1

FINS1612: Capital Markets and Institutions

Chapter 1 : A modern financial system an overview
1.1 Functions of a financial system
Money
o Acts as medium of exchange
o Allows specialisation in production
o Solves the divisibility problem; ie. where medium of exchange does not represent equal value for the
parties to the transaction
o Facilitates saving
o Represents a store of wealth
Role of Markets
o Facilitate exchange of goods and services by:
Bringing opposite parties together
Establishing rates of exchange ie. prices
Makes things easier to do the exchange
Surplus Units
o Savers of funds available for lending
Deficit Units
o Borrowers of funds for capital investment and consumption
Financial instrument
o Issued by a party raising funds, acknowledging a financial commitment and entitling the holder to
specified future cash flows
Double coincidence of wants satisfied
o A transaction between two parties that meets their mutual needs
Flow of funds
o Movement of funds through the financial system between savers and borrowers giving rise to
financial instruments
Financial system
o Comprises financial institutions, instruments and markets facilitating transactions for goods and
services and financial transactions.
o Everything and everyone is in it for the transaction to occur or take part in the market
Attributes of Financial assets
o Return or yield
Total financial compensation received from an investment expressed as percentage of the
amount invested.
o Risk
Probability that the actual return on an investment will vary from the expected return
o Liquidity
Ability to sell an asset within a reasonable time at current market prices and for reasonable
transaction costs
Means a lot of buyers and sellers
o Time pattern of cash flows
When the expected cash flows from a financial asset are to be received by the investor or
lender
An efficient financial system:
o Encourages savings
o Directs savings to the most efficient users
o Is a combination of assets and liabilities comprising the desired attributes of return , risk ,liquidity
and timing of cash flows

2
1.2 Financial institutions
Most people have used the services of a financial institution at some stage, even if the service was simply a
basic bank account
Financial institutions may specialised in:
o Taking deposits , providing advice to corporate and government clients or offering financial contracts
such as insurance
Financial institutions are essential to the operation of the modern financial system
Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial
transactions
Institutions may be categorised by differences in the sources and uses of funds
o Depository financial institutions
o Investments banks and merchant banks
o Contractual savings institutions
o Unit trusts
Depository financial institutions
o Mainly attract the savings of depositors through on- demand deposit and tem deposit accounts; eg.
Commercial banks , building societies and credit cooperatives
o Mainly provide loans to borrowers in household and business sectors
o Eg. Banks , earn money from interest rates
Investment banks and merchant banks
o Mainly provide off-balance sheet (OBS)( not shown on the balance sheet) advisory services to
support corporate and government clients eg. Advice on mergers and acquisitions , portfolio
restructuring, finance and risk management
o May also provide some loans to clients but are more likely to advise on raising funds directly in
capital markets.
o Do not make money from interest rates but instead use the advisory fee
Contractual saving institutions
o The liabilities of these institutions are contracts that require, in return for periodic payments to the
institution, the institution to make payments to the contract holders if a specified event occurs eg.
Life and general insurance companies and superannuation funds
o The large pool of funds is then used to purchase both primary and secondary market securities
o Payouts are made for insurance claims and to retirees.
Unit Trusts
o Formed under a trust deed and controlled and managed by a trustee
o Funds raised by selling units to the public ; investors purchase units in the trust
o Funds are pooled and invested by fund managers in a range of asset classes specified in the trust
deed
o Types of unit trusts include equity , property , fixed interest and mortgage trusts
o Trustee- like a contract
Equity
o Ownership interest in an asset
o Residual claim on earnings and assets
Dividend
Liquidation
o Types
Ordinary share
Hybrid ( or quasi- equity ) security
Preference shares- might have some minimum periodic interest payment
Convertible notes
1.3 Financial Instruments

Debt
o

Contractual claim to:

Periodic interest payments
Repayment of principal
o Ranks ahead of equity
o Can be:
Short term ( money market instrument) or medium to long term ( capital market
instrument)
Secured or unsecured
Negotiable ( ownership transferable ; eg. Commercial bills and promissory notes) or nonnegotiable ( eg. Term loan obtained from a bank)
Derivatives
o A synthetic security providing specific future rights that derives its price from ( help cover the risks
involved);
A physical market commodity
Gold and oil
Financial security
Interest rate sensitive debt instruments, currencies and equities
o Used mainly to manage price risk exposure and to speculate
Three basic derivative contracts
o Futures contract
o Forward contract
o Option Contract
1.4 Financial markets
Matching principle
Primary and secondary market transactions
Direct and intermediated finance
Wholesale and retail markets
Money markets
Capital markets

Matching principle
o Short-term assets should be funded with short term ( money market ) liabilities eg. seasonal
inventory needs funded by overdraft
o Longer term assets should be funded with equity or longer term ( capital market) liabilities eg.:
Equipment funded by debentures
Lack of adherence to this principle accentuated effects of frozen money markets with the
sub- prime market collapse
Primary market transactions
o The issue of new financial instrument to raise funds to purchase goods , services or assets by:
Business
Governments
Individuals
o Funds are obtained by the issuer
o Direct finance
Secondary market transaction
o The buying and selling of existing financial securities
No new funds raised and therefore no direct impact on original issuer of security
Transfer of ownership from one saver to another saver

Provides liquidity , which facilitates the restructuring of portfolios and securities owners
Direct finance
o Users of funds obtain finance through primary market via direct relationship with providers ( savers0
o Advantages
Avoids costs of intermediation
Increases access to diverse range of markets
Greater flexibility in range of securities users can issue for different financing needs
o Disadvantages
Matching of preferences
Liquidity and marketability of a security
Search and transaction costs
Assessment of risk , especially default risk
Intermediated financial flow markets
o A financing arrangement involving two separate contractual agreements whereby the saver provides
funds to an intermediary and the intermediary provides funding to the ultimate user of the funds
o Advantages
Asset transformation
Maturity transformation
Credit risk diversification and transformation
Liquidity transformation
Economies of scale
Wholesale markets
o Direct financial flow transactions between institutional investors and borrowers
Involves larger transactions
Retail markets
o Transactions conducted primarily with financial intermediaries by the household and small- to
medium- sized business sectors
Involves smaller transactions
Money Markets
o Wholesale markets in which short-term securities are issued and traded
o For short term
Capital markets
o Markets in which longer term securities are issued and traded with original term to maturity in
excess of one year

Summary

The Financial system is composed of financial institutions, instruments and markets facilitating transactions
for goods and services and financial transactions
Financial instruments may be equity , debt or hybrid
Financial markets may be classified according to:
o Primary and secondary transactions
o Direct and intermediated flows wholesale and retail markets
o Money markets and capital markets
o Financial institutions

Commercial banks
Main activities

Commercial banks provide a full range of financial services

Asset Management
o Loans portfolio is tailored to match the available deposit base ( orientated around assets)

Liability management
o Deposit base and other funding sources are managed to meet loan demand
Borrow directly from domestic and international capital markets
Provision of other financial services
Off-balance- sheet (OBS) business
Importance of banks (again):
o Asset transformation
o Maturity transformation
o Credit risk diversification & transformation
o Liquidity transformation
o Economies of scale

Source of Funds

Banks- balance sheet

Banks have a liability to give back the money

Sources of funds appear in the balance sheet as either liabilities or shareholders funds
Banks offer a range of deposit and investment products with different mixes of liquidity, return, maturity
and cash flow structure to attract the savings of surplus entities
Current account deposits
o Funds held in a cheque account
o Highly liquid be able to with drawl how much you want
o May be interest or non-interest bearing
Term Deposits
o Funds lodged in an account for a predetermined period at a specified interest rate
Term: one month to five years
Loss of liquidity owing to fixed maturity
Higher interest rate than current or call accounts
Generally fixed interest rate ( banks do penalties if you do withdrawl)
Negotiable certificates of deposit (CDs)
o Issued by a bank in its own name
o Issued at a discount to face value
o Highly negotiable security
o Short term (30 to 180 days)
Debt liabilities
o Medium- to longer term debt instruments issued by a bank
Debenture ( like a loan)
Unsecured note
Foreign currency liabilities

6
o

Debt instruments issued into the international capital markets that are denominated in a foreign
currency
Allows diversification of funding sources into international markets
Facilitates matching of foreign exchange denominated assets
Meets demand of corporate customers for foreign exchange products
Loan Capital and shareholders equity
o Sources of funds that have characteristics of both debt and equity (e.g. subordinated debentures
and subordinated notes)
Subordinated means the holder of the security has a claim on interest payments or the
assets of the issuer, after all other creditors have been paid (excluding ordinary shareholders)

Use of Funds

Uses of funds appear in the balance sheet as assets

The majority of bank assets are loans that give rise to an entitlement to future cash flows; i.e. interest and
repayment of principal:
o Personal and housing finance
o Commercial lending
o Lending to government
Personal and Housing finance
o Housing finance
Mortgage
Amortised loan
o Investment property
o Fixed-term loan
o Credit card
Commercial lending
o Involves bank assets invested in the business sector and lending to other financial institutions
Fixed- term loan
o A loan with negotiated terms and conditions
Period of the loan
Interest rates
Timing of interest payments
Repayment of principal
Overdraft
Bills of exchange
Leasing
Lending to government
o Treasury notes
Short-term securities issued by the government
o Treasury bonds
Medium- to longer-term securities issued by the government that pay a specified interest
coupon stream
o State government debt securities
o Low risk and low return

Off balance sheet Business

OBS transactions are a significant part of a banks business

OBS transactions include:
o direct credit substitutes
o trade- and performance-related items

o Commitments Underwriting, Repos

o foreign exchange, interest-rate- and other market-rate related contracts
Direct credit substitutes
o An undertaking provided by a bank to support the financial obligations of a client.
Trade- and performance-related items
o An undertaking provided by a bank to a third party promising payment under the terms of a
specified commercial contract.
Commitments
o The contractual financial obligations of a bank that are yet to be completed or delivered.
o E.g., underwriting.- if people dont buy the number of shares at a price or something than the bank
buys it
Foreign exchange, interest-rate- and other market rate-related contracts:
o The use of derivative products to manage exposures to foreign exchange risk, interest rate risk,
equity price risk and commodity risk (i.e. hedging)
o E.g., futures, options, foreign exchange contracts, currency swaps, forward rate agreements (FRAs)
o Also used for speculating
To the extent that these OBS activities involve risk taking and positions in derivative securities, OBS activities
raise some concerns about bank regulation
This is a particularly important concern when the size of off balance sheet activities is considered
The notional value of such activities is more than 5 times the total value of assets held by the banks

Regulation and Supervision

The GFC has focussed attention on the regulation of the financial system
A number of financial institutions collapsed during the crisis
The amount of leverage on the balance sheets of these institutions was a primary factor contributing to their
weakness (high leverage- more risky)
Debate concerning bank regulation and prudential supervision has concentrated on how regulators can
maintain a stable financial system

Capital Adequacy Standards

The business activities of financial institutions will inevitably involve the need to write-off of abnormal
business losses
The capital held by financial institutions serves as the buffer against such losses
If capital is inadequate, a financial institution may face insolvency. This has significant implications for the
stability of the financial system
The capital adequacy standards set down in Basel II and III define the minimum capital adequacy ( hold a
minimum amount of capital) for a bank
The standards are designed to promote stability within the financial system
Functions of capital
o Source of equity funds
o Demonstrates shareholder commitment
o Provides funding for growth and source of future profits
o Write-off periodic abnormal business losses
Development of international capital adequacy standards
o Basel I (1988)
o Basel II (2008)
o Basel III (2010)
Basel II mainly focuses on:
o Credit risk of banks assets and OBS business
o Market risks of banks trading activities

o Operational risks of banks business operations

o Form and quality of capital held to support these exposures
o Risk identification, measurement and management processes adopted
o Transparency through accumulation and reporting of information
Minimum capital adequacy requirement applies to commercial banks and other institutions specified by
prudential regulators
Basel II Capital adequacy standard: Minimum risk based capital ratio of 8% (no less than 8%)
Minimum 4% held as Tier 1 capital ( there are some capital that is more reliable than others)
o Highest quality core capital
o E.g., paid-up ordinary shares; retained earnings
Remainder can be held as Tier 2 (supplementary) capital
o Upper Tier 2. E.g., mandatory convertible notes
o Lower Tier 2. E.g., term subordinated debt

Overview of basel 2 structure

Pillar 1 Capital Adequacy

Three risk components: credit risk, operational risk, and market risk.
Credit risk risk that borrowers will not meet their commitments when due.
Basel II provides three alternative ways for a bank to measure credit risk:
o Standardised approach
o Foundation internal ratings-based approach (FIRB)
o Advanced internal ratings-based approach (AIRB)
Operational risk- exposures that may impact on normal day to day business functions of an organisation.
Eg. Internal/ external fraud, workplace safety, business practices
Main operational risk management objectives:
o Operational objectives
o Financial impact objectives
o Regulatory objectives

Market risk risk of losses resulting from changes in market rates in exchange rates, interest rates, equities
and commodities
o General market risk changes in the overall market for exchange rates, interest rates, equities, and
commodities ( overall market- effects every player in the market)
o Specific market risk changes in the value of a security due to issuer-specific factors
o Two approaches to market risk capital requirements
Internal modelrequires a statistical probability model that measures financial risk
exposures, i.e. value at risk (VaR)
Standardised approach
Pillar 2 Supervisory review of capital adequacy
Intended to ensure banks have sufficient capital to support all risks and encourage improved risk
management policies and practices in identifying, measuring and managing risk exposures such as:
o risks incompletely/not captured in Pillar 1 and factors external to the bank, such as a changing
business cycle
o additional risk management practices such as education/ training; internal responsibilities,
delegation and exposure limits; increased provisions and reserves; and improved internal controls
and reporting practices
Four key principles of supervisory review
Pillar 3 Market discipline
Aim is to develop disclosure requirements that allow the market to assess information on the capital
adequacy of an institution, i.e. increase the transparency of an institutions risk exposure, risk management
and capital adequacy
Prudential supervisors to determine minimum disclosure requirements and frequency
Basel II recommends a range of qualitative and quantitative information disclosure relating to principal parts
of Pillars I and II
Basel III was developed in 2010.
Aims to enhance the risk coverage of the Basel II framework by enhancing capital adequacy requirements
Three principal aims:
o Boost the banking sectors ability to absorb shocks arising from financial and economic stress
o Improve risk management and governance
o Strengthen banks transparency and disclosure
Examples:
o Increase minimum Tier 1 capital to 6% (4% in Basel II) of risk-weighted assets by 2015.
o Increase minimum Common Equity Tier 1 capital to 4.5% (2% in Basel II) of RWA by 2015.
o Improve the quality of capital (e.g. tighter definition of Common Equity Tier 1 capital to include only
common stocks, retained earnings, and other comprehensive income).
o Minimum liquidity coverage ratio to ensure banks have sufficient high-quality liquid assets for
expected net cash outflows.

The Share Market and the Corporation

The Nature of a Corporation

Share Market
o A formal exchange facilitating the issue, buying and selling of equity securities
Publicly listed corporation
o A company whose shares are quoted and traded on a formal stock exchange
Ordinary share
o The principal form of equity issued by a corporation, which bestows a claim to residual cash flows
and ownership and voting rights
The corporation differs from other business forms
o Ownership claims are widespread and easily transferable

10
o
o

Owners (shareholders) do not affect the day- to day affairs of the company
Shareholders liability is limited to:
The issue price of shares of a limited liability company
Advantages of the corporate form
o Can obtain large amounts of finance at a relatively cheap cost
o The liquidity of securities facilitates investor diversification and encourages investment in corporate
securities (becomes less risky)
o Separation of ownership and control facilitates:
Appointment of specialised management
Greater effectiveness in the planning and implementation of strategic decisions
o Perpetual succession the corporate form is unaffected by changes in management or ownership
o The Corporate form is suited to large scale operations
Disadvantages of the corporate form
o Main disadvantage arises from the separation of ownership and control
Conflict of interest between owners (principals) and managers (agents) known as the agency
problem
Management may try to run business of their own benefit, rather than that of shareholders,
ie. Maximise shareholder value (share price)
o Factors moderating conflict of interest between owners and managers
Investors ability to sell shares in a corporation, causing the share price to fall
Dismissal from the board at AGM by shareholders
Threat of takeover and loss of employment
Use of performance incentives, such as share options

The stock exchange

Primary market role

A stock exchange facilitates the efficient and orderly sale of new financial securities
o New floats/ initial public offerings (IPOs)
Initial listing of a corporation on the stock exchange
o Rights issue
Issue of additional shares to existing shareholders on a pro- rata basis
o Placements
Issue of new shares to selected institutional investors
o Dividend reinvestment plans
Reinvestment of dividends into corporation for additional shares

Secondary Market Role

The stock exchange facilitates trading in existing shares

o No new funds are raised by the issuing company
o An active, liquid , well organised secondary market increases the appeal of buying new shares in
the primary market
o Market liquidity
Ratio of share turnover to market capitalisation
o Market turnover
Number of shares on issue x current share price

Managed product role

The stock exchange provides a market for trading managed products

o Equity- based managed products are professionally managed funds

11
o

The units in these funds are bought and sold on the stock exchange in the same way as shares in
corporations.

Derivative market role

The stock exchange provides a market for trading equity related derivative products
o A derivative is a financial security that derives its price from an underlying commodity (eg. Gold) or
financial instrument (eg. BHP shares)
o Derivative products are described as:
Exchanged- traded contracts: standardised financial contracts traded on a formal exchange
Over the counter contracts : non-standardised contracts negotiated between writer and
buyer
o Derivatives serve as a:
Risk management tool (hedge)
Speculative instrument

The private equity Market

Private equity is an alternative funding source for companies unable or not wanting to access equity capital
through a public issue
Source of funds
o Superannuation funds and life insurance offices
Use of funds
o Start-ups , business expansion, recovery finance for distressed companies , management buyouts
o Aim is generally to:
Improve profitability sufficiently to realise value through an IPO
Break up business to achieve return on investment

Corporations Issuing Equity in the share Market

The investment decision

The objective of financial management is to maximise shareholder value

Four main aspects of financial management
1. Investment decision (capital budgeting)
a. Invest in which assets?
2. Financing decision (capital structure)
a. How to fund the purchase of these assets
3. Liquidity (working capital) management
a. How best to manage current assets and current liabilities (there is a trade off with how much
to hold)
4. Dividend policy decision
a. How to retain and / or distribute profits
A corporation first determines the assets in which it will invest funds according to organisational objectives
o Real assets; eg. Plant and equipment
o Financial assets; eg. Equities , bonds
Competing investment alternatives should be evaluated on the basis of shareholder wealth maximisation
Two important measures used to quantify the contribution of an investment to shareholder wealth
o Net present value (NPV)
o Internal rate of return (IRR)

NPV

The difference between the present value of cash flows associated with an investment and the cost of the
investment

12

The NPV decision rule

o Accept an investment that has a positive NPV; ie. Reject an investment with a negative NPV (choose
higher NPV)
NPV ( and IRR) determinants:
o The accuracy of the forecasted cash flows
o The discount rate ( required rate of return)

IRR

The required rate of return resulting in NPV = 0

The IRR acceptance rule
o Accept the investment if its IRR is greater than the firms required rate of return
Limitations of IRR
o Non-conventional cash flows
Can result in multiple IRRs
o Mutually exclusive projects
Where only one of two or more investment alternatives can be chosen, the IRR may not
choose the project with the highest NPV.

The financing decision

The financing decision concerns the capital structure used to fund the firms business activities
The financial objective of a corporation is to maximise return, subject to an acceptable level of risk
Returns are generated from the net cash expected cash flows derived from:
o Business risk
o Financial risk

Business risk

The level of business risk depends upon the type of operations of the business, i.e:
o Industry sector that influences the level of fixed versus variable operating costs
Also affected by:
o Sectoral growth rates
o Market share
o Aggressiveness of competitors
o Competence of management and workforce

Financial risk

Exposure to factors that impact on the value of assets, liabilities and cash flows
The level of financial risk of a company is borne by the security holders (debt and equity)
Financial risk categories
o Interest rate risk
Risk of adverse movements in interest rates
o Foreign exchange risk
Risk of adverse movements in exchange rates
o Liquidity risk
Risk of insufficient cash in the short term
Financial risk and the debt to equity ratio (D/E)
o D/E is the ratio of funds borrowed (debt) to funds contributed by shareholders (equity)
o D/E indicates the risk of being unable to meet interest due and principal repayments associate with
use of debt. i.e. risk of insolvency
o Earnings per shares (EPS) is the net return on a companys shares expressed in cents per share (CPS)

13

If the cost of debt is less than the return achieved, issuing more debt will benefit
shareholders on account of higher EPS
However, high debt levels increase a companys level of financial risk and, thus, the risk of
insolvency
What is the appropriate D/E ratio?
o Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in practice are:
Industry norms
Historical levels of firms ratio
Limit imposed by lenders through loan covenants, ie. Restrictions placed on a borrower
specified in a loan contract
Managements assessment of the firms capacity to service debt.

Initial Public Offering (IPO)

Initial public offering (IPO) is an offer to investors of ordinary shares in a newly listed company on a stock
exchange
o New share issuer must meet listing requirements
o The promoter appoints advisers (stockbroker, merchant bank, other specialists) and possibly
underwriters
o Underwriters
Ensure a company raises the full amount of the issue
Assist with advice on the structure , price , timing and marketing of the issue and allocation
of securities

Listing on a stock exchange

A company seeking to have its securities quoted on a stock exchange (ie. To join the official list ) must
comply with listing rules, which are additional to the corporations legislation obligations
A non-complying listed company can be suspended from quotation or delisted
Listing rule principles embrace the interests of listed entities, maintain investor protection, and maintain the
reputation and integrity of the market

Different forms of equity finance are available to established companies

Different forms of equity finance are available to established companies

o Additional ordinary shares
Rights issue, takeover issues, dividend reinvestment schemes
o Preference Shares
o Quasi- equity
Convertible notes, options, warrants

Equity funding for listed Firms

Rights issue

Issue of ordinary shares to existing shareholders

Issue pro rata eg. 1:5 or 1 for 5
Factors influencing the issue price
o Companys cash flow requirements
o Projected earnings flows from the new investments funded by the rights issue
o Cost of alternative funding sources

Takeover issues

14

Acquiring company issues additional ordinary shares to owners of target company in settlement of the
transaction
Alleviates need for owners of acquiring company to inject cash for the purchase of the company

Dividend reinvestment schemes

Shareholders have the option of reinvesting dividends in additional ordinary shares

No brokerage or stamp duty payable
Schemes may be suspended in low growth periods

Preference shares

Classed as hybrid securities ie. They have characteristic of both debt and equity
Fixed dividend rates are set at issue date
Rank ahead or ordinary shareholders in the payment of dividends and liquidation

Summary

Objective of financial management is to maximise shareholder value

Four key financial management decisions involve investment, financing, liquidity (working capital ) and
dividend
Appropriate investment decision techniques are NPV and IRR
The financial decision concerns the choice of capital structure (D/E) and influences a firms financial risk
Additional equity can be raised through ordinary shares, preference shares, convertible notes and other
quasi- equity

15
Week 4 - Equity Markets II
Share-market investment

Investors buy shares to receive returns from dividends and capital gains (losses)
Other factors encouraging investment in securities quoted on a stock exchange (SX)
o Depth of the market
Overall capitalisation of corporations listed on an SX
o Liquidity of the market
Volume of trading relative to the size of the market
o Efficient price discovery
Speed and efficiency with which new information is reflected in the current share price
Two types of risk impact on security returns
1. Systematic risk
Factors that generally impact on share prices in the market; e.g. economic growth, and changes in
interest rates and exchange rates
2. Unsystematic risk
Factors that impact specifically on the share price of a corporation; e.g. resignation of the CEO,
technology failure, board problems
Diversified Investment Portfolio

A portfolio containing a wide range of securities

Diversifies most of the unsystematic risk of the individual securities
a. Investors will not receive higher returns for unnecessarily bearing unsystematic risk
The remaining risk is systematic risk, which is measured by beta
a. Beta is a measure of the sensitivity of the price of an asset relative to the market
Expected portfolio return is the weighted average of expected returns of each share
Portfolio variance (risk) is the correlation of pairs of securities within the portfolio

Investors may take one of two approaches

1. Active investment approach
a. Portfolio structure is based on share analysis, new information and risk-return preferences
2. Passive investment approach
a. Portfolio structure is based on the replication of a specific share market index, e.g. industrial or
telecommunications sector index
Some managed funds are index funds Portfolios are structured to fully or partially replicate a specific share market
index

Investors need to consider asset allocation within a share portfolio

o Risk versus return
o Investment time horizon
o Income versus capital growth
o Domestic and international shares
Asset allocation may be:
o strategic
o tactical

Buying and selling shares

Direct investment in shares

o Investor buys and sells shares through a stockbroker
Discount broker, i.e. phone and Internet

16

Full-service advisory broker

o Consideration of liquidity, risk, return, charges, taxation, etc.
Indirect investment in shares
o Investor purchases units in a unit trust or managed fund, e.g. equity trusts

Taxation

Pre-dividend imputation (prior to 1987)

o Dividends were taxed twice - first at company level (as profits) and then at the investors marginal
rate
Dividend imputation (since 1987)
o Removed the double taxation of dividends
o Investors receive franking credit for the tax a company pays on a franked dividend

Capital gains tax on shares purchased

Prior to 19/9/1985 tax free

19/9/198521/9/1999
o Taxpayers marginal tax rate applied if held less than 12 months
o Taxpayers marginal tax rate applied to indexed capital gain if held over 12 months
Since 21/9/1999
o 50% discounted gain if held at least 12 months; or
o indexed capital gain or 50% discounted gain if purchased 19/9/198521/9/1999

Financial performance indicators

Potential investors are concerned with the future level of a companys performance
Companys performance affects both the profitability of the company and the variability of the cash flows
Indicators of company performance
o Capital structure
o Liquidity
o Debt servicing
o Profitability
o Share price
o Risk

Capital structure

Proportion of company assets (funding) obtained through debt and equity

o Usually measured by debt to equity ratio (D/E)
Higher debt levels increase financial risk; i.e. firm may not be able to meet interest payments
o Also measured by proprietorship ratio, which is the ratio of shareholders funds to total assets

17

Indicates firms longer term financial viability/stability; a higher ratio indicates less reliance
on external funding

Liquidity

The ability of a company to meet its short-term financial obligations

Measured by current ratio
o Fails to consider the not very liquid nature of certain current assets, such as inventory

Measured by liquid ratio

The higher the current and liquid ratios, the better the liquidity position of a firm

Debt Servicing

Ability to meet debt-related obligations, i.e. interest and repayment of debt

Measured by debt to gross cash flow ratio
o Indicates number of years of cash flow required to repay total firm debt
Measured by interest coverage ratio

Profitability

Wide variation in the measurement of profitability

o Earnings before interest and tax (EBIT) to total funds ratio
o Earnings per share (EPS)
o The amount of money you put in to the company and the amount you get back

EBIT to total funds ratio =

Wide variation in the measurement of profitability

o EBIT to long-term funds ratio

EBIT to long- term funds ratio =

Wide variation in the measurement of profitability (cont.)

o Return on equity (net income/equity)
o Higher ratios indicate greater profitability

Share Price

Represents investors view of the present value of future net cash flows of a firm
Share price performance indicators
Price to earnings ratio (P/E)
o Share price divided by earnings per share
o A higher P/E indicates more growth in future net cash flows
share price to net tangible assets ratio (P/NTA)

18
o

Measures the theoretical premium or discount at which a firms share price is trading relative to its
NTA

Risk
Variability (uncertainty) of the share price
Two components
1. Systematic risk (often referred to as beta)
Arises from factors affecting the whole market, e.g. state of the domestic economy and world economy
2. Non-systematic risk
Arises from firm-specific factors, e.g. management competence, labour productivity, financial and
operational risks
Can be eliminated in a well-diversified portfolio
Pricing of Shares

Share price is mainly a function of supply and demand for a share

o Supply and demand are influenced mainly by information
o Share price is considered to be the present value of future dividend payments to shareholders
o New information that changes investors expectations about future dividends will result in a change
in the share price
Estimating the price of a share ( assuming that
cash flows equal dividends)
o General dividend valuation model
o Valuing a share with a constant dividend

(D0)
Valuing a share with constant dividend growth (g)

Cum-dividend and ex-dividend

o Dividends are payments made to shareholders, expressed as cents per share
o Dividends are declared at one date and paid at a later, specified date
o During the period between the two dates, the shares have the future dividend entitlement attached,
i.e. cum-dividend
o Once the dividend is paid the shares are traded ex-dividend
o Theoretically, the share price will fall on the ex-dividend date by the size of the dividend
o Example:

Bonus share issues

o Where a company has accumulated reserves, it may distribute these to existing shareholders by
making a bonus issue of additional shares
o As with dividends, there will be a downward adjustment in share price when shares go ex-bonus
o As no new capital is raised, there is no change in the assets or expected earnings of the company
Share splits
o Involves division of the number of shares on issue
o Involves no fundamental change in the structure or asset value of the company
o Theoretically, the share price will fall in the proportion of the split

19

Pro-rata rights issue

o Involves an increase in the companys issued capital
o Typically issued at a discount to market price
o Theoretically, the market price will fall by an amount dependent on the:
number of shares issued
size of the discount

A renounceable right is a right that can be sold before it is exercised

o The value of the right is determined by Equation 6.12

Stock-market indices and published share information

Stock- market indices

Measure of the price performance of a share market or industry sector; e.g.:

o Performance benchmark index
Measures overall share-market performance based on capitalisation and liquidity ie ASX200
o Tradeable benchmark index
A narrow index used as the basis for pricing certain derivative products ie, equity index
futures contracts
o Market indicator index
Measure of overall share-market performance Dow Jones, S&P500, Nikkei etc

Market Indicator indices

Price-weighted, e.g. Dow Jones

o Weighting of a company proportional to its share price
Capitalisation-weighted, e.g. S&P/ASX All Ords
o Weighting of a company proportional to market capitalisation
Share-price index measures capital gains/losses from investing in an index-related portfolio
Accumulation index includes share price changes and reinvestment of dividends
Global industry classification standard (GICS) comprises 10 standard international industry sector indices; e.g.
energy, materials, industrials

Published share information

Newspapers and financial journals provide share-market information to varying degrees of detail; e.g.
Australian Financial Review

Summary

20

Factors a share investor should consider

o Diversification, portfolio return and risk
o Active or passive investment
o Direct or indirect investment
o Taxation
o Company financial performance indicators
o Capital structure, liquidity, debt servicing, profitability, share price, risk
Factors that influence a companys share price
o Expected future dividends
o Bonus shares issues
o Share splits
o Pro-rata rights issues

Equity Markets III

Share Price

Share price is determined by supply and demand of a companys shares

Expectation of bad company performance causes investors to sell their shares, increasing supply and
reducing the price
Expectation of good company performance increases demand and leads to an increase in share price
What causes the shifts in demand and supply of a companys securities on the secondary market?
Three approaches to answering this question
1. Fundamental analysis: top-down
2. Fundamental analysis: bottom-up
3. Technical analysis

Fundamental analysis

Considers macro and micro factors that impact upon cash flows and future share prices of various industry
sectors and firms
o Macro factors include interest rates, economic growth, business investment
o Micro factors are firm-specific and relate to managements impact on company performance

Top-down approach

Considers macro factors

o Economic growth of international economies
o Exchange rates
o Interest rates
o Domestic economy
Growth rate
Balance of payments
Inflation
Wage and productivity growth
Government responses to changes in the above factors

Economic growth

The higher the growth rate in the rest of the world, the greater the demand for Australian exports
Sectors benefitting from international growth determined by source of the growth
Growth can be driven by:
o increased consumer demand
o increased business investment in equipment

21
Flip side of growth

Generally, greater domestic growth leads to increased profitability of firms

But high growth can lead to any of the following factors that can reduce firm profitability:
o Deterioration in balance of payments
o Increase in inflationary pressures
o Pressure on wages
o Depreciation of the exchange rate
o Rise in interest rates

Currency

Affect the domestic currency profit of exporters that quote their products in foreign currency prices
o A strengthening Australian dollar (AUD) makes these firms worse off because the AUD value of their
exports is lower
o The strength of the AUD over the past few years has led to calls for assistance from the
manufacturing industry, for example
Exchange rates also affect firms indirectly
o E.g. devaluation of currency increases cost of imports, thereby increasing inflation

Interest Rates

Have both a direct and indirect impact on a firms value

Direct effect on profitability
o Represents the cost of debt finance for borrowers and the return for finance providers
Indirect effect on profitability
o Rise in interest rates may indicate a slowing of economic activity
o Future reduction in profitability
A strong relationship exists between interest rates and exchange rates

Balance of payments

If current account is in deficit (i.e. total international payments exceed total international receipts):
o some export income is diverted to service debt
o need to borrow foreign currency to service debt
Indirect effect on firms profitability
o Government may increase interest rates to slow economic growth and control the debt

Inflation

Effect of inflation on firms real profit

Tax treatment of inflation
o Makes historical-based depreciation allowances inappropriate
o Combined with higher replacement costs, leads to an overstatement of after-tax profit
Inventory
o Inflated selling price of inventory creates an illusion of inventory profits

Bottom- Up approach

Following identification of the best economies and industry sectors for investment using the top-down
approach, the bottom-up approach can be used to identify the best companies within these
Bottom-up approach considers micro factors using ratios and other measures of a firms financial
characteristics and performance
Considers factors such as:

22
o

Accounting ratios that assess a companys capital structure, liquidity, debt servicing, profitability,
share price and risk (see Chapter 6), observing the trend and making comparisons with firms in the
same industry
Additional information on key management changes, corporate governance and strategic direction

Comparing Companies

Technical analysis

Explains and forecasts share price movements based on past price behaviour
Assumes markets are dominated at certain times by mass psychology, from which regular patterns emerge
Two main forecasting models
o Moving averages (MA)
o Charting

Moving Averages

Smooth out a series facilitating the identification of trends in the series

Calculation of MA
o Assuming a five-day moving average, the MA is calculated by taking the average of the price series
for the preceding five days
Trading rules
o Buy when the price series cuts the MA from below
o Buy when the MA series is rising strongly and the price series cuts or touches the MA from above for
only a few observations
o Sell when the MA flattens or declines and the price series cuts the MA from above
o Sell when the MA is in decline and the price series cuts or touches the MA from below for only a few
observations

Charting

Investigating patterns in price charts

Several techniques
o Trend lines
o Support and resistance lines
o Continuation patterns
o Reversal patterns

Trend lines

23

Trends are regular movements in share prices

Two types of trends
1. Uptrend lineconnecting the lower points of rising price series
2. Downtrend lineconnecting the higher points of falling price series
Return lineline drawn parallel to a trend line to create a trend channel

Critical issue is to determine when the trend line is going to change

Support and resistance lines

Support levelswhere there is sufficient demand to halt further price falls

Resistance levelswhere there is sufficient supply to halt further price increases
Strong levelshistorical support and resistance
Weak levelssupport and resistance based on more recent activity

Continuation patterns
Sideways share trading that does not normally signal a change in trend
Two types
1. Trianglescomposed of a series of price fluctuations, each smaller than its predecessor Symmetrical triangle
(no change in trend); ascending triangle (uptrend); descending triangle (downtrend)
2. Pennants and flagsformed during a sharp rise in prices (the pole); then trading volume reduces and
increases suddenly to take prices sharply higher
Reversal patterns
Occur after a major market move
Result in a head and shoulders pattern
Three successive rallies and reactions, the second rally being stronger than the first and third rallies
I.
II.
III.

Left shoulderformed by volume-strong rally on uptrend, followed by reduced-volume reaction

Headsecond rally increases price before reaction moves price back to previous low
Right shoulderfinal rally marked by reduced volume indicating price weakness

Validity of technical analysis

Even where techniques have no apparent underlying validity, if they are followed by enough participants
they may impact on share price behaviour at times
More likely to forecast successfully when share prices move out of a range explained by economic and
financial fundamentals

Ethics
Ethics is black or white , no grey area

Ethics
o A set of guiding moral principles or values
Ethical Behaviour
o Refers to behaviour that conforms to those values
Both terms are often used to imply
o good ethics and good behaviour

So what happened?

24

What else since GFC?

Ethics is not a new concept

There are no new sins; the old ones just get more publicity.
The Code of Hammurabi for Ancient Babylon (c. 1800): If a builder builds a house for a man and does not make its
construction firm, and the house which he has built collapses and causes the death of the owner of the house, the
builder shall be put to death
Tulip Speculation 1636 (Holland) Market bubble Futures of tulip were traded when physical tulips were no longer
available. It went up to 10k in present day USD. Investors took the word of those who promised future delivery and
then realised that there is no delivery. The collapse impacted on Holland economy.
Charles Ponzi (1882 1949) - Promised his investors 50% return within 45 days. All started with arbitrage of coupons
between Spain and U.S bought for 1cent in Spain and redeem in U.S for 6 cents. But the arbitrage window closed.
He continue to pay investors with funds from new entrants whilst taking his usual cut.
Recent example (2009) - Bernard Madoff promised 12% return.
(1994) Rogue Trader: The man who brought down Barings Derivative trader Nick Leeson covered up losses up to
USD1.4bn (2x the banks trading capital). Brought down the oldest English bank (1762-1995)
Whats common- Betrayal of trust

25
Aligning interests to gain trust

Global survey by CFA Institute and Edelman Berland in 2013 revealed that trust among institutional and
retail investors has eroded.
o 48% said they do not trust financial services investors do what is right
o Only 15% has great deal of trust in investment management industry
When it comes to the attributes that investors value the most:
o 35% said acting in the best interest of the client
o 17% - ability to achieve high returns and commitment to ethical conduct
o Only 7% - amount / structure of fees
Investors have moved beyond just good performance and are more interested in trustworthy behaviours

Restoring Trust

First Embrace transparency

o Clearly articulate investment success and missteps
o Disclose conflicts of interest, quickly address problems
o Fully disclose fees and impact
Second Demonstrate Integrity
o Resolving conflict of interest in favour clients
o Structure fees to align with clients risk/return objectives
Third Improve communication
o Communicate with clients early and often throughout investment process
o Fairly represent the investments made, risk, expenses
o Avoid ambiguity in communications

A crisis of Culture

A global survey of 382 financial services executives in Sept 2013 shows:

o Most firms have attempted to improve adherence to ethical standards
o Industry executives champion the importance of ethical conduct
o But, executives struggle to see the benefits of greater adherence to ethical standards
o Needs to address knowledge gaps
o Lack of understanding and communication between departments continues to be the norm

CFA Code of Ethics

Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants
in the global capital markets.
Place the integrity of the investment profession and the interests of clients above my own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional
activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
ourselves and the profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve my professional competence and strive to maintain and improve the competence of
other investment professionals.

Standards of Professional Conduct

I.

There are a total of 7 standards:

Professionalism

26
II.
III.
IV.
V.
VI.
VII.

Integrity of Capital Markets

Duties to Clients
Duties to Employers
Investment Analysis, Recommendations, and Actions
Conflicts of Interest
Responsibilities as A CFA Institute Member or CFA Candidate

I (A) Knowledge of the Law

As an investment professional, your conduct is determined by these organizations:

o Government and regulatory agencies
o Licensing agencies
o Professional associations
As a member of CFA Institute or candidate in the CFA Program, you must
o understand and comply with all applicable laws.
o comply with the stricter of applicable law or the Code and Standards.
o not knowingly participate in any violation.
o dissociate from any violation.

Applicable Law

27

Dissociation From Violation

I (B) Independence and Objectivity

28
Avoid situations that could cause or be perceived to cause a loss of independence or objectivity in recommending
investments or taking investment action.

Maintain your professional integrity by remaining independent and objective at all times.
Avoid compromising your own or anothers independence and objectivity.
Ways in which your independence and objectivity may be compromised or perceived to be compromised
include the receipt of:
o Gifts
o Invitations to lavish events
o Tickets
o Favours
o Job referrals
o Additional compensation

I (C) Misrepresentation
Must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or
other professional activities.

A misrepresentation is any untrue statement or omission of a fact or any statement that is otherwise false or
misleading
To avoid misrepresentation, consider the following action items:
o Be honest about your professional credentials and your firms performance
o Exercise care and due diligence when relying on third-party information
o Disclose the use of external managers
o Be forthcoming with the risk and unpredictability of investments
o Acknowledge sources of ideas and materials that are not yours

I (D) Misconduct
Avoid dishonest, fraudulent, or deceitful conduct that reflects adversely on your professional reputation, integrity, or
competence.

Trust is the epicenter of the operations of the financial market as a whole.

Your professional reputation, integrity, and competence are the starting point on this critical path to trust.

III Duties to Clients

III (A) Loyalty, Prudence and Care

What it means to have a duty of loyalty, act with reasonable care, and exercise prudent judgment.

29

III (B) Fair dealing

Deal with clients fairly with respect to investment recommendations and actions.
Recommend policies and procedures that will help to ensure that investment recommendations or changes
in prior recommendations are disseminated to clients fairly and objectively.
Recommend policies and procedures to ensure that all individual and institutional clients are treated in a fair
and impartial manner when taking investment actions.
Some suggested actions for fair dealing compliance
o Limit the number of people involved.
o Shorten the time frame between decision and dissemination.
o Publish guidelines for pre-dissemination behaviour.
o Disseminate investment recommendations simultaneously.
o Maintain a list of clients and their holdings.
o Develop and document trade allocation procedures.

III (C) Suitability

In an advisory relationship, make reasonable inquiry of your client situation to make suitable investment
recommendations.
Document the clients needs, circumstances, and investment objectives in an investment policy statement.
o Client identification
o Investor objectives
o Investor constraints
o Performance measurement benchmarks
o Review and update the investment policy statement regularly.
o Document attempts to carry out the review if circumstances prevent it.
o Develop test procedures for choosing investments that include
an analysis of the impact on the portfolios diversification.
a comparison of the investment risks with the clients assessed risk tolerance.
the fit of an investment with the required investment strategy.

III (D) Performance Presentation

Give a fair and complete presentation of performance information by:

o applying the Global Investment Performance Standards (GIPS), or
o without the GIPS standards:
considering the knowledge and sophistication of the audience to whom a performance
presentation is addressed,

30

presenting the performance of the weighted composite of similar portfolios rather than
using a single representative account,
including terminated accounts as part of performance history with a clear indication of when
the accounts were terminated,
including disclosures that fully explain the performance results being reported, and
maintaining the data and records used to calculate the performance being presented.

III (D) Preservation of confidentiality

Maintain client confidentiality related to information
1. you receive as a result of your ability to conduct a portion of the clients business or personal affairs and
2. that arises from or is relevant to that portion of the clients business that is the subject of the special or
confidential relationship.
Disclose client information when
1. the information concerns illegal activities on the part of the client;
2. disclosure is required by law; or
3. the client or prospective client permits disclosure of the information.
What is the simplest and the most effective way to comply to Standards III (D)
o Avoid disclosing any information received from a client except to authorised fellow employees who
are also working for the client.
If you want to disclose information received from a client that is outside the scope of the confidential
relationship and does not involve illegal activities, first ask yourself the following:
o In what context was the information disclosed? If disclosed in a discussion of work being performed
for the client, is the information relevant to that work?
o Is the information background material that, if disclosed, will enable you to improve service to the
client?
Summary: Good ethics in finance and investment industry

In finance and investment industry, opportunities to be unethical arise every day.

Ethical behaviour among investment and finance professionals is critical to maintaining public trust
Day-to-day dilemmas, simple questions to ask yourself:
o Does this violate the law?
o Is this honest?
o What if I were on the other side?

Short Term Debt

Trade Credit - is not free- no such thing as free lunch

Short-term debt is a financing arrangement for a period of less than one year with various characteristics to
suit borrowers particular needs
o Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds
Matching principle
o Short-term assets should be funded with short-term liabilities
o The importance of this principle was highlighted by the GFC
A supplier provides goods or services to a purchaser with an arrangement for payment at a later date
Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)
Borrow money from the bank if the interest rate is lower than the rate of trade credit
From providers perspective
o Advantages include increased sales
o Disadvantages include costs of discount and increased discount period, increased total credit period
and accounts receivable, increased collection and bad debt costs

31
Example
A ice cream stand may sign an agreement, under which the distributor agrees to provide ice cream stock under the
terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10
days. This means that the operator has 60 days to pay the invoice in full.
If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and
make an extra 20% on the ice cream sold.
However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days,
obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days.

The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is:
Opportunity cost

% discount
365

100 % discount days difference between

early and late settlement

1.0 365

99.0 23
0.160298 or 16.03% p.a.

Wal-Mart in the United states relies more on trade credit than bank borrowing
Its trade credit is 8 times the amount of capital invested by shareholders.

Bank Overdrafts

Major source of short-term finance

Allows a firm to place its cheque (operating) account into deficit, to an agreed limit ( Go negative)
Generally operated on a fully fluctuating basis
Lender also imposes an establishment fee, monthly account service fee and a fee on the unused overdraft
limit
Interest rates negotiated with bank at a margin above an indicator rate, reflecting the borrowers credit risk
o Financial performance and future cash flows
o Length of mismatch between cash inflows and outflows
o Adequacy of collateral
Indicator rate typically a floating rate based on a published market rate, e.g. BBSW
In some countries overdraft borrower may be required to hold a credit average balance or compensating
credit balance

Commercial Bills

A bill of exchange is a discount security issued

with a face value payable at a future date
A commercial bill is a bill of exchange issued
to raise funds for general business purposes
A bank-accepted bill is a bill that is issued by a
corporation and incorporates the name of a
bank as acceptor

32

Features of commercial billsparties involved (bank-accepted bill) (cont.)

Drawer
o Issuer of the bill
o Secondary liability for repayment of the bill (after the acceptor)
o
Acceptor
o Undertakes to repay the face value to the holder of the bill at maturity
o Acceptor is usually a bank or merchant bank
o Bank acceptor is more safe than bank endorsed
Payee
o The specified party to whom the bill is to be paid, i.e. the party who receives the funds
o Usually the drawer, but the drawer can specify some other party as payee
Discounter
o The party that discounts the face value and purchases the bill
o The provider or lender of the funds
o May also be the acceptor of the bill
Endorser
o The party that was previously a holder of the bill
o Signs the reverse side of the bill when selling, or discounting, the bill
o Order of liability for payment of the bill runs from acceptor to drawer and then to endorser
The flow of funds ( bank- accepted bills)

33

The flow of funds (non-bank bills)

o Alternatively, a bill can be drawn by the bank and accepted by the borrower
o The bank is both drawer and discounter of the bill
If the bank rediscounts a bill (sells to a third party), the bank becomes the endorser, creating
a bank-endorsed bill
o Funds are lent to borrower as payee
o At maturity date the borrower, as acceptor of the bill, is liable to pay face value to the holder of the
bill
Establishing a bill financing facility
o Borrower approaches bank or merchant bank
o Assessment made of borrowers credit risk
o Credit rating of borrower affects size of discount
o Maturity usually 30, 60, 90, 120 or 180 days
o Minimum face value usually $100 000
Advantages of Commercial bill financing
o Lower cost than other short-term borrowing forms, i.e. overdraft, fully-drawn advances
o Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest
rates)
o A bill line
Arrangement with a bank where it agrees to discount bills progressively up to an agreed
amount
o Term of loan may be extended by rollover at maturity

Calculations: Discount securities

Calculations considered
o

Calculating priceyield known

Calculating face valueissue price and yield known

Calculating yield

Calculating Price- yield Known

34
Example 3: A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a
face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of
9.52% per annum and 9.48% per annum. Which quote should the company accept, and what amount will the
company raise?
$500 000 365
$496 118.04
365 (0.0952 30)
or
$500 000 365
$496 134.23
365 (0.0948 30)

An alternative formula for calculating price

Calculating Face Value- issue Price and yield known

Face value price[

365 (

yield
days to maturity)
100
]
365

Example 4: A company needs to raise additional funding of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to
discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn?
365 (0.0875 60)
]
365
$507 191.78

Face value $500 000[

Calculating yield

Yield

(sell price - buy price) (days in year 100)

buy price
days to maturity

Promissory Notes

Also called P-notes or commercial paper, they are discount securities, issued in the money market with a
face value payable at maturity but sold today by the issuer for less than face value
Typically available to companies with an excellent credit reputation because:
o there is no acceptor or endorser
o they are unsecured instruments
Calculationsuse discount securities formulae
Issue programs
o Usually arranged by major commercial banks and money market corporations
o Standardised documentation
o Revolving facility
o Most P-notes are issued for 90 days
By tender, tap issuance or dealer bids

Negotiable certificates of Deposit

35

Short-term discount security issued by banks to manage their liabilities and liquidity
Maturities range up to 180 days
Issued to institutional investors in the wholesale money market
The short-term money market has an active secondary market in CDs
Calculationsuse discount securities formulae

Inventory Finance, Accounts receivable financing and factoring

Inventory finance
Most common form is floor plan finance
Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles
o Bailment commonfinance company holds title to dealerships stock- to promote the financial
companies
Dealer is expected to promote financiers financial products
Accounts receivable financing
o A loan to a business secured against its accounts receivable (debtors)
o Mainly supplied by finance companies
o Lending company takes charge of a companys accounts receivable; however, the borrowing
company is still responsible for the debtor book and bad debts
Factoring
o Company sells its accounts receivable to a factoring company
Converting a future cash flow (receivables) into a current cash flow
o Factoring provides immediate cash to the vendor; plus it removes administration costs of accounts
receivable
o Main providers of factor finance are the finance companies
o Factor is responsible for collection of receivables
Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be
made to the factor
Recourse arrangement
o Factor has a claim against the vendor if a receivable is not paid
Non-recourse arrangement
o Factor has no claim against vendor company

Medium to long Term Debt

Term Loans or Fully Drawn Advances

Term loan
o

A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and equipment

Secured by mortgage over asset purchased or other assets of the firm

Fully drawn advance

o

A term loan where the full amount is provided at the start of the loan

Provided by:
o

mainly commercial banks and finance companies

to a lesser degree, investment banks, merchant banks, insurance offices and credit unions

Term loan structures

36
o

Interest only during term of loan and principal repayment on maturity

Amortised or credit foncier loan

Deferred repayment loan

o
o

Loan instalments commence after a specified period related to project cash flows and the
debt is amortised over the remaining term of the loan

Interest may be fixed (for a specified period of time; e.g. two years) or variable
Interest rate charged on term loan is based on:

Periodic loan instalments consisting of interest due and reduction of principal

an indicator rate (e.g. BBSW or a banks own prime lending rate) and is also influenced by:

credit risk of borrowerrisk that borrower may default on loan commitment, giving
rise to a risk premium

term of the loanusually longer term attracts a higher interest rate

repayment schedulefrequency of loan repayments (e.g. monthly or quarterly) and

form of the repayment (e.g. amortised or interest-only loan)

Loan covenants
o Restrict the business and financial activities of the borrowing firm ( dont want the firm to get more
risky)
Positive covenant

Negative covenant

Requires borrower to take prescribed actions; e.g. maintain a minimum level of

working capita

Restricts the activities and financial structure of borrower; e.g. maximum D/E ratio,
minimum working-capital ratio, unaudited periodic financial statements

o Breach of covenant results in default of the loan contract entitling lender to act
Calculating the loan instalment- ordinary annuity
where :

1 (1 i )n
[
]
i

R the instalmentamount
A the loan amount (present value)
i the current nominalinterest rate per period expressedas a decimal
n the number of compounding periods.

Example 1: Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the purchase of
a new high-speed CD burner. The bank offers a $150 000 loan, amortised over five years at 8% per annum,
payable monthly. Calculate the monthly loan instalments.

A $150 000
Calculating the loan instalmentannuity due
0.08
i
0.006667
12
A
n 5 years 12 months 60 R
$150 000

1 (1 0.006667)60
]
0.006667
R $3041.49 per month
[

1 (1 i )n
[
](1 i )
i

37

Example 2: A business proprietor is purchasing a computer system for the business at a cost of $21 500. A
finance company has offered a term loan over seven years at a rate of 12% per annum. The loan will be repaid
by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments.
A $21500
0.12
i
0.01
12
n 7 12 84
$21500
R
1 (1 0.01)84
[
] (1 0.01)
0.01
$21500

57.21494
$375.78 monthly instalment

Mortgage Finance

A mortgage is a form of security for a loan

o

The borrower (mortgagor) conveys an interest in the land and property to the lender (mortgagee)

The mortgage is discharged when the loan is repaid

If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on the property, i.e. take
possession of assets and realise any amount owing on the loan

Use of mortgage finance

o

Mainly retail home loans

To a lesser degree commercial property loans

Commercial banks, building societies, life insurance offices, superannuation funds, trustee
institutions, finance companies and mortgage originators

Interest rates
o

Both variable and fixed interest rate loans are available to borrowers

With fixed interest loans, interest rates reset every five years or less

With interest-only mortgage loans, interest-only period is normally a maximum of five years

Mortgagee (lender) may reduce their risk exposure to borrower default by:
o

Up to 10 years as businesses generate cash flows enabling earlier repayment

Providers (lenders) of mortgage finance

o

Up to 30-year terms

requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value

Calculating the instalment on a mortgage loan

A
R
1 (1 i )n
[
]
i

38

Example 3: A company is seeking a fully amortised commercial mortgage loan of $650 000 from its bank. The
conditions attached to the loan include an interest rate of 8% per annum, payable over five years by equal
end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount.
A $650 000

0.08
0.02
4
n 5 4 20
i

R
[

$650 000
1 (1 0.02)20

]
0.02
$39 751.87 monthly instalment
Securitisation and mortgage finance
o Mortgage originators, commercial banks and other institutions use securitisation to manage their
mortgage loan portfolios
o Involves conversion of non-liquid assets into new asset-backed securities that are serviced with cash
flows from the original assets
o Original lender sells bundled mortgage loans to a special-purpose vehicle
That is, a trust set up to hold securitised assets and issue asset-backed securities like bonds,
providing investors with security and payments of interest and principal
The securitisation of mortgage finance suffered a large contraction during the GFC.
o Securitised mortgage assets in 2007: $215 billion
o Securitised mortgage assets in 2010: $112 billion
These falls were recorded in Australia despite the much lower default rates experienced on mortgages
compared to other parts of the world

Debentures, unsecured notes and subordinated debt

Debentures (most secure corporate bond)and unsecured notes

o

Are corporate bonds

Issued the same way as shaires

Specify that the lender will receive regular interest payments (coupon) during the term of the bond
and receive repayment of the face value at maturity

Unsecured notes are bonds with no underlying security attached

Debentures:

are secured by either a fixed or floating charge over the issuers unpledged assets

are listed and traded on the stock exchange

have a higher claim over a companys assets (e.g. on liquidation) than unsecured note
holders

Issuing debentures and notes

o There are three principal issue methods
1.Public issueissued to the public at large, by prospectus
2.Family issueissued to existing shareholders and investors, by prospectus
3.Private placementissued to institutional investors, by information memorandum
o Usually issued at face value, but may be issued at a discount or with deferred or zero interest
o A prospectus contains detailed information about the business

39

Subordinated debt
o More like equity than debt, i.e. quasi-equity
o Claims of debt holders are subordinated to all other company liabilities
o Agreement may specify that the debt not be presented for redemption until after a certain period
has elapsed
o May be regarded as equity in the balance sheet, improving the credit rating of the issuer

Calculations: fixed- interest securities

Price of a fixed-interest bond at coupon date

o

The price of a fixed-interest security is the sum of the present value of the face value and the
present value of the coupon stream

1 (1 i )n
P C[
] A(1 i )n
i
Example 4: Current AA+ corporate bond yields in the market are 8% per annum. What is the price of an
existing AA+ corporate bond with a face value of $100 000, paying 10% per annum half-yearly coupons, and
exactly six years to maturity?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12

Price of a fixed-interest bond between coupon dates

1 (1 i )n
n
k
P C
A(1 i ) (1 i )
i

Yield of a bond- describes the total rate of return, coupon payment- amount of interest throughout the lifetime
of bond

Example 5: Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+ corporate
bond with a face value of $100 000, paying 10% per annum half-yearly coupons, maturing 31 December
2016, would be sold on 20 May 2011 at what price?

40

Examples

Most major issues are conducted in the US.

Lets looks at some corporate debt that is on issue in Australia.
o Woolworths Notes II were issued on 24 November 2011 and will mature on 24 November 2036
unless redeemed before that date.
o Notes are dated, unsecured, subordinated, cumulative notes issued by Woolworths. The Issue Price
is $100 per Note. This is also the Face Value.

Leasing

A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the
asset for an agreed period of time in return for periodic rental payments
Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the asset
Advantages of leasing for lessee over borrow and purchase alternative
o Conserves capital
o Provides 100% financing
o Matches cash flows (i.e. rental payments with income generated by the asset)
o Less likely to breach any existing loan covenants
o Rental payments are tax deductible
Advantages of leasing for lessor over a straight loan provided to a lessee
o Leasing has relatively low level of overall risk as asset can be repossessed if lessee defaults
o Leasing can be administratively cheaper than providing a loan
o Leasing is an attractive alternative source of finance to both business and government
Types of leases
o Operating lease
Short-term lease
Lessor may lease the asset to successive lessees (e.g. short-term use of equipment)
Lessee can lease asset for a short-term project
Full-service leasemaintenance and insurance of the asset is provided by the lessor
Minor penalties for lease cancellation
Obsolescence risk remains with lessor
o Finance lease
Longer term financing
Lessor finances the asset
Lessor earns a return from a single lease contract
Net leaselessee pays for maintenance and repairs, insurance, taxes and stamp duties
associated with lease
Residual amount due at end of lease period
Ownership of the asset passes to lessee on payment of the residual amount

41
o

Sale and lease back

Existing assets owned by a company or government are sold to raise cash; e.g. government
car fleet
The assets are then leased back from the new owner
This removes expensive assets from the lessees balance sheet
Direct finance lease
Involves two parties (lessor and lessee)
Lessor purchases equipment with own funds and leases asset to lessee
Lessor retains legal ownership of asset and takes control or possession of asset if lessee
defaults
Security of the lessor provided by:
lease agreement
leasing guaranteean agreement by a third party to meet commitments of the
lessee in the event of default
Leveraged finance lease
Lessor contributes limited equity and borrows the majority of funds required to purchase
the asset
Lease manager
Structures and negotiates the lease and manages it for its life
Brings together the lessor (or equity participants), debt parties and lessee
Asset then leased to lessee
Lessor gains tax advantages from the depreciation of equipment and the interest paid to the
debt parties
Equity leasing
Similar to a leveraged lease, except funds needed to buy asset are provided by the lessor
Therefore, it is usually smaller than a leveraged lease
Has many characteristics of a leveraged lease, including the formation of a partnership to
purchase the asset, but not the advantage of leverage

Summary

When choosing the most appropriate source of medium- to long-term debt, a borrower should consider the
following factors:
o Fixed or variable interest rate
o Term of the financing arrangement
o Repayment schedule
o Loan covenants
o Whether secured by fixed or floating charge, or unsecured
o The merits of leasing an asset as opposed to buying an asset

42
Foreign Exchange Markets
Exchange rate regimes

Exchange rate is value of one currency relative to that of another currency

Major currencies like USD, GBP, JPY, EUR and AUD adopt floating exchange rate (free float) regime
o Where exchange rate determined by supply and demand factors in the FX markets
Other types of exchange rate regimes include:
o Managed float
Exchange rate held within defined band relative to other currency
o Crawling peg
Exchange rate allowed to appreciate in controlled steps over time
o Linked exchange rate
Value of currency tied to value of another currency or basket of currencies

FX market participants

FX markets
o Comprise all financial transactions denominated in foreign currency, currently estimated to be over
USD4.00 trillion per day
o Facilitate exchange of value from one currency to another
o Internationally adopted FX market conventions to improve market functionality
FX market participants can be classified as:
o FX dealers and brokers
o central banks
o firms conducting international trade transactions
o investors and borrowers in the international money markets and capital markets
o foreign currency speculators
o arbitrageurs

FX dealers and brokers

FX dealers
o Are financial institutions, typically commercial banks and investment banks, that quote two-way (i.e.
buy and sell) prices and act as principals in the FX market
o Usually licensed or authorised by the central banks of the countries in which they operate
FX brokers
o Source from another dealer (talking about wholesalers market)
o Transact almost exclusively with FX dealers; they obtain the best prices in global FX markets
matching FX dealers buy and sell orders for a fee

Why actively selling FX- these dealers speculators taking positions from their beliefs.
- Investors and borrowers in the international markets and capital market
- They dont play a major part- in FX (the points)
Central banks

Enter FX market to:

o purchase foreign currency to pay for government imports or pay interest on, or redeem, government
debt
o change the composition of holdings of foreign currencies in managing official reserve assets
o influence the exchange rate

Firms conducting international trade transactions

43

Exporters receive foreign currency for the sale of their goods and services
Exporters use the FX market to sell foreign currency and buy AUD
Importers use the FX market to buy foreign currency (sell AUD) for purchasing imports

Investors and borrowers in the international money markets and capital markets

Commercial bank foreign borrowings are usually converted into the home currency
o Payments of interest and principal need to be made in the denominated currency of the loan
Corporations and financial institutions investing overseas
o Need to purchase FX in order to make investments
o Dividends or interest payments received from overseas investments will be denominated in a foreign
currency

Speculative transactions

Businesses and financial institutions may attempt to anticipate future exchange rate movements to make a
profit
There is a risk involved that the exchange rate will move:
o in the opposite direction to that anticipated
o in the anticipated direction but by less than expected
o

Example : Take a risk, based on a benefit that a rate will more in a particular direction

If, today:
Spot rate: USD1= AUD0.9725
Exchange rate expected today + n days:

USD1= AUD1.0225

Then, today:
Buy USD1 at a cost of AUD0.9725
Then, at today + n days:
Sell USD1 and obtain AUD1.0225
Arbitrage transactions

Profit is made through FX transactions that involve no FX risk exposure

Types of arbitrage
o Geographic
Where two dealers in different locations quote different rates on the same currency
o Triangular
Occurs when exchange rates between three or more currencies are out of perfect alignment

Example:

Triangular arbitrage- mispricing, they should be in parity

USD1 = AUD1.3525
USD1 = SGD1.3525
AUD1 = SGD 0.9870

Arbitrage strategy
Sell AUD1.3525 and receive USD1

44
Sell USD1 to receive SGD1.3525
Sell SGD1.3525 to receive AUD1.3703
If there is arbitrage, prices will change eventually to reach equilibrium.
Operation of the FX market

The FX market:
o is a global market, operating 24 hours a day according to business hours across the time zones

o
o

consists of a vast and highly sophisticated global network of telecommunications systems that
provide the current buy and sell rates for various currencies in dealing rooms located around the
globe
involves larger FX dealers like commercial, investment and merchant banks providing the FX function
as part of their overall Treasury operations within which they establish an FX dealing room
London- most major FX trading centre

Spot and forward transactions

FX market instruments are typically:

o Spot transactions
Have maturity date two business days after the FX contract is entered into
Used, for example, if an Australian importer has an account in USD to pay within the
next few days
o Forward transactions
Have maturity date more than two days after FX contract is entered into
Used, for example, if Australian importer has to pay a USD liability in two months,
and covers or hedges against an appreciation of the USD
Dealers may also provide short-dated transactions if necessary
o Tod value transactionssame-day settlement
o Tom value transactionssettlement tomorrow

Spot market quotations

- Offer to buy and sell the first currency in the quotation
- They are from the dealers perspective (bid- ask spread)

Asking for a quotation

o The price of a currency is expressed in terms of another currency

45
o

The first currency mentioned is the price being sought (also called base currency or the unit of
quotation)
o The second currency is the terms currency
Example: USD/AUD is the price of USD1 in terms of AUD
Two-way quotations
o Example: Australian dollar/euro may be expressed as EUR/AUD1.37551.3765, usually abbreviated
to EUR/AUD1.375565
The two numbers indicate the dealers buy (bid) and sell (offer) price
A dealer quoting both bid and offer prices is a price-maker
The dealer will buy EUR1 for AUD1.3755
The dealer will sell EUR1 for AUD1.3765
Dealer buys low and sells high
Two-way quotations (cont.)
o The difference between the buy and sell price is the spread, represented in percentage terms in
Equation 15.1

Transposing spot quotations

o

Example: Given a quotation of EUR/AUD1.37551.3765, the AUD/EUR quotation can be determined

by transposing the quotation, i.e. reverse and invert

Reverse the bid and offer prices: 1.37651.3755

Then take the inverse (divide both numbers into 1)
1.000

1.000

1.3765

1.3755

AUD/EUR0.72650.7270

Calculating cross-rates
o All currencies are quoted against the USD
o There are two ways currencies can be quoted against the USD:
Direct quotethe USD is the base currency
Indirect quotethe USD is the terms currency and the other currency is the base currency
o When FX transactions occur between two currencies, usually where neither currency is the USD, the
cross-rate needs to be calculated
Method of cross-rate calculation depends on whether the quote is direct or indirect

Calculating cross-rates (cont.)

o

Example 3: Crossing two direct FX quotations:

USD/EUR0.725055
USD/JPY81.4050
To determine the EUR/JPY cross-rate:
81.40/0.7255 = 112.20
81.50/0.7250 = 112.41

46
EUR/JPY 112.20-41

Calculating cross-rates (cont.)

o

Example 4: Crossing a direct and indirect FX quotation:

GBP/USD1.6270-75
USD/NZD1.3292-97
To determine the GBP/NZD cross-rate:
1.6270 x 1.3292 = 2.1626
1.6275 x 1.3297 = 2.1641
GBP/NZD2.1626-41
Example 5: Crossing two indirect FX quotations:
AUD/USD0.926269
GBP/USD1.627075
To determine the AUD/GBP cross-rate:
0.9262/1.6275 = 0.5691
0.9269/1.6270 = 0.5697
AUD/GBP0.569197
Summary

Forward market quotations

Forward points and forward exchange rates

o The forward exchange rate is the FX bid/offer rates applicable at a specified date beyond the spot
value date
o The forward exchange rate varies from the spot rate owing to interest rate parity
Interest rate parity is the principle that exchange rates will adjust to reflect interest rate
differentials between countries
Forward points and forward exchange rates (cont.)
o Forward exchange rates are quoted as forward points, either above or below the spot rate
Forward points represent the forward exchange rate variation to a spot rate base
If the forward points are rising, add them to the spot rate (i.e. base currency is at a forward
premium; interest rate of the base currency is lower)
If the forward points are falling, subtract them from the spot rate (i.e. base currency is at a
forward discount; interest rate of the base currency is higher)
Forward points and forward exchange rates (cont.)
Example: Given AUD/USD (spot)

47

0.963040
and six-month forward points:
0.00320.0027
Since the forward points are falling, subtract them from the spot rate to obtain the six-month forward rate
of:
0.95980.9613
Forward points and forward exchange rates (cont.)
o Equation 15.2 is a generalised formula to calculate forward points:

Forward points and forward exchange rates (cont.)

o Example 6: A company approaches an FX dealer for a forward quote on the USD/CHF with a threemonth (90-day) delivery. The spot rate is USD/CHF1.1560. The dealer needs to calculate the forward
points. Assume the three-month eurodollar interest rate is 3.00% per annum and the three-month
euroswiss franc interest rate is 4.00% per annum
o The three-month forward rate is USD/CHF1.1589. The points are added to the spot rate as the
interest rate of the base currency is lower

Forward points and forward exchange rates (cont.)

o Forward exchange contract
Locks in an exchange rate today for delivery of foreign currency at a specified future date
FX dealers quote forward points on standard delivery dates, usually monthly out to 12
months, of a specified amount of one currency against another
As the dealer does not know what the spot rate will be on a future date, they will carry out
the FX transaction today even though delivery will not occur until the future date; i.e.:
Borrow funds in one market and purchase the foreign currency that will be needed
at a future date
Invest the purchased foreign currency in that market until delivery is due
The difference between the cost of borrowed funds and the return received on the
invested foreign currency will be adjusted against the spot rate today

Summary

FX market participants include companies, dealers, central banks, investors, speculators and arbitrageurs
FX market instruments are usually either spot or forward transactions
o Involve the quotation of the dealers buy-sell prices
o Cross-rates calculations are necessary between two non-USD currencies
o Forward exchange rates are quoted as forward points either above or below the spot rate
o The euro has grown in acceptance to become a hard currency accepted in international trade
transactions
If US interest rate is 1% and AUD is 4%.- Borrow from USD for 1 year and invest in AUD for 4% in one year
Countries with a lower interest rates, should trade at a forward premium

48
o

Singapore = discount , Korea= premium

Exchange Rate Determinants

FX markets and an equilibrium exchange rate

Previous chapter:
o focused on the structure and operations of the FX markets
This chapter:
o focuses on the factors that influence the value of a currency (in a floating exchange rate regime) in
order to attempt to forecast future exchange rates with some reliability and accuracy

Factors that influence exchange rate movements

Main factors influencing exchange rate movements

o Relative inflation rates
o Relative national income growth rates
o Relative interest rates
o Exchange rate expectations
o Government or central bank intervention

Relative inflation rates

Relative inflation rates influence the price of and, therefore, the demand for foreign goods by residents
The change in demand for imported goods, in turn, affects the demand for foreign currency used to buy
these goods
o This view of the determination of the value of a currency is called purchasing power parity (PPP) and
is discussed in detail later
Example: increase in US rate of inflation relative to Australia
o Effect for Australian residents
US imports more expensive, decreasing demand for these goods; therefore, reducing the
supply of AUD
o Effect for US residents
Some US demand for goods and services, and assets will switch to Australian items,
increasing demand for AUD to pay for these items
o Net effect is an appreciation of the AUD
Inflation changes with PPP
Us inflation increase more than AUD
o Buying US importer decreases and demand decreases, USD decreases until AUD increases

Relative national income growth rates

Example: Australian income growth rates rise relative to the US

o Australian demand for imports increases, increasing the supply of AUD, which, in turn, causes the
AUD to depreciate
o A secondary effect could be an increase in foreign investment in Australia, increasing the demand for
AUD, causing the AUD to recover some value

Relative interest rates

Example: if Australian interest rates rise relative to the US

o Effect for US residents
US residents and companies may redirect some of their cash into Australian interest-bearing
instruments, increasing the demand for the AUD
o Effect for Australian residents

49

Australian investors and businesses are more likely to keep their surplus funds invested in
Australia, causing a decrease in the supply of the AUD
o Net effect
AUD will appreciate
Expectations about the value of the currency during the investment period
o An analysis of the effect of interest rates on the exchange rate cannot ignore expectations about the
value of the currency during the investment period
o Table 16.1 illustrates the interaction of interest rate differentials and expected changes in the
exchange rate over the investment period on currency value

From Table 16.1 the following impact on the value of the AUD would be evident:
o Scenario 1: AUD would depreciate
The 3% benefit obtained from placing funds in the Australian money market would be more
than offset by the 5% depreciation of the AUD
o Scenario 2: AUD would appreciate
The 3% benefit obtained from placing funds in the Australian money market would be offset
only partly by the 2% depreciation of the AUD
Reason for change in nominal interest rate
o The analysis has ignored whether a change in the nominal interest rate is due to a change in the:
real rate of return; or
inflation expectations premium
Example: if nominal interest rates rise owing to an increase in the inflation expectations premium:
o the currency may not appreciate, and could depreciate because of:
the effect of inflationary expectations (PPP theory)
businesses and individuals seeking to invest cash holdings in overseas securities to avoid a
loss of value
Example: if nominal interest rates rise owing to an increase in the real rate of return:
o the currency may appreciate because of an inflow of funds from the rest of the world

Carry Trades

Exchange rate expectations

50

Motivation for turnover in the FX market

o Only part of the turnover in the FX market is accounted for by transactions associated with exports,
imports and financial assets
o A significant portion of turnover is motivated by changes in exchange rate expectations
Exchange rate expectations are based on expectations about future changes in:
o relative inflation
o relative income growth
o relative interest rates
Example: AUD expected to depreciate
o Effect for Australian residents
Seek to buy foreign currency before AUD falls
Increasing supply of AUD on FX markets
o Effect for foreign residents
Defer purchases of AUD
Reduces demand for AUD
o Net effect
AUD depreciates as expected

Government or central bank intervention

Policies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or
interest rates between countries
Also, the market participants expectations that the government will alter its policy affects these variables in the
future
A central bank may also influence the currency by:
o intervening in international trade flows
o intervening in foreign investment flows
o directly intervening in the FX market
International trade flows
o Intervention aimed at increasing exports and/or reducing imports by using the following:
Subsidies to exporters, making exports more competitive
Increases demand for Australian exports and demand for AUD
Intervention on the import side
Tariffscharge levied on imports increasing their prices
Quotasrestriction on the amount imported
Embargoprohibition on import of specified goods or services

Summary

Demand and supply determine the value of a currency in a floating exchange rate regime
Factors influencing the demand and/or supply of a currency
o Relative inflation rates (PPP)
o Relative national income growth rates
o Relative interest rates
o Exchange rate expectations
o Central bank or government intervention

INTEREST RATE DETERMINATION

MACROECONOMIC CONTEXT OF INTEREST RATE DETERMINATION

In most developed economies monetary policy actions are directed at influencing interest rates
By understanding what motivates a central bank in its implementation of interest rates policy:

51

o financial market participants can anticipate changes in a governments interest rate policy
o lenders and borrowers can make better-informed decisions
A central bank may increase interest rates if there is:
o inflation above target range
o excessive growth in GDP
o a large deficit in the balance of payments
o rapid growth in credit and debt levels
o excessive downward pressure on FX markets
An increase in interest rates (i.e. tightening of monetary policy) will:
o eventually increase long-term rates
o slow consumer spending
reducing inflation and demand for imports
o decrease the size of the current account
o possibly attract foreign investment, causing the domestic currency to appreciate
Three effects of changes in interest rates
1. Liquidity effect
The effect of the RBAs market operations on the money supply and system liquidity
o E.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSs
2. Income effect
A flow-on effect from the liquidity effect
If interest rates rise, economic activity will slow, allowing rates to ease
o Increased rates reduce spending levels and income levels
3. Inflation effect
As the rate of growth in economic activity slows, demand for loans also slows
This results in an easing of the rate of inflation

as inflation decreases, nominal rates fall

Liquidity, income and inflation effects of changes in interest rates (cont.)

o It is difficult to forecast the extent of liquidity, income and inflation effects on changes in interest
rates
Particularly when the business cycle is about to change, i.e. is at a peak or trough
o Economic indicators provide an insight into possible future economic growth and the likelihood of
central bank intervention
Economic indicators
o Leading indicators
Economic variables that change before a change in the business cycle
o Coincident indicators
Economic variables that change at the same time as the business cycle changes
o Lagging indicators
Economic variables that change after the business cycle changes

52
o

Difficulties exist with:

knowing the extent of the timing lead or lag of such indicators
consistently performing indicators, e.g. rates of growth in money measures were once lead
indicators and are now lagging indicators

LOANABLE FUNDS APPROACH TO INTEREST RATE DETERMINATION

The loanable funds (LF) approach is the preferred way of explaining and forecasting interest rates because it
is:
o preferred by financial market analysts
o a conceptually simplistic model
Alternatively, macroeconomics uses demand and supply of money to explain rates
The loanable funds (LF) approach
o LF are the funds available in the financial system for lending
o Assumes a downward-sloping demand curve and an upward-sloping supply curve in the loanable
funds market; i.e.:
as interest rates rise demand falls
as interest rates rise supply increases
Demand for loanable funds
o Two sectors
1. Business demand for funds (B)
o Short-term working capital
o Longer-term capital investment
2. Government demand for funds (G)
o Finance budget deficits and intra-year liquidity
o Demand for loanable funds (B + G)

Supply of loanable funds

o Comprises three principal sources
1. Savings of household sector (S)
2. Changes in money supply (M)
3. Dishoarding (D)
Dishoarding is the opposite of hoarding (cash)
Hoarding is the proportion of total savings in economy held as currency
Dishoarding occurs (i.e. currency holdings decrease) as interest rates rise and more
securities are purchased for the higher yield available
Says that as interest rate rises, it is costly to hold funds in cash
Dishoarding causes a change in the supply curve

53

Equilibrium in the LF market

o In Figure 13.9 equilibrium is point E and the equilibrium rate is i0
o E is a temporary equilibrium because the supply and demand curves are not independent
The level of dishoarding will change
The money supply is unlikely to increase proportionately in subsequent periods
A change in business and/or government demand

With less saving the supply will shift more to the left.

Impact of disturbances on rates

o Expected increase in economic activity
Initial effect is that businesses sell securities, yields increase (price decreases), dishoarding
occurs
o Inflationary expectations
The demand curve shifts to the right and the supply curve shifts to the left, resulting in
higher interest rates and unchanged equilibrium quantity

TERM STRUCTURE OF INTEREST RATES

Yield is the total return on an investment, comprising interest received and any capital gain (or loss)
Yield curve is a graph, at a point in time, of yields on an identical security with different terms to maturity

54

Differently shaped yield curves are evident from time to time

o Normal or positive yield curve
Longer term interest rates are higher than shorter term rates
o Inverse or negative yield curve
Short-term interest rates are higher than longer term rates
o Humped yield curve
Shape of yield curve changes over time from normal to inverse
The fact that the shape of the yield curve changes over time suggests that monetary policy interest rate
changes are not the only factor affecting interest rates
Three theories have been advanced to explain the shape of the yield curve:
1. Expectations theory
2. Market segmentation theory
3. Liquidity premium theory

1. EXPECTATIONS THEORY

The current short-term interest rate and expectations about future short-term interest rates are used to
explain the shape and changes in shape of the yield curve
Longer term rates will be equal to the average of the short-term rates expected over the period
The theory is based on assumptions, e.g.:
o Large number of investors with reasonably homogenous expectations
o No transactions costs and no impediments to interest rates moving to their competitive equilibrium
levels
o Investors aim to maximise returns and view all bonds as perfect substitutes regardless of term to
maturity
Example: The rate on a one-year instrument is 7% per annum. The investor expects to obtain 9% per annum
on a one-year investment starting in one years time. What is the current twoyear rate?

55

the two interest rates

should equal, if not there would be arbitrage

Explanation for the shape of yield curves

o Inverse yield curve
Will result if the market expects future short-term rates to be lower than current short-term
rates
o Normal yield curve
Will result from expectations that future short-term rates will be higher than current shortterm rates
o Humped yield curve
Investors expect short-term rates to rise in the future but to fall in subsequent periods

2.SEGMENTED MARKETS THEORY

Assumes that securities in different maturity ranges are viewed by market participants as imperfect
substitutes (i.e. investors will operate within some preferred maturity range)
o Rejects two assumptions of the expectations theory
o Preferences of participants are motivated by reducing the risk of their portfolios; i.e. minimising
exposure to fluctuations in prices and yields
The shape and slope of the yield curve are determined by the relative demand and supply of securities along
the maturity spectrum

56

If the central bank increases the average maturity of bonds by purchasing short-term bonds and selling longterm bonds
o Segmented markets theory suggests:
short-term yields decrease and long-term yields increase
although financial system liquidity is unchanged, economic activity is affected because areas
of expenditure sensitive to:
short-term interest rates will expand
long-term interest rates will contract
Expectations theory suggests:
o no effect on expectations about future short-term interest rates, and therefore no effect on the
economy

EXPECTATIONS APPROACH VERSUS SEGMENTED MARKETS APPROACH

The emphasis of the segmented markets theory on risk management denies the existence of investors
seeking:
o arbitrage opportunities
without their participation, the extreme segmentation theory would facilitate discontinuities
in the yield curve
o speculative profit
speculators trading actions are dictated by expectations
3. LIQUIDITY PREMIUM THEORY
Assumes investors prefer shorter term instruments, which have greater liquidity and less maturity and
interest rate risk and, therefore, require compensation for investing longer term
This compensation is called liquidity premium
The liquidity premium can be included in the expectations theory equation

L is the size of the liquidity premium

57

RISK STRUCTURE OF INTEREST RATES

Default risk is the risk that the borrower (i.e. issuer) will fail to meet its interest payment obligations
Commonwealth government bonds are assumed to have zero default risk
o As they are risk-free, they offer a risk-free rate of return
Some borrowers may have greater risk of default (i.e. state government or private sector firms)
Investors will require compensation for bearing the extra default risk

58

Company can change the yield curves

SUMMARY

Changes in monetary policy interest rate settings are likely to affect the state of the economy, which in turn
affects interest rates generally
o This occurs through the liquidity effect, income effect and inflation effect
Leading, coincident and lagging economic indicators assist in assessing the direction of the economy, likely
future monetary policy actions and the effect on interest rates
A more disciplined approach to forming a view on future interest rates is provided by the loanable funds
theory
The term structure of interest rates is represented by a yield curve, which may be normal, inverse, humped
or flat
The expectations, segmented markets and liquidity preference theories describe how a yield curve obtains
its shape
The risk structure of interest rates reflects the level of credit risk, over time, of a particular debt issue

Futures Contracts and Forward Rate Agreements

HEDGING USING FUTURES CONTRACTS

Futures contracts and FRAs are called derivatives because they derive their price from an underlying physical
market product
Two main types of derivative contracts
o Commodity (e.g. gold, wheat and cattle)
o Financial (e.g. shares, government securities and money market instruments)
Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of
changes in interest rates, exchange rates and share prices
Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to
another party
A futures contract is the right to buy or sell a specific item at a specified future date at a price determined
today
The change in the market price of a commodity or security is offset by a profit or loss on the futures
contract
Example: Farmer Joes 10 tonne wheat crop will be harvested and ready for sale in 3 months time. What is
the risk that he needs to protect against?
Futures contract is an agreement to buy or sell a specified asset at a specified time in the future.
Buy Futures/Long position = Agreement to buy an asset in the future
Sell Futures/Short position = Agreement to sell an asset in the future?

59

Does Farmer Joe short futures or long futures?

Decision Rule
(i) What you want to do with the asset in the future, do in the futures market now, or;
(ii) Whatever position you have in the asset, take the opposite position in the futures.
Farmer Joe;
(i) Wants to sell wheat in the future therefore sells futures/takes short position today.
(ii) Has a long position in wheat, therefore takes a short position in wheat futures.

Reasons for the second contract- may not meet the conditions, dont have to go give wheat
Q. In relation to the wheat future hedge undertaken by Farmer Joe, who might have taken the other side of the short
position? Would their futures position be profit or loss?
- People who expect the price to be higher than 300 in the future, there will be a loss.
- A hedge fund- type of speculator
- Bakery- opposite, they worry that wheat prices will rise, Aim to eliminate price volatility
Q. What would happen to Farmers Joes futures position if the price of wheat inface rose during the hedging period?
What would happen to his position in the physical wheat?
- loss (future), profit for physical market
It would be difficult to find a counter party to match your requirements if the market expected to fall
Information
The current spot price of wheat is $300/tonne.
3 month wheat futures are trading at $300/tonne.
After 3 months the spot price of wheat falls to $250 per tonne.

Who might have taken the other side of Farmer Joes Futures position? What happens to their profit/loss in
the futures market?
What if the entire market expected wheat prices to fall?
What if the price of wheat in fact rose during the hedging period?

MAIN FEATURES OF FUTURES TRANSACTIONS

60

Orders and agreement to trade

o Futures contracts are highly standardised and an order normally specifies:
whether it is a buy or sell order
the type of contract (varies between exchanges)
delivery month (expiration)
price restrictions (if any) (e.g. limit order)
time limits on the order (if any)
Margin requirements
o Both the buyer (long position) and the seller (short position) pay an initial margin, held by the
clearing house, rather than the full price of the contract
o Margins are imposed to ensure traders are able to pay for any losses they incur owing to
unfavourable price movements in the contract
o A contract is marked-to-market on a daily basis by the clearing house
i.e. repricing of the contract daily to reflect current market valuations
o Subsequent margin calls may be made, requiring a contract holder to pay a maintenance margin to
top up the initial margin to cover adverse price movements
Closing out of a contract
o Involves entering into an opposite position
o Example:
Company S initially entered into a sell one 10-year Treasury bond contract with company B
Company S would close out the position by entering into a buy one 10-year Treasury bond
contract for delivery on the same date, with a third party, say company R
The second contract reverses or closes out the first contract and company S would
no longer have an open position in the futures market
Contract delivery
o Most parties to a futures contract:
manage a risk exposure or speculate
do not wish to actually deliver or receive the underlying commodity/instrument and close
out of the contract prior to delivery date
o ASX Trade24 requires financial futures in existence at the close of trading in the contract month to
be settled with the clearing house in one of two ways
Standard deliverydelivery of the actual underlying financial security
Cash settlement
o Settlement details, including the calculations of cash settlement amounts, for each contract traded
on the ASX Trade24 are available on the exchanges website at www.asx.com.au

FUTURES MARKET INSTRUMENTS

- every future contract must be identical , must be able to universally grade commodity.
Things go down- short, things go up- long (speculators)

Futures markets can be established for any commodity or instrument that:

o is freely traded
o experiences large price fluctuations at times
o can be graded on a universally accepted scale in terms of its quality
o is in plentiful supply, or cash settlement is possible and volatile
Examples:
o Commodities
Mineralsilver, gold, copper, petroleum, zinc
Agriculturalwool, coffee, butter, wheat and cattle
o Financial

61

Currenciespound sterling, euro, Swiss franc

Interest rates
Short-term instrumentsUS 90-day treasury bills, three-month Eurodollar deposits,
Australian 90-day bank-accepted bills
Longer-termUS 10-year T-notes, Australian three-year and 10-year
Commonwealth Treasury bonds
Share price indicesS&P/ASX 200 Index

FUTURES MARKET PARTICIPANTS

Four main categories of participants

o 1.Hedgers
o 2. Speculators
o 3.Traders
o 4.Arbitragers
These participants provide depth and liquidity to the futures market, improving its efficiency

1.Hedgers
(borrowing hedge same as selling a bill)- you worry about interest rates will go up

Attempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share prices
Take the opposite position to the underlying, exposed transaction
Example:
o An exporter has USD receivable in 90 days. To protect against falls in USD over the next three
months, the exporter enters into a futures contract to sell USD

2. Speculators

Expose themselves to risk in an attempt to make profit

Enter the market with the expectation that the market price will move in a direction favourable for them
Example:
o Speculators who expect the price of the underlying asset to rise will go long and those who expect
the price to fall will go short

3. Traders

Special class of speculator

Trade on very short-term changes in the price of futures contracts (i.e. intra-day changes)
Provide liquidity to the market

4. Arbitragers

Simultaneously buy and sell to take advantage of price differentials between markets
Attempt to make profit without taking any risk
Example:
o Differentials between the futures contract price and the physical spot price of the underlying
commodity

HEDGING: RISK MANAGEMENT USING FUTURES

Futures contracts may be used to manage identified financial risk exposures such as:
o Hedging the cost of funds (borrowing hedge)
o Hedging the yield on funds (investment hedge)
o Hedging a foreign currency transaction
o Hedging the value of a share portfolio

62
HEDGING THE COST OF FUNDS (BORROWING HEDGE)

HEDGING THE VALUE OF A SHARE PORTFOLIO

RISKS IN USING FUTURES MARKETS FOR HEDGING

The risks of using the futures markets for hedging include the problems of:
o standard contract size
o margin risk
o basis risk
o cross-commodity hedging
Standard contract size
o Owing to contract size the physical market exposure may not exactly match the futures market
exposure, making a perfect hedge impossible
o Table 19.6

63

Margin payments
o Initial margin required when entering into a futures contract
o Further cash required if prices move adversely (i.e. margin calls)
o Opportunity costs associated with margin requirements
Basis risk
o Two types of basis risk
Initial basis
The difference between the price in the physical market and the futures market at
commencement of a hedging strategy
Final basis
The difference between the price in the physical market and the futures market at
completion of a hedging strategy
(when you close out early?)
o A perfect hedge requires zero initial and final basis risk
Cross-commodity hedging
o Use of a commodity or financial instrument to hedge a risk associated with another commodity or
financial instrument
Often necessary as futures contracts are available for few commodities or instruments
o Selection of a futures contract that has price movements that are highly correlated with the price of
the commodity or instrument to be hedged

When hedging share portfolio- risk is that share price will fall
- Future market- you can take a short position
Choose which country if there is no future contracts available in that country- choose country with highest stock
market correlation.
FORWARD RATE AGREEMENTS (FRAS)

The nature of the FRA

o An FRA is an over-the-counter product enabling the management of an interest rate risk exposure
It is an agreement between two parties on an interest rate level that will apply at a specified
future date
Allows the lender and borrower to lock in interest rates
Unlike a loan, no exchange of principal occurs
Payment between the parties involves the difference between the agreed interest rate and
the actual interest rate at settlement
(lock in a rate and be able to borrow, over the counter and private agreement- main diff?)
o Disadvantages of FRAs include:

64

risk of non-settlement, i.e. credit risk

no formal market exists
The FRA specifies:
FRA agreed date, fixed at start of FRA
notional principal amount of the interest cover
FRA settlement date when compensation is paid
contract period on which the FRA interest rate cover is based (end date)
reference rate to be applied at settlement date

Pay FRA the dealer the difference = for a company dealer normally a bank

65

see homework book for timeline

Main advantages of FRAs

o Tailor-made, over-the-counter contract, providing great flexibility with respect to contract period
and the amount of each contract
o Unlike a futures contract, an FRA does not have margin payments
Main disadvantages of FRAs
o Risk of non-settlement (credit risk)
o No formal market exists and concern about difficulty closing out FRA position is overcome by
entering into another FRA opposite to the original agreement

Summary

A futures contract
o An agreement between two parties to buy or sell a specified commodity or instrument at a specified
date in the future, at a price specified today
o May be used as a hedging strategy by opening a position today that requires a closing transaction that is
the reverse of the exposed transaction in the physical market
o Limitations include margin calls, imperfect hedging owing to basis risk, and availability

OPTIONS MARKETS
- allows to speculate
- enter in position today- cost- there is a premium-one of the main differences between futures contract and dont
have to go through with options
- asymmetry pay off- it depends on price of the underlying asset.
THE NATURE OF OPTIONS

Options differ from futures because they provide asymmetric cover against price movements

66

Options limit the effects of adverse price movements without reducing profits from favourable price movements
Options involve the payment of a premium by the buyer to the seller (writer)
An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial
instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date) An
option will be exercised only if it is in the buyers best interests

-right to buy at the agreed appointed price- strict price

- rule holder exercises options only when you can make money (monetary value)

Types of options
o Call options
Give the option buyer the right to buy the commodity or instrument at the exercise price
o Put options
Give the buyer the right to sell the commodity or instrument at the exercise price

( if think price will increase- long call option, if decrease- long put option)

Options can be exercised either:

o only on expiration date (European); or
o any time up to expiration date (American)
o (Asian- like American but strike price is by the moving average)
Premium
o The price paid by an option buyer to the writer (seller) of the option (what you pay up front when long)
Exercise price or strike price
o The price specified in an options contract at which the option buyer can buy or sell

OPTION PROFIT AND LOSS PAYOFF PROFILES

Call option profit and loss payoff profiles

o Example: a call option for shares in a listed company at a strike or exercise price (X) of $12, and a
premium (P) of $1.50
o Figure 20.1 indicates the profit and loss profiles of a call option for (a) the buyer or holder (long call)
and (b) the writer or seller (short call)
o The critical break points of the market price of the share (S) at expiration date are $13.50 If S
(market price of asset) > X (i.e. > $12) , option is in the money

67

Call option profit and loss payoff profiles (cont.)

o The value of the option to the buyer or holder (long call party) is:
o V = max(S - X, 0) - P
o The value of the option to the writer (short call party) is: V = P - max(S - X, 0)
Put option profit and loss payoff profiles
o Example: a put option for shares in a listed company at a strike or exercise price (X) of $12, and
premium (P) of $1.50
Figure 20.2 indicates the profit and loss profiles of a put option for (a) the buyer or holder
(long put) and (b) the writer or seller (short put)
The critical break points of the market price of the share (S) at expiration date are $12
Buyer exercises option if S < X (i.e. < $12)

Put option profit and loss payoff profiles (cont.)

o The value of the option to the buyer or holder (long put party) is:
o V = max(X - S, 0) - P
o The value of the option to the writer (or short put party) is:
o V = P - max(X - S, 0)
Covered and naked options
o ( whether you are holding on the underlying asset)

68
o
o

Unlike the case with futures, the risk of loss for a buyer of an option contract is limited to the
premium
However, sellers (writers) of options have potentially unlimited risk and may be subject to margin
requirements unless they write a covered option
I.e. the writer of an option holds the underlying asset or provides a financial guarantee
The writer of a call option has written a covered option if the writer either:
owns sufficient of the underlying asset to satisfy the option contract if exercised; or
is also the holder of a call option on the same asset, but with a lower exercise price
The writer of a put option has written a covered option if the writer is also the holder of a put option
on the same asset, but with a higher exercise price

ORGANISATION OF THE MARKET

Option markets are categorised as:

o Over the counter
o Exchange-traded (many things are standardised)
These are recorded through a clearing house
Clearing house acts as counterparty to buyer and seller, thus creating two options contracts
through the process of novation
The clearing house allows buyers and sellers to close out (i.e. reverse) their contracts
International options markets
o An exchange in a particular country will usually specialise in option contracts that are directly related
to physical or futures market products also traded in that particular country
o Trading on international exchanges varies
The largest exchanges, the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange
(CME), retain open-outcry trading on the floor involving 4000 to 5000 people
o International links between exchanges allow 24-hour trading
The Australian options markets
o Types of options traded
Options on futures contracts
Share options
Low-exercise-price options (not sure if this one one of them is extremely low risk, hence a
higher premium)
Warrants
Over-the-counter options
o Options on futures contracts
Traded on the ASX
Buyer of options contract has the right to buy (call) or sell (put) a futures contract
Options on futures available for:
90-day bank-accepted bills
SPI200 index futures contract
three-year and 10-year Commonwealth Treasury bonds
overnight options on the above Treasury bonds and share price index futures
contracts
o Share options
Traded on the ASX
Based on ordinary shares of specified listed companies
Usually three or more options contracts for each company, each with identical expiration
dates but different exercise prices
The options clearing house maintains a system of deposits, maintenance margins and a
share scrip depository
o Low exercise price options (LEPOs)

69

Traded on the ASX since 2005

A highly leveraged option on individual stocks, with an exercise price between 1 and 10
cents, and a premium similar to the price of the underlying stock
Exercisable only at expiration date (i.e. European)
Available over a range of high-liquidity stocks listed on the ASX
Warrants
( to make additional money- issue wants as a form of compensation, can be attached to debt
issues- want investors to invest)
An options contract (i.e. contractual right but not obligation to buy or sell an underlying
asset)
Two classes of warrants
Equity warrants attached to debt issues made by companies raising funds through
primary market debt issues
o Option to convert debt to ordinary shares of the issuing company (discussed
in Chapter 5)
Warrants issued as financial products for investment and to manage risk exposure to
price movements in the market
o Issued by financial institutions
o American- or European-type contracts
o Traded on ASX Trade, the ASXs electronic trading system
o Settlement of contracts through ASX Trade
Over-the-counter markets
Used to trade options not traded on the exchanges, e.g. semi government securities and
other money-market instruments or securities with unusual maturities
Allows flexibility in terms of:
amount
term
interest rate
price
Used to set interest rate caps, floors and collars

FACTORS AFFECTING AN OPTION CONTRACT PREMIUM

Option price (or premium) is influenced by four key factors

1. Intrinsic value
2. Time value
3. Price volatility
4. Interest rates

1.Intrinsic value

The market price of the underlying asset relative to the exercise price
The greater the intrinsic value, the greater the premium, i.e. positive relationship
Options with an intrinsic value
o Positive are in the money and the buyer is able to exercise contract at a profit
o Negative are out of the money and the buyer will not exercise
o Zero are at the money

70

2.Time value

The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a
profit (in the money); i.e. positive relationship
If the spot price moves adversely, the loss is limited to the premium

3.Price volatility

The greater the volatility of the spot price, the greater the chance of exercising the option for a profit, or a
loss
The option will be exercised only if the price moves favourably
The greater the spot price volatility, the greater the option premium; i.e. positive relationship

4.Interest rates

Interest rates have opposite impacts on put and call options

o Positive relationship between interest rates and the price of a call
Benefit of present value of deferred payment if exercised > lower present value of profit if
exercised
Negative relationship between interest rates and the price of a put
o Opportunity cost of holding asset
o Lower present value of the profit if exercised

OPTION RISK MANAGEMENT STRATEGIES

Single-option strategies
o Example: long asset (i.e. bought) and bearish (negative) about future asset price
Strategy
Limit downside risk by writing (selling) a call option, i.e. short call
Figure 20.5 and Table 20.4 in the textbook illustrate the profit profile of this strategy
o Example: short asset (i.e. sold) and bullish (positive) about future asset price
Strategy
Buy a call in the underlying asset (i.e. take a long-call position)
Figure 20.6 and Table 20.5 in the textbook illustrate the profit profile of this strategy

71

Combined-options strategies
o Example: expectation of increased price volatility, with no trend
Strategy
Hold (buy) a put option
Hold (buy) a call option with common exercise price
Long straddle provides positive pay-off for both large upward and downward price
movements
If prices remain unchanged, individual makes loss equal to sum of premiums
Figure 20.11 in the textbook illustrates the profit profile
o Example: expectation of increased volatility, without trend, with stagnation
Strategy
Hold (buy) call option with out-of-the-money exercise price
Hold (buy) put option with out-of-the-money exercise price
With long strangle loss is decreased if price remains unchanged, compared with
long straddle
Figure 20.12 in the textbook illustrates the profit profile
o Example: expectation of asset price stability
Strategy
Take opposite position to long straddle and long strangle
Strategy I: Short straddle
o Sell call and put options with same exercise price
Strategy II: Short strangle

72

o Sell call and put options, both out of the money

Figure 20.13 in the textbook illustrates the profit profiles

CONCLUSION

The potential gains and losses to buyers and sellers of futures contracts are different from those of options
o Options provide one-sided price protection that is not available through futures
o The option buyer limits losses and allows profits to accumulate
However, the premium may be quite high

Summary

The holder of an option (long party) has the right to buy (call) or sell (put) the commodity at a specified
exercise price
The writer (seller) is the short party
ASX trades standardised options, unlike over-the-counter market
The premium paid to buy an option is affected by its intrinsic value, time value, price volatility, and interest
rates
A broad array of option strategies may be adopted by hedgers and speculators

Read homework book for more notes on options