28, 29, 30, 32, 45, 50, 54, 55, 56,

57, 58, 59, 72, 75, 81, 93, 95, 159, 166, 169, 170, 202, 206, 209, 218

unsystematic risk ................................... 133, 134, 209

V

variation margin ............................................. 143, 201 vehicle currency ..................................... 117, 124, 181 very accurately determined maturity (VADM) bonds

.......................................................................... 110

W

Wall Street Journal ................................ 76, 85, 91, 173 Weak-form efficiency ............................................... 12 wholesale markets ................................................... 55

Y

Yahoo! Finance ......................................................... 85 yield curve ................................................................ 32 yield-to-maturity ............................................... 23, 77

Z

zero-coupon security ............................................... 77

214

a.

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