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University of Sunderland BA (Hons) in Banking and Finance Financial Markets Peter Howells Professor of Monetary Economics Bristol Business School

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Page 1: Financial Markets Module

University of Sunderland BA (Hons) in Banking and Finance

Financial Markets Peter Howells

Professor of Monetary Economics Bristol Business School

Page 2: Financial Markets Module

Published by The University of Sunderland © 2010 The University of Sunderland First published June 2010

All rights reserved. No part of this publication may bereproduced, stored in a retrieval system, or transmitted, in anyform or by any means, electronic, mechanical, photocopying,recording or otherwise without permission of the copyrightowner.

While every effort has been made to ensure that references towebsites are correct at time of going to press, the world wide webis a constantly changing environment and the University ofSunderland cannot accept any responsibility for any changes toaddresses.

The University of Sunderland acknowledges product, service andcompany names referred to in this publication, many of which aretrade names, service marks, trademarks or registered trademarks.

Technical reviewer: Hamid Seddighi, University of Sunderland

Instructional design and publishing project management byWordhouse Ltd, Reading, UK

Index prepared by Indexing Specialists (UK) Ltd, Hove, UK

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Contents

Introduction vi

Unit 1 An introduction to financial systems 1

Introduction 1

1.1 The key characteristics of a financial system 2

1.2 The advantages of using a financial system in lending and borrowing 9

1.3 Market efficiency and the real economy 13

1.4 The financial system and economic development 17

Self-assessment questions 20

Feedback on self-assessment questions 20

Summary 22

Unit 2 Money markets – functions and operations 23

Introduction 23

2.1 The characteristics and uses of money market instruments 24

2.2 Pricing money market instruments 25

2.3 Pricing instruments in a supply and demand framework 33

2.4 The users of money markets 34

Self-assessment questions 38

Feedback on self-assessment questions 39

Summary 40

Unit 3 Capital markets (I) 41

Introduction 41

3.1 The characteristics and uses of fixed interest securities 42

3.2 Understanding the data 44

3.3 Pricing fixed interest securities 46

3.4 ‘Duration’, price elasticity and the term structure of interest rates 52

3.5 Users and markets 58

Self-assessment questions 62

Feedback on self-assessment questions 63

Summary 64

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Unit 4 Capital markets (II) 66

Introduction 66

4.1 The characteristics and uses of company shares 67

4.2 Understanding share price data 68

4.3 The pricing of company shares 72

4.4 The required rate of return 81

4.5 The trading of company shares 45

Self-assessment questions 91

Feedback on self-assessment questions 92

Summary 94

Appendix 94

Unit 5 The efficient market hypothesis (EMH) 96

Introduction 96

5.1 The basis and implications of the EMH 97

5.2 Evidence on informational efficiency 108

5.3 Behavioural finance 114

Self-assessment questions 121

Feedback on self-assessment questions 121

Summary 123

Unit 6 The foreign exchange market (I) 124

Introduction 124

6.1 Foreign exchange markets 125

6.2 Forward rates and other forex derivatives 128

6.3 Using foreign exchange derivatives 137

Self-assessment questions 142

Feedback on self-assessment questions 142

Summary 144

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Unit 7 The foreign exchange market (II) 145

Introduction 145

7.1 Exchange rate determination 146

7.2 Interpreting the evidence 154

7.3 Arbitrage and speculation in forex markets 157

7.4 Foreign exchange risk and its implications 161

Self-assessment questions 164

Feedback on self-assessment questions 164

Summary 168

Unit 8 Exchange rate systems 169

Introduction 169

8.1 The advantages and disadvantages of fixed and floating exchange rates 170

8.2 The theory of currency union 180

8.3 European Monetary Union (EMU) 182

8.4 Other currency arrangements 185

Self-assessment questions 191

Feedback on self-assessment questions 192

Summary 193

Unit 9 The regulation of financial markets 194

Introduction 194

9.1 The need for regulation 195

9.2 Financial regulation in the USA, UK and EU 205

9.3 Globalisation and financial markets 215

Self-assessment questions 220

Feedback on self-assessment questions 221

Summary 222

References 223

Index 228

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Introduction

Welcome to the Financial Markets learning pack! It has been designed to assistyou in studying for the core module of the BA in Banking and Finance andcovers all topics in the official module descriptor.

As we prepared this learning pack, the world was breathing a sigh of relief athaving (just) avoided a catastrophic collapse of its major financial systems.Much of the explanation for the near-disaster focused on banks. But it wasinvestment banks, trading new types of securities linked to wildly over-valuedassets that were at the centre of the problem. As we finished the pack Europewas looking at the prospect of a contagious default of major western govern -ments on their debts, the so-called ‘sovereign debt problem’, as financialmarkets became increasingly reluctant to hold government debt and to refi -nance past borrowing. There was even speculation about the possible break upof the Eurozone. Whatever the outcome may be, you can be certain that thestability of financial systems, and the behaviour of financial markets, is an issuethat will worry us all for many years to come.

For this reason, it has never been more important to understand how financialsystems work, both in theory – where everything goes smoothly, and in practice– where things can go seriously wrong. One of the saddest aspects of the recentcrisis has been the way in which innocent people – firms, households andindividuals – have been affected, losing their savings, facing pension reductionsor repossession of their homes. As financial systems become more complexunderstanding why these things happen will become ever more important,especially since governments expect individuals to take more responsibility fortheir financial welfare and to rely less on the state.

In this learning pack we shall learn how a financial system works and inparticular at the role played by financial markets. To begin with, therefore, weshall take an overview of a financial system, what it consists of and what itdoes. We then move on to look at a series of markets. The first of these are theso-called money markets where large amounts of money are lent and borrowedfor very short periods. Money markets are particularly interesting because theseare the markets in which central banks conduct monetary policy by setting anofficial short-term interest rate. We then turn our attention to capital markets– markets for long-term lending and borrowing. We’ve divided this into twoparts, treating bond markets first and then looking at the markets for companyshares or ‘equities’. So far as the media are concerned, it is equity markets thatgenerate the most excitement and attract most attention, but we shall see thatbond markets are much larger and have the ability to pose major problems forgovernments. During the 2008 financial crisis it was widely agreed thatfinancial markets had been substantially ‘overvalued’ before the crash. (If youdid not believe this, you had to believe that they were undervalued afterwards.)Either way, here was evidence that markets could get prices seriously ‘wrong’.This runs counter to economic orthodoxy which traditionally places much faithin the ‘efficient markets hypothesis’ (EMH) and we look at this in Unit 5,immediately after our examination of bond and equity markets.

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But the efficient markets hypothesis applies, in principle, to all financialmarkets. Indeed, many of the studies of the EMH use evidence on exchangerates. Foreign exchange (or ‘forex’) markets form the subject of units 6 and 7.Firstly we look at how exchange rates are expressed, how to read the data andthe various types of forex contract that one can use. We then look at the theoryof exchange rate determination. We shall discover that while there arenumerous theories, each of which sounds entirely sensible, none is well-confirmed by the facts and exchange rates are more volatile than one wouldexpect in the light of the theories.

Given the risk and disruption caused by forex fluctuations, it seems sensible tolook at the possibility of adopting a system of fixed exchange rates. In unit 8,we look at the possible costs and benefits and at attempts to operate suchsystems, world-wide until 1972 and then in Europe after 1999. Finally we takea look at the controversial issue of regulation. There is widespread agreementthat a financial system requires careful regulation, perhaps more than othersectors of the economy. But regulation was obviously unable to prevent thecrisis that broke out in 2008. Maybe ‘better’ regulation could have done so; butmaybe booms and busts are always with us.

How to use this packThe learning pack will take you step by step through the module in a series ofcarefully planned units and provides you with learning activities and self-assessment questions to help you master the subject matter. The pack shouldhelp you organise and carry out your studies in a methodical, logical andeffective way, but if you have your own study preferences you will find it aflexible resource too.

Before you begin using this learning pack, make sure you are familiar with anyadvice provided by the University of Sunderland on such things as study skills,revision techniques or support and how to handle formal assessments.

If you are on a taught course, it will be up to your tutor to explain how to usethe pack in conjunction with a programme of face-to-face workshops – whento read the units, when to tackle the activities and questions and so on.

If you are on a self-study course, or studying independently with remote tutorsupport, you can use the learning pack in the following way:

■ Scan the whole pack to get a feel for the nature and content of the subjectmatter.

■ Plan your overall study schedule so that you allow enough time to completeall units well before your examinations – in other words, leaving plenty oftime for revision.

■ For each unit, set aside enough time for reading the text, tackling all thelearning activities and self-assessment questions and for the suggestedfurther reading. Your tutor will advise on how they will plan activitiesaround these materials and opportunities to network with other students.

Now let’s take a look at the structure and content of the individual units.

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Overview of the unitsThe learning pack breaks the content down into nine units, which vary fromapproximately eight to ten hours’ duration each. However, we are not advisingyou to study for this sort of time without a break! The units are simply aconvenient way of breaking the syllabus into manageable chunks. Most peoplewould try to study one unit a week, taking several breaks within each unit. Youwill quickly find out what suits you best.

You will see that each unit is divided into sections. It is assumed, for the mostpart, that you will study the units in the order presented. However, the sequencefor some units is more important for others. This is indicated at the beginningof each unit. What is more important is that you try to study each section ofeach unit in the order presented. Each unit is written on the strict assumptionthat you will understand the material in each section before moving to the next.

Each unit begins with a brief introduction which sets out the areas of thesyllabus being covered and explains, if necessary, how the unit fits in with thetopics that come before and after.

After the introduction there is a statement of the unit learning objectives. Theobjectives are designed to help you understand exactly what you should be ableto do after you’ve studied the unit. You might find it helpful to tick them off asyou progress through the unit. You will also find them useful during revision.There is one unit learning objective for each numbered section of the unit.

Following this, there are prior knowledge and resources sections. These will letyou know if there are any topics you need to be familiar with before tacklingeach particular unit, or any special resources you might need, such as acalculator, graph paper or specific books.

Then the main part of the unit begins, with the first of the numbered mainsections. At regular intervals in each unit, we have provided you with learningactivities, which are designed to get you actively involved in the learningprocess. You should always try to complete the activities – usually on a separatesheet of your own paper – before reading on. You will learn much moreeffectively if you are actively involved in doing something as you study, ratherthan just passively reading the text in front of you. The feedback or answers tothe activities are provided immediately following the activity. Do not betempted to skip the activity.

Throughout the unit key terms are highlighted bold with the definitionappearing in the margin.

Each unit contains recommended reading which also appears in the margin andwhich refers you to relevant chapters of supporting textbooks including thecore textbook. It is essential that you do this reading, since it is not possible toput everything you need to know in a single learning pack. At level 3 of a degreewider reading is key to developing deeper subject learning through acontemporary, contextual and critical perspective. This is important to considerwhen approaching the related assessment of the module.

We provide a number of self-assessment questions in each unit. These are tohelp you to decide for yourself whether or not you have achieved the learning

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objectives set out at the beginning of the unit. As with the activities, you shouldalways tackle them. The feedback or answers follow immediately after at theend of the unit. If you still do not understand a topic having attempted the self-assessment question, always try to re-read the relevant passages in the textbookreadings or unit, or follow the advice on further reading. Your allocated tutorwill be available to deal with questions arising from the material and will assistyour study through the unit.

At the end of the unit is the summary. Use it to remind yourself or check offwhat you have just studied, or later on during revision.

Finally, where possible, we have made reference to material on the internet sincethis is easy to access. You may find that addresses change. This can beannoying; but with a bit of effort you should be able to track the material down(nothing disappears completely from the web). And by searching you shouldlearn even more! Good luck and enjoy it.

Core textbooksThe essential text that accompanies this learning pack is The Economics ofMoney, Banking and Finance by Peter Howells and Keith Bain. The 4th editionwas published by FT-Prentice Hall in 2008. The main strength of this book isthat it supports every unit in this learning pack. Furthermore, if you arestudying the ‘Money, Banking and Finance’ module, it also supports every unitin that learning pack. Like this learning pack, it makes the issues accessible tothose with little previous experience of economics and/or finance and is writtenin a very accessible style. In particular, it encourages students to relate the‘theory’ they are learning to events as they are reported in the financial press.Most chapters have a section on how to read the financial press as well asexercises with solutions. There is also a ‘companion website’ where students cando a number of self-assessment tasks and undertake more advanced work.

A second text, Financial Markets and Institutions by the same authors waspublished in its 5th edition in 2007. This has many of the features of TheEconomics of Money, Banking and Finance, including a companion website,but is written at a rather simpler level and contains less detail.

AcknowledgementsWe are grateful to the following for permission to reproduce copyright material:The London Stock Exchange for the data in Tables 1.1 and 4.3 and Figure 5.1;the Financial Times for the headline on page 145 and for the extract on page162; the UK Office of Public Sector Information (OPSI) for the data in Figure3.1 and Table 3.3 and the Bank for International Settlements for permission toreproduce the data in Tables 6.1–6.3.

The Case Studies starting on pages 117 and 187 were made available by thegenerous permissions policy of VoxEU.org.

In some instances we have been unable to trace the owners of what might becopyright material and we would appreciate any information that would enableus to do so.

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x Copyright © 2010 University of Sunderland

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1Copyright © 2010 University of Sunderland

‘…there is a firm consensus that a well-functioning financialsector is a precondition for the efficient allocation of

resources and the exploitation of an economy’s growthpotential…’

Thiel (July 2001)

IntroductionIn this unit, you will learn what a financial system is and what it does. Weshall explain what its advantages are, when it functions well and whypeople are willing to pay for the services offered by the financial system.In particular we shall see how a well-functioning financial systemcontributes to the rest of the economy.

Unit learning objectives

On completing this unit, you should be able to:

1.1 Describe the key characteristics of a financial system.

1.2 Demonstrate the advantages of a financial system in promotinglending and borrowing.

1.3 Show how efficient financial markets improve the functioning ofthe real economy.

1.4 Identify links between a well-functioning financial system andeconomic development.

Prior knowledge

The unit requires no prior knowledge but you will find sections 1.2–1.4 easier tounderstand if you have some prior knowledge of economics (both macro andmicro) and/or finance.

Resources

The whole unit is supported by the core text (Howells and Bain, 2008: ‘Role ofa Financial System’); Howells and Bain (2007) is a lower-level text but ‘TheFinancial System’ and ‘The Financial System and the Real Economy’ may also beuseful to students coming to this material for the first time. Piesse et al (1995),although a bit dated, is helpful (especially ‘Introduction to the Financial System’and ‘Financial Markets and Institutions’). Mishkin (2007) ‘Overview of theFinancial System’ covers much of the material here. Ang (2008) is essentialreading for section 1.4. In section 1.4, you will need access to the internet inorder to pursue the debates about finance and development.

An introduction tofinancial systems1Unit

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1.1 The key characteristics of a financialsystemWe frequently read and hear of references to ‘the financial system’ especiallywhen, as in the last two years, something goes seriously wrong. But whatexactly does the phrase mean? At the most general level we can say that afinancial system consists of:

■ a set of financial institutions

■ a set of financial markets

■ the end users of the markets and institutions

■ a set of regulatory authorities.

Consider each of these key terms carefully.

Financial institutionsWhat do we mean by ‘financial institutions’? These are firms which providevarious types of financial service. We shall see that many of them are engagedin lending and borrowing (or ‘financial intermediation’ as it is called). Inaddition to intermediation, they may provide a range of financial services likefinancial advice and planning, insurance, a facility for making payments andopportunities to adjust the way in which one holds one’s wealth. Not allinstitutions do everything or at least not to an equal degree. The reason that weidentify different types of institution reflects the fact that they specialise to somedegree. Figure 1.1 lists the main categories of financial institution.

Figure 1.1: Financial institutions

If we summarise the main financial services as follows:

■ financial intermediation

■ insurance and pensions

■ a payments mechanism

■ portfolio adjustment facilities

can you say which of the institutions listed in Figure 1.1 specialise in each ofthese services?

■ intermediation – all

■ insurance and pensions – insurance companies and pension funds

■ payments – banks and building societies

■ portfolio adjustment – mainly unit trusts, open-ended investmentcompanies (OEICs) and investment trusts.

Recommended reading for thissection includes:

Howells and Bain (2008) ‘Role ofa Financial System’; Howells and

Bain (2007) ‘The FinancialSystem’; Piesse et al (1995)

‘Introduction to the FinancialSystem’; Mishkin (2007)

‘Overview of the FinancialSystem’.

■ banks ■ insurance companies■ building societies ■ pension funds■ credit unions ■ unit trusts and OEICs■ friendly societies ■ investment trusts

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Copyright © 2010 University of Sunderland 3

Notice that in Figure 1.1 we have listed the institutions in two columns. Thereason for this is that the assets they offer to lenders (that is, the liabilities ofthe institutions) differ in an important respect. The principal liabilities ofinstitutions in the left-hand column are deposits. Notice that these have a fixednominal value. If you have £100 in the bank and you do not add to it or makecash withdrawals, you have a guaranteed £100. It does not fluctuate with thestate of the stock market, for example. Furthermore, you can usually turn yourdeposit into cash (that is notes and coin) very quickly. For example, you canwithdraw your deposit ‘on demand’ through a cash machine.

The liabilities of the other institutions are very different. Take the case of apension fund. The pension fund has a liability to meet only when the saverretires. He or she cannot withdraw the pension whenever it suits. Furthermore,the value of the pension when it comes to be paid, may depend on what hashappened to the value of stocks and shares in the recent past. Savings in a unitor investment trust can usually be withdrawn more quickly but withdrawalrequires notice and again the value will be uncertain, depending on what hashappened in financial markets.

Why does this distinction matter? It matters to economists because thecharacteristics of deposits (fixed nominal value, instant access) means that theyfunction as money. This is the fundamental reason why we distinguish between‘deposit-taking institutions’ (left-hand column) and ‘non-deposit-takinginstitutions’ (right-hand column). For this reason, banks and building societiesare sometimes singled out for more special treatment and are called monetaryfinancial institutions (MFIs).

Financial marketsLet us turn now to ‘financial markets’. A market is any organisational devicethat brings buyers and sellers together for the purpose of trading. Traditionally,the ‘device’ was a physical location – a market square for example. Withmodern communications, however, there is no need for buyers and sellers tomeet face to face. Provided that both sides know the identity of the other (oftenreferred to as the ‘counterparties’) and they know how to contact them, tradingcan take place very easily, rapidly and at low cost. Figure 1.2 lists the betterknown financial markets in a modern, developed, economy.

■ The equity (company share) market ■ The options markets

■ The corporate bond market ■ The swap markets

■ The government bond (‘gilts’) market ■ Futures markets

■ The market for asset backed securities

■ The ‘repo’ (repurchase agreement) market

■ The discount market

■ The interbank market

■ The certificate of deposit market

■ The commercial paper market

■ The foreign exchange market

Figure 1.2: Some financial markets

Unit 1 An introduction to financial systems

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Notice that Figure 1.2 divides these markets into groups, similar to the way inwhich Figure 1.1 treated institutions. Firstly we have distinguished capitalmarkets (above the dashed line) from money markets (below it). The distinctionhere refers to the maturity (or life) of the instrument that is being traded. Wehave put the company share market at the top of the list because a company’sshares exist for so long as the company exists as an independent entity. Theyhave no maturity or redemption date. By contrast, bonds usually do have afixed maturity – a date on which they will be bought back by the issuer –though this may be a long way into the future. Bonds can have a maturity of25 years or more when first issued.

Below the dashed line we have a selection of money markets, markets in whichshort-dated instruments are traded. Many central banks are active in the repur -chase market and they tend to do deals with a 14-day maturity. The dis countmarket is dominated by treasury bills, which usually have an initial maturity of91 days. Certificates of deposit (CDS) are commonly issued for one month, threemonths or six months. There is no precise maturity at which we can draw a hardand fast line between capital and money markets, but we can say as a roughguide that capital markets are trading instruments with a remaining life of fiveyears or more, while money markets are trading instruments with a maturity ofless than five years (and frequently very much shorter).

What factors will firms have in mind when choosing between money andcapital markets as sources of funds?

The primary consideration will be the length of time for which they needthe funds. If they are required to set up a new line of business with newequipment and maybe new buildings, then this will involve very substantialexpenditure which may not show a profit for a number of years. The firmwill prefer to borrow for a long period by issuing shares or bonds. Bycontrast, if the funds are required to expand the scale of some currentactivity, they may only be needed to buy additional raw materials which willsoon be turned into finished goods and sold at a profit which will repay theloan. This might suggest the firm issues commercial bills or some other formof commercial paper.

However, these decisions will also be affected by the levels of interest ratesand expectations of future interest rates. For example, long-term rates aregenerally higher than short-term rates and firms borrowing long term willaccept that. However, if this ‘spread’ widens, long-term borrowers will try toborrow for the shortest possible period, while if it narrows they mightborrow for longer than they originally planned. Also, if interest ratesgenerally are expected to fall in future, long-term borrowers might bewilling to borrow short term in order to take out a new loan in the futurewhen interest rates have fallen. Equally if interest rates are expected to rise,short-term borrowers might decide to borrow for longer than usual in orderto ‘lock in’ the benefits of the low current rates.

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capital market

money market

maturity

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In the right-hand column, we have markets for derivatives. These are so-calledbecause the value (or price) of the instrument depends to some extent on whatis happening to the price of another (or ‘underlying’) asset. For example, youmight buy the option to buy shares in Tesco plc at, say, £4 in six months’ time.You will do this if you think that there is a good chance that the Tesco price insix months is likely to be over £4. To have this option of course you will haveto pay something, say 15p per share. And this option price (actually called a‘premium’) is to some extent dependent on (or derived from) the underlyingshare price. If the Tesco share price shoots up, the option to buy at £4 becomesmore valuable. These derivatives markets have grown very rapidly indeed inrecent years.

Before we leave our discussion of financial markets, let us just note that thesemarkets are not separate from the institutions that we discussed in the lastsection. In fact the users of the markets are very often financial institutions ofone form or another. This does not mean that households and individuals areexcluded. Individuals can buy government bonds, company shares, equityoptions and so on. But even in the case of individuals, the trade will involvesome financial institution or another. (In other words, the counterparty will bean institution.) This is because the market has to be ‘made’ by someone. If westay with Tesco plc, for example, in order for you to buy or sell Tesco sharesyou have to know who is willing to sell to or buy from you. This will be aninvestment bank that has chosen to ‘make a market’ in company sharesincluding Tesco plc.

End users of the financial systemThe end users of a financial system are the firms, households and individualsthat wish to make use of the services offered by the institutions and markets.But why do we talk about end users rather than just ‘users’ or consumers orclients? In fact, we have just seen why, in the last paragraph. The term ‘enduser’ is important when we are looking at the intermediation role of thefinancial system.

Remember that ‘intermediation’ relates to the lending/borrowing function ofthe financial system. Suppose we consider the case of a firm which wishes toborrow for the long term by issuing, say, new shares or possibly corporatebonds. The new securities are initially sold to an investment bank that makesa market in the firm’s existing securities. At this point, we might say that theinvestment bank has made a loan to the firm, taking the securities in exchange.This is true, but the investment bank has no intention of lending long term tothe firm. As soon as it has possession of the shares (or maybe even before it getspossession) it arranges to sell them on in smaller parcels to investors who wishto hold them as part of their portfolio. This may be a household that is lookingfor a home for its surplus income, in which case we have found the end user.In this case, the household is the ultimate lender while the firm is the ultimateborrower. These are the end users, while the investment bank is acting as anintermediary. Of course, the chain could be much longer. The shares might havegone from the investment bank to a pension fund which is looking forsomewhere to invest its members’ savings. If this happens, then we introduceanother intermediary into the chain. The pension fund is holding the new sharesand is obviously, in a sense, lending to the firm by holding the shares. But thepension fund is not the ultimate lender. The ultimate lender is the employeewhose pension contribution has been used by the pension fund.

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ultimate lender

ultimate borrower

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In many economies, the largest single borrower in the financial system is theGovernment. Governments frequently run budget deficits since their taxrevenue is insufficient to cover expenditure, especially expenditure on capitalprojects. This government borrowing takes the form of the issue of governmentbonds – fixed interest securities that we study in Unit 6. Over the years, thisstock of bonds grows, adding to what is called (roughly) the ‘national debt’.These bonds, once issued, become part of someone’s savings – usually througha pension fund or some other long-term savings plan. Provided that the stockof debt grows at a rate which is similar to the growth of a country’s economy,there is no problem with this expanding debt and certainly no plan to repay it.However, during the financial crisis of 2008 and the associated recession, manygovernments found themselves having to provide a lot of financial assistance,especially to their banking systems, while suffering from falling tax revenuesand increased unemployment benefits. This has led to a rapid increase indebt/GDP ratios in several countries to the point where there is some concernabout whether future governments will be able to meet the interest payments.Greece, Portugal and Iceland saw their government bonds ‘downgraded’ byrisk-rating agencies in 2009 and the UK came close. The situation has beeneased to some degree by dramatically expansionary monetary policies carriedout by central banks. These have been buying up government bonds in the openmarket in a process known as ‘quantitative easing’. When the central bank buysthese bonds, the sellers receive bank deposits (ie ‘money’) in exchange. And soquantitative easing is a way of pushing money into the economic system in thehope that people will spend it (rather than hoard it).

A simpler example, which we shall need in the next section (1.2), arises whena household increases its deposit in a bank. The household is lending to thebank and the bank is thus a borrower from the household. At the same time,the bank lends to borrowers who may be a household buying a house or a firmhoping to expand. So the bank is itself a borrower and a lender. But it is not theultimate borrower or lender; this is the firm or household.

What we have said so far could be summed up in a simple diagram, like Figure1.3. At each end of the system we have the ultimate lenders and ultimateborrowers. Funds from lenders to borrowers via intermediaries or via marketsand the dotted arrows show that some intermediaries (especially investmentbanks and mutual funds) are very active participants in the markets.

Figure 1.3: A simple model of a financial system

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Lenders Borrowers

Intermediaries

Markets

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Why will some ultimate lenders (and borrowers) prefer to use financialmarkets while others prefer intermediaries?

It is mainly a question of cost and information. Thinking of lenders first,many savers prefer to use intermediaries like banks and building societiesbecause they are familiar with the way in which they work. Furthermore,intermediaries will accept small savings because they can pool them intolarger loans. There is a cost to the lender in the sense that the return paidon these small savings will be lower than might be available elsewhere, butlending on a small scale through financial markets also has substantial costssince there are often minimum commissions and fees and these can besubstantial as a fraction of a small transaction. Large lenders will certainlyfind lending by buying securities and other traded assets much cheaper thansmall savers.

From a borrower’s point of view, borrowing by issuing securities has a highfixed cost (paid to the investment bank managing the deal) but this may bea very small fraction of the funds raised if the deal is large enough. But theborrower has to meet other requirements – regarding disclosure ofinformation – and needs to have an established history and reputation if thesecurities are going to be willingly bought and held. Smaller borrowerscannot make the necessary information about themselves available to themarkets and the costs of issuing securities would be prohibitive.

The regulatory authoritiesWe end this brief discussion of what constitutes a financial system with a quicklook at the role of the regulatory authorities. It is a characteristic of financialactivity that it is always and everywhere subject to much higher levels ofregulation than other types of economic activity. Furthermore, deposit-takinginstitutions are subject to the toughest regulation of all. In the UK, mostfinancial regulation is the responsibility of the Financial Services Authority(FSA). In the USA it is divided between the Federal Reserve Board and theSecurities and Exchange Commission. In the Eurozone, responsibilities aredivided between the European Central Bank (ECB) and national regulators.Above all this, we have the Basel Committee, which lays down regulations forthe conduct of international banks which are then meant to be applied by eachnational regulator. Why is financial activity subject to so much regulation?

Ultimately, the explanation lies with a concept known as asymmetric infor -mation. This refers to a situation in which one party to a transaction hasdifferent information from the other. ‘Different’ usually means that one hasmore information than the other and this is where the problem lies. Consider,for a moment, how this asymmetry may affect market participants and howsome degree of regulation may be required.

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Recommended reading for thissection includes:

Howells and Bain (2008)‘Regulation of Financial Markets’;

Howells and Bain (2007)‘Regulation of Financial Markets’;Piesse et al ‘Role of Government’.

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Suppose you are thinking of buying shares in Microsoft. What informationwould you want in order to make a confident decision and how might yoube sure of getting it?

You would certainly want information about Microsoft’s recent profit record.You might want to know how these profits are generated by different partsof the business. You would want to know something about Microsoft’scapital structure: how many shareholders have a claim on these profits?How much debt does the company have (since debt holders have a priorclaim on the company’s earnings)? You would want to know aboutMicrosoft’s immediate investment plans in order to make a judgementabout likely future profits. You would also want to know that the keydecision-makers in Microsoft were not using their ‘inside information’ totrade in the shares before you had a chance to use the information.

Requirements to make information publicly available and to prevent itsabuse by insiders are enforced by regulation. The details will vary betweencountries. In some cases the conditions have to be met in order for the firmto have its shares ‘listed’ on a stock exchange; in some cases therequirements will be imposed by companies’ legislation.

However the regulation is performed, it is unlikely that a market for companyshares could function without some guarantee as to the availability and use ofinformation. As a general rule, it is assumed that the borrower is betterinformed than the lender, since the relevant information refers to the likelyreturn on the funds and the risk to which they will be put. Since the borrowerknows more about the details of the projects being funded, the borrower hasan information advantage. Regulation goes some way to maintaining a fairerbalance.

Another argument for some degree of regulation (much heard since the 2008financial crisis) concerns the stability of the financial system. For example, oncea bank has received funds from its depositors, the bank can increase its profitsby using the deposits to fund loans or investments with a higher level of riskthan depositors expected (since they do not have the information). If the loansor the projects go bad, the bank becomes insolvent and depositors lose theirwealth (and their means of payment). Worse than this, once depositors loseconfidence in banks (which they do as soon as one fails) then there is likely tobe a ‘run’ on all banks as depositors all try to withdraw their savings at once.You may have heard of the famous case of the Lehman Brothers investmentbank in the USA which was declared insolvent in September 2008. This causeda colossal loss of confidence which shook the whole financial system becausebanks lost confidence in each other and would not lend to anyone (except thecentral bank). In the worst case, banks could refuse to transmit funds of anykind to each other and then the whole payments system collapses. It is this risk

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of contagion – the high probability that one bank failure will spread likewildfire – that makes regulators very reluctant to allow a major bank to fail. Toprevent this the regulators may offer deposit insurance which discouragesdepositors from making panic withdrawals. Or they encourage a weak bank tomerge with a strong bank, or the Government puts additional capital into thebank as we’ve seen with the Lloyds Banking Group and the Royal Bank ofScotland.

Ironically, this reluctance to allow bank failures creates a further case forregulation. This is because the implicit guarantee offered by the regulatorsagainst bank failure may encourage riskier behaviour by banks and otherinstitutions. To prevent this, tighter supervision of intermediaries is required.

The advantages of using a financialsystem in lending and borrowingIn Learning activity 1a we identified four types of services that a financialsystem provides. The first thing that we can say about a well-functioningfinancial system is that it provides a whole range of services that consumersfind useful. Provided the cost of using the service is less than the value that theconsumer places on it, the services will be bought. So, we can see quite anumber of advantages of consuming financial services in the same way that wesee people benefiting from lots of other services – travel, restaurants, entertain -ment, legal advice and so on.

However, in this section we are mainly concerned with the benefits of usingmarkets and these lie primarily with the financial system’s role in channellingfunds from ‘deficit’ to ‘surplus’ units (lenders to borrowers) and also in pro -viding an opportunity for portfolio adjustment. We shall focus on lending/borrowing first.

The easiest way to understand why lenders and borrowers are so keen to useorganised markets (or financial intermediaries) is by thinking what it would belike without them. We could, for example, lend directly to each other, cuttingout the middleman and avoiding the costs of the market or the intermediary.However, the fact that we don’t do that, and that we are prepared to pay avariety of fees and commissions in order to have access to organised markets,suggests that there must be some real advantages over direct lending. Look atthe situation from a lender’s point of view first. The lender will be concernedabout:

■ Search costs – we need to find a borrower who wants to borrow the sameamount that we have to lend and for the same period.

■ Contract costs – unless the loan is very small we shall need to draw up alegally enforceable contract. We may need the services of a lawyer.

■ Enforcement costs – if the borrower falls behind with payments of interest(or defaults completely) we shall need to exert pressure to encouragepayment or recover what we can.

We could put the three costs together and call them transaction costs. But costis not the only problem. There is also the major issue of:

■ risk

contagion

9Copyright © 2010 University of Sunderland

1.2

Recommended reading for thissection includes:

Howells and Bain (2008) ‘FinancialMarkets’ and ‘Financial

Institutions’; Howells and Bain(2007) ‘The Financial System and

the Real Economy’; Piesse et al(1995) ‘Introduction to the

Financial System’; Mishkin (2007)‘An Overview of the Financial

System’.

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which we know is partly the result of asymmetric information. And anotherone that is sometimes related to it is:

■ illiquidity.

The borrower will also face problems if forced to consider raising a loan privatelyfrom an individual lender. There will be formidable search costs, since it is morethan likely that the loan required will be much larger than any individual lenderwould wish to finance. There could also be a degree of risk. This would take theform of ‘risk of early repayment’ and would arise because of the lender’s desire toavoid illiquidity. This would mean that the borrower had to accept a contract thatallowed the lender to demand early repayment in certain circumstances. Thiscould be disastrous for a firm that was only half-way through commissioning anew project. As a rule, a borrower wants to borrow for the longest possible periodwhile the lender wants to lend for the shortest. Leaving aside the issue of costs,which of course both sides wish to minimise, we could say that there is somedegree of conflict between lenders and borrowers. At the very least there is amismatch of preferences – primarily over loan size and duration. Organisedmarkets go a long way to resolving these conflicts as we shall see now. We shalldeal firstly with transaction costs and then questions of risk and liquidity.However, before we do this we need to be aware of the distinction between aprimary market and a secondary market. The primary market is the market fornewly-issued shares. In this case, a firm requiring additional long-term fundsengages an investment bank to advertise a certain quantity of shares for sale onterms that the investment bank thinks will strike an appropriate balance betweenraising the maximum capital and being attractive to shareholders. If the new issueis successful, then the firm receives the proceeds of the share sale, minus the feesthat it must pay to the investment bank for managing the sale. Notice that the firmgets additional funds because it has issued new shares. However, most trading infinancial markets involves the buying and selling of existing securities. This is thesecondary market. Clearly in this case the buying and selling involves no newlending. Both primary and secondary markets contribute to the reduction of costsand the reconciliation of conflicting preferences.

Markets and cost reductionThe first thing we need to recognise about any organised market is that it tradesstandardised products. This is related again to information. A market cannotfunction satisfactorily unless the participants know exactly what they aretrading. Hence a market for company shares expects those shares to have somecommon characteristics. These relate to voting rights, frequency of dividendpayments, arrangements for registration of ownership. Fixed interest securitiestraded in bond markets will also have fundamentally similar characteristics.This standardisation of features is one of the first elements in the reduction ofcosts. A company share is a company share and there is no need for individualcontracts to be drawn up specifying the rights and obligations of the seller (theborrower) and the buyer (the lender).

There is a substantial reduction in search costs (for borrowers) in so far as firmsknow that there is a national stock market in which they can raise additionalfunds by making new issues. It is quite possible that certain investment banksspecialise in handling new issues for certain sectors of the economy but theseareas of specialisation are well-known or can be obtained from the managersof the exchange.

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The search costs are also reduced for lenders by means of the publication of‘share listings’ by the exchange, together with up to the minute informationabout prices and other key variables. Market makers and brokers advertisetheir services to potential shareholders. The saving of transaction costs forlenders is dramatically illustrated by the very low commissions paid to brokersand market makers for the sale/purchase of shares. In the UK, traditionalbrokers charge around 0.25 per cent of the value of the transaction once thecontract size exceeds about £15,000. But there are online brokers prepared tocharge a flat-rate commission of £25 for smaller deals. In addition, there isthe ‘bid-ask’ spread. The spread is the difference between the prices at whichmarket makers are prepared to buy and sell securities. The market makers arefirms, usually investment banks, who make up the membership of theexchange in question and in return for their membership they agree to obeycertain rules, the principle one of which is to offer always to buy and sell arange of specified assets. In an equity market, the market maker will offer tomaintain a market in a specified list of shares. This means holding a stock or‘inventory’ of the relevant shares and adding to or selling from that stock inresponse to requests from investors, adjusting the price as sell or buy ordersdominate the order book. Most market makers will list the alpha shares. Lesspopular shares will have fewer market makers and this reduced competition isusually reflected in larger ‘bid-ask’ spreads. For alpha stocks, the differencebetween the bid price (the price at which the market maker offers to buy) andthe ask price (at which the market maker sells) is likely to be around one percent of the central price. Remember that these are the charges for (effectively)arranging a loan. In most countries, these commissions and ‘bid-ask’ spreadsfell throughout the 2000s partly as a result of increased use of electronic tech -nology. We shall learn more about detailed trading arrangements in later unitswhen we look at different types of market.

Markets, liquidity and riskSo far we have concentrated on the role of primary markets in helpinginvestors to buy newly issued stocks. This does not mean that the secondarymarket is unimportant. Firstly we should note that when the equity market isworking in this secondary capacity it is providing the ‘portfolio adjustmentfacilities’, described in learning activity 1a. Secondly, it is performing animportant role in support of the primary market because it is telling the invest -ment bank, handling a new issue, how existing investors see the company andthis should be a strong guide as to the terms on which they are likely tosubscribe new capital. For example, if the market price is high, the firm willbe highly valued and, other things being equal, it will be cheaper to raise newcapital than if the market price of the shares were low. The terms of the newissue will normally be close to, but better than, the terms on which the existingshares are trading, when seen from an investors point of view. This is whynew issues are usually sold ‘at a discount’ to the price of existing shares.Finally, the existence of a secondary market makes the relevant securitiesmuch more attractive than they would be in its absence because it means thatthey can be sold quickly, and for a reasonably certain price, if the holder needsto raise funds quickly. This is an illustration of how organised markets createliquidity.

Making assets liquid makes them more attractive to investors and, other thingsbeing equal, should make it cheaper and easier for firms to raise new capital

11Copyright © 2010 University of Sunderland

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through new issues. Since liquidity means that assets can be sold quickly and fora reasonably certain price, the creation of liquidity helps to reduce risk. However,markets do a lot to reduce risk further by helping to ‘discover’ or provideinformation (see section 1.1 under ‘The regulatory authorities’). The startingpoint is that participation in the market requires a high level of disclosure and therules that cover disclosure are very strict. In order for a company’s shares to belisted on a stock exchange, for example, they have to publish a set of annualaccounts which must be prepared in accordance with a set of rules that shouldmean that the accounts give a true and accurate picture of the state of thebusiness. These accounts must be updated half yearly and, in addition, firmsmust disclose immediately any information that is likely to affect their financialposition. This information is then analysed by market makers as well asinvestment banks, mutual funds and other financial firms who are usually themajor holders of shares (see section 2.4). The results of this analysis then alsobecome publicly available quite quickly, since once one major participant isknown to have made a buy/sell decision, this becomes public knowledge andother investors, including private buyers and sellers can follow suit.

Inevitably, the amount of information that is available about a firm is likely toincrease with the firm’s size and with its age. A large firm is likely to have a largenumber of shares in issue. (Its shares will be alpha shares, and so many peoplewill be buying and selling and therefore analysing the firm’s performance.)Additionally, a firm whose shares have been quoted for a long time will havebuilt up a reputation. Investors will be familiar with it and with its manage -ment. Its behaviour will be predictable.

‘Most trading in the stock market is secondary trading which involves nonew lending or borrowing and is therefore of little economic value.’Comment critically on this statement.

Firstly, as a factual statement it is correct. Total turnover in stock marketsvastly exceeds the amount of money raised by new issues as you will see inUnit 4. Therefore most of this trading is simply redistributing the ownershipof existing assets. However. three possible benefits should be considered:

1. The ability to buy and sell shares cheaply and easily makes a very long-term instrument into a relatively liquid one. As such, company shares aremuch more attractive as an asset than they would otherwise and thisattractiveness makes it possible for firms to pay much lower dividendsthan would otherwise be necessary. This reduces firms’ cost of capital.

2. The ability to buy and sell shares cheaply and easily enables investors tomake quick and cheap adjustments to their portfolio. This enables themto adjust their exposure to risk and return to their needs which willchange over time.

3. The market’s attitude to existing shares may be a useful disciplinarydevice for the managers of firms. If investors do not like the way inwhich a firm is being run, they will sell the shares, reducing the value ofthe firm and raising its cost of capital. If the value falls enough, the firmmay become a target for takeover.

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Market efficiency and the real economyIt seems an obvious thing to say that an economy will be better served by afinancial system (and financial markets) which are efficient, rather thaninefficient. This is of course true, but we need to define ‘efficiency’ carefullyand to understand that there is one special meaning of efficiency that appliesto financial markets and is controversial, above all since the financial crisis of2008. We look at each of these briefly and when we do that we shall link eachtype of efficiency to certain benefits for the real economy. We shall link the firsttype of efficiency to the encouragement of saving, investment and economicgrowth (what we might call ‘macro’ benefits) and we shall link the second typeof efficiency to resource allocation (what we might call ‘micro’ benefits). Thisis a bit of a simplification since both types of efficiency are relevant in somedegree to both sets of outcomes. But it helps us to distinguish the different typesof efficiency and it forces us to think about several ways in which the financialsystem may interact with the real economy.

Operational efficiency, investment and growthThe first sense in which most people will think of the term efficiency refers totechnical or operational efficiency. This refers to a market’s ability to carry outtransactions quickly, cheaply and reliably. For example, a buyer of shares needsto know that the broker or market maker will buy/sell the shares at (or veryclose to) the price that has just been displayed on the internet. It will not besatisfactory to find that the trade was not done for, say, thirty minutes after theinstruction when the price had changed significantly. We have already men -tioned the need to minimise costs. Market participants also want to know thatthe paperwork – settlement of the trade and the transfer of funds – will occurquickly and securely. These are all aspects of operational efficiency, which isgenerally regarded as satisfactory in most major markets and is generallyimproving (as regards speed and accuracy) as a result of improving communica -tions technology.

In section 1.2 we looked at a number of advantages that follow from usingfinancial markets. We summarised the benefits by saying that markets make iteasier and cheaper to lend and to borrow. If this is true, then it amounts tosaying that without organised markets lending and borrowing would be verydifficult and expensive. Hence, we can be sure that a well-functioning financialsystem will encourage more lending and borrowing than would otherwise bethe case. Why does this matter for the economy as a whole?

First of all, we all of us know borrowing helps consumers to buy goods andservices beyond what is possible from their current income. Current incomebecomes less of a constraint and lending and borrowing enables us to shift ourconsumption in time: postponing it or bringing it forward. However, we aremore interested here in another benefit: the financing of real investmentprojects. Notice that we say ‘real’. This is to distinguish the kind of investmentthat we are interested in here – which is the purchase of machinery, buildings,equipment and so on that facilitates the production of other goods and services– from the purchase of financial assets (or ‘financial’ investment). From thisdefinition we can see that real investment is something that is normally doneby firms (or public authorities) rather than by households.

1.3

13Copyright © 2010 University of Sunderland

Recommended reading for thissection includes:

Howells and Bain (2008) ‘FinancialMarket Efficiency; Howells and

Bain (2007) ‘Financial MarketEfficiency’; Mishkin (2007) ‘The

Stock Market … and the EfficientMarket Hypothesis’.

operational efficiency

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The purchase of real capital goods typically involves a large expenditure whichhas to be made before the equipment begins to work and earn a profit. It isusually impossible for the firm to make this expenditure out of current income.Consequently, it must either draw on existing savings (out of previous profits)or it must borrow. This means that the cost of borrowing (sometimes calledthe ‘cost of capital’) plays a major role in the decision to invest. The lower isthe cost of borrowing, the more likely is it that a particular investment willrecover its cost and make a profit. At low costs of borrowing, there will bemore profitable-looking projects than there will be when borrowing costs arehigh. In Figure 1.4, we show this relationship between investment spendingand the cost of borrowing.

Figure 1.4: Lending, borrowing and investment

Figure 1.4 can be used to show how the amount of investment depends,amongst other things, on the quality of the financial system. Start with thefigure as drawn. The cost of capital is set at C which is partly dependent oninvestors’ willingness to buy and hold, say, company shares. Now imagine thatthe system develops certain improvements. Maybe the costs of trading fall, orthe markets becomes more liquid or brokers start to target new investors. Thiswill encourage more people into the market and, other things being equal, wewould expect share prices to rise. In the next section we explain why a rise insecurity prices is equivalent to a fall in the cost of capital. So, theseimprovements in the share market that have made shares more attractive, havemade it cheaper for firms to raise new funds.

Why does this matter? The answer is that there is a widespread belief amongsteconomists that one of the principal determinants of an economy’s rate ofgrowth is the rate at which the capital stock expands and is replaced.Expanding the capital stock gives workers more equipment to work with;replacing capital equipment at frequent intervals gives a firm access to the latesttechnology. Both of these should make workers more productive and anincrease in output per head is just another way of referring to an increase in realincome. In so far as we are concerned with material standards of living, a highlevel of investment should help bring rapid improvements.

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Informational efficiency and resource allocationThe second, and more controversial, meaning of efficiency refers to informa -tional efficiency. The issue here is the extent to which all information that isrelevant to the valuation of an asset is incorporated in the price and this mustalso introduce the question of time or speed of incorporation. Broadly speaking,a financial market which manages to absorb all relevant information into theprice of assets being traded so quickly as to prevent anyone profiting from theinformation is regarded as efficient. Let us assume for the moment that suchefficiency is typical. There are some very strong implications. We postpone thefull list until Unit 5, but just consider these for now:

■ If information is incorporated so fully and so quickly, it will be impossiblefor anyone to earn consistently abnormal rates of return. To ‘beat themarket’ they will have to guess and occasionally they will guess lucky butat other times they will guess wrong.

■ If markets are informationally efficient, anything that can be learned frompast price behaviour will have been learned and will be already incorporatedin the price. Therefore, the only thing than can change prices is ‘news’ andnews, by definition, is random – sometimes good and sometimes bad withabsolutely no pattern.

■ If prices incorporate all the relevant information, those prices will be‘correct’ prices and this ensures that funds will flow to where they are mostproductive.

If we are thinking about the financial system making the best contribution thatit can to the real economy, then it is this third implication that concerns usmost. We must postpone a full discussion until Unit 5 but briefly, the argumentgoes like this. The price of a security in any market depends upon three thingswhich are referred to as ‘fundamentals’. These are:

1. The future stream of earnings, which may be in the form of interest or avariable dividend linked to the profitability of the firm – both of these arelinked to the underlying productivity of the project that the funds arefinancing.

2. The level of risk that comes with those earnings.

3. The rate of interest, since the rate of interest is combined with a riskpremium (from 2) in order to discount the earnings (in 1).

Take now the case of a firm with a high share price, relative to the dividend thatthe firm is paying. According to our three conditions, the share price will behigh because investors are optimistic about the future stream of earnings,relative to the risk involved. Why should the future stream of earning be soimpressive? It can only mean that the firm is likely to make large future profitsand this means that its projects are highly-valued by society (represented byconsumers’ willingness to pay a good price for the outputs) and efficientlyoperated. These are the sorts of activities that society appears to value and thefirm should be encouraged to produce more.

Now consider the significance of the share price being high relative to thedividend being paid. This means that the firm’s cost of capital (at least, equitycapital) is low since it could if it wished issue new shares (and raisecorresponding funds) for only a small payment in dividend. Imagine instead

15Copyright © 2010 University of Sunderland

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that the share price were half what it is (and the dividend were unchanged). Anew issue would now bring in much less capital, each unit of which would nowbe twice as costly as before.

Of course, the opposite will be true. A low valued firm will find it expensive toraise new funds and expand. And if our reasoning is correct, then this is as itshould be since the firm cannot be delivering highly-rated benefits to society.Indeed, it might be a good idea if the shares were to fall a bit lower in pricebecause another firm may then take it over and turn it into something moreuseful.

So if all goes according to the efficient markets theory, capital is attracted to‘good’ firms (who find it relatively cheap), but is in short supply to ‘poor’ firms(who find it expensive). ‘Good’ firms will expand while ‘poor’ firms willstagnate, maybe shrink and/or maybe taken over.

The idea that financial markets make very efficient use of information is thebasis of the efficient market hypothesis (EMH). This is a controversial issuewhich we discuss more fully in section 5.2.

Which of the following statements is consistent with the hypothesis thatmarkets are informationally efficient?1. Some unit trust funds consistently produce higher rates of return than

others.2. When it comes to takeovers there are no ‘bargains’.3. Buying shares whenever their price falls by ten per cent in a month will

produce superior returns in the long run.

1. This is consistent. The EMH only says that it is impossible to earnabnormal rates of return consistently. ‘Abnormal’ means rates of returnthat are higher than the market rate for a given level of risk. If some unittrust managers set out to specialise in high-risk portfolios while othersspecialise in low-risk, we should expect to see the former earn higherreturns consistently.

2. This is consistent. Firms may have a low share price and so the value ofthe company is low. It may look cheap. But if the share priceincorporates all relevant information it will be cheap because it is apoorly performing firm. This is not a ‘bargain’.

3. This is inconsistent. It suggests that there is a ‘rule’ which leads toabnormal returns. But the EMH says that if such a rule were to exist,then everyone would know it. And if they know it, they will use it andthis immediately makes the rule useless because any shares that mighthave yielded abnormal returns identified in this way, would have theinformation in their price and would not fall by ten per cent.

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The financial system and economicdevelopmentWe have just discussed two ways in which the functioning of a financial system,including financial markets, may affect the real economy. As the financialsystem expands and improves we would expect to see less consumption butmore saving, investment and economic growth; if the financial system isinformationally efficient this will go some way to ensuring that funds flow totheir most productive uses. In this section, we take these same ideas, which areusually applied to developed economies with sophisticated financial systems,and show how they can be applied to the process of economic development inpoorer countries.

The idea that ‘finance’ plays an important role in economic development goesback a long way, at least to Schumpeter (1911). Other writers in a similar traditioninclude Gurley and Shaw (1955) and Hicks (1969). Their arguments were broadlysimilar to what we said under ‘Operational efficiency, investment and growth’above, namely, that the financial system helps to mobilise saving and investmentand therefore, for many less developed countries, policy should be directedtowards encouraging the growth of a financial system. More recently, McKinnon(1973) and Shaw (1973) took this argument a stage further by introducingelements of our discussion under ‘Informational efficiency and resource allocation’in so far as they were concerned with the financial system’s ability to directresources to their most efficient use. They laid less stress on simply expanding thefinancial system and placed more emphasis on ensuring that it worked well. Thetarget of their criticism was the practice in many less developed countries of whatcame to be known as ‘financial repression’. Financial repression was characterisedby high levels of government regulation of the financial system. This took manyforms, including high reserve requirements on banks, obligations on banks to holdhigh levels of government debt and ceilings on interest rates.

As we shall see in Unit 9, regulation may sometimes be essential but it inevitablyacts like a tax and in so doing it raises the price and reduces the quantity of theactivity concerned. More interesting was their attack on interest rate ceilings.Taking a charitable view of interest rate ceilings, one might say that they were awell-intentioned device to encourage investment by holding the cost of borrowingbelow the market-clearing level. However, this overlooks two things. The first isthat if saving is not adequately rewarded, it will not be forthcoming. Hence whilelow interest rates may encourage the demand for loans, it will discourage thesupply. There will be excess demand, but the amount of borrowing will be limitedto the amount of saving. Borrowing will be ‘supply-constrained’. So this well-intentioned measure has the opposite effect of what was intended.

The second issue is at least as interesting. In the normal appraisal of investmentprojects, the key question is whether the project will earn a return which coversthe cost of capital. Consequently, the higher the cost of capital the ‘better’ orat least more productive the project has to be. By holding down the cost ofcapital, many poor quality projects will now pass this test. Recall that there isexcess demand for the limited funds available. How are the limited funds to findtheir way to the best projects? The McKinnon and Shaw argument is that theywill not. At best, some sort of human agency – bank managers, public officials– will do their best to identify the most deserving cases. At worst, the limitedfunds will be allocated by corrupt methods. The result will be a very poor

1.4

17Copyright © 2010 University of Sunderland

Recommended reading for thissection includes:

Ang (2008); Mishkin (2007)‘Economic Analysis of Financial

Structure’.

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quality of rather limited investment. The contribution to growth and develop -ment will be much smaller than it should be. The policy implication is clear.What is required is ‘financial liberalisation’.

Over the years there has been much further discussion of the financial repres -sion hypothesis and a good deal of empirical testing, initiated by famous paperby King and Levine (1993). One problem for empirical researchers is that longtime series of data for individual countries is not available, because, althoughthe theoretical argents began in the 1970s, developing countries often did notrecord the necessary data until later. Many of the studies are therefore cross-sectional – comparing countries with different degrees of liberalisation ratherthan the same country before and after. A good survey of the results (and of thetheoretical debates is in Ang (2008). What most of the studies show is thatthere is a widespread association between finance and economic growth where‘finance’ refers both to the size of the financial sector (the traditional view) andthe more recent ‘liberalisation hypothesis’. The problem, as so often in eco -nomics, is distinguishing cause and effect.

The original King and Levine (1993) study focused mainly on banking variablesas indicators of ‘finance’. From our point of view it is interesting that morerecent work has gone on to look at the effect of stock markets on economicgrowth. Studies by Demirguc-Kunt and Maksimovic (1998) and Levine andZervos (1998) confirm a positive link between markets and economic growth.Finally, we should note that there are dissenting voices. In particular, JosephStiglitz (2000) has argued that financial liberalisation has led to increasedinstability within financial systems and is responsible for the increasedfrequency of financial crises. This is a point of view that has attracted increasedattention since 2008.

Business sector October March October2008 2009 2009

Basic materials 0 4222.35 197.20

Industrials 0 33.12 622.54

Consumer goods 0 457.48 876.54

Healthcare 0 0 0

Consumer services 3.40 0 287.39

Telecoms 0 0 0

Utilities 0 0 0

Financial 10.75 28.86 533.57

Technology 75.00 0 0

Total 89.15 4741.81 2517.24

Table 1.1: Funds raised by the issue of new ordinary company shares on theLondon Stock Exchange (£ million)Source: London Stock Exchange, Market Statistics, October 2008, March 2009, October 2009

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1. Write a brief commentary on what is shown.

2. What sort of factors might play a part in firms’ decisions regarding thetiming of new issues? Figure 1.5 may suggest some ideas. It shows thebehaviour of the FTSE-100 index covering the period June 2008 toDecember 2009.

Figure 1.5: FTSE-100 index

1. The figures show very large variations in new issue activity. In October2008 firms raised only £89 million while in March they raised almost£4742 million, an increase of 50 fold. The figures also show considerablevariation across sectors. Some sectors like healthcare, telecoms andutilities raised nothing over the period while basic materials, industrialand consumer goods raised much more.

However, it is worth noting that this is just a small sample and the figuresare monthly. We might expect to see large fluctuations from month tomonth since one large new issue in one month and no large issues inanother would make a large difference. We should always be careful notto read too much into a small sample.

2. The major effect upon the timing of new issues will be the timing offirms’ requirements for additional capital. However, there may be someflexibility in this. It may be possible to advance or postpone someexpenditures or to finance them in some other, temporary, way if itseems beneficial to delay the new issue.

If there is any flexibility, the firms and the ‘underwriters’ of new issues willgenerally want to make the new issue when market conditions arefavourable. The underwriters will be an investment bank and they will haveagreed with the firm beforehand that they will take up any new shares thatare not sold, in order that the firm can be certain of getting the funds that it

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29/10/08

18/12/08

06/02/09

28/03/09

17/05/09

06/07/09

25/08/09

14/10/09

03/12/09

date

leve

l

FTSE100 (adjusted close)

Unit 1 An introduction to financial systems

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needs. But the bank will not want to hold these unsold shares for longerthan necessary. They will therefore favour a situation where there is likely tobe strong demand. They will certainly not want to launch the issue wheninvestors are selling their shares and share prices are falling. It is noticeablethat the FTSE index was falling steeply in October 2008 which was also moreor less the height of the financial crisis when high levels of uncertaintyencouraged investors to hold safe assets like money. The big sales in ourtable (in March 2009) coincided with the very lowest turning point and therevival of enthusiasm for company shares, as shown by the chart.

Self-assessment questions1.1 Distinguish between long-term and short-term financial markets.

1.2 How might the regulation of financial activity increase the level of risk?

1.3 How do financial markets help to solve the problem of asymmetricinformation?

1.4 How do conditions in secondary markets affect the ability of firms toraise new capital by the issue of new shares?

1.5 Why might we expect financial markets to be reasonably efficient atreacting to relevant information?

1.6 Outline two ways in which the performance of a financial system mayaffect economic growth.

Feedback on self-assessment questions1.1 There is no strict definition, but in practice, long-term or ‘capital’ markets

are markets for instruments with a maturity in excess of five years. Short-term or ‘money’ markets are markets for instruments with less than oneyear to maturity. This leaves a grey or indeterminate area of one to fiveyears. Instruments in this maturity are usually treated as belonging to themarket in which most instruments of that type fall. So, government bondsof. say three years to maturity, would be regarded as capital marketinstruments because the bulk of government bonds most certainly belongin that category; by contrast, a two year CD would still be a moneymarket instrument since the vast majority of CDs are money marketinstruments.

1.2 Where regulation offers protection after something goes wrong, it reducesthe costs of the malfunction. So, for example, if the authorities guaranteethe safety of bank deposits when a bank gets into trouble, the guaranteelessens the costs of the bank’s insolvency. But by reducing the costs ofcertain actions, this may serve to encourage them. If depositors know thattheir deposits are safe, they do not need to be too concerned about whata bank is doing with those deposits; if shareholders know that their bankis ‘too big to fail’ then they do not have the usual incentive to monitor thebank’s management. Both situations may encourage riskier behaviour bythe bank. Hence more regulation will be needed to prevent this.

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1.3 Financial markets require users to disclose a large amount of informationabout themselves as a condition of access to the market. This is par -ticularly true for borrowers (typically large firms). Remember that in thetext we said that it was usually the borrower that had the informationadvantage and so this forced disclosure goes some way to restoring abalance. Furthermore, the organisers of the market will themselvespublish a lot of information. They will show the price of the assets(company shares, for example) in ‘real time’ as well as the volume oftrading in each stock. Thus, if someone makes a large sale which causesa share’s price to drop this is notified instantly to all participants in themarket and will act as a signal to everyone that there may be somethingwrong with the firm.

1.4 The main advantage of the secondary market is that it adds to the liq -uidity of the asset being traded. The degree of liquidity in a market issometimes described as its ‘depth’ and it is measured by reference to howlarge a sale or purchase can be, without causing a change in market price.The advantage of this liquidity to the issuer is that it makes shares muchmore attractive than they would otherwise be and this reduces the levelof dividends that the issuer has to pay subsequently. There is a furtheradvantage which is that an active secondary market in a firm’s sharesgives a clear signal as to the cost of raising new capital. New shares willhave to be issued on terms which are close to what shareholders arecurrently requiring to hold the shares.

1.5 Part of the answer lies in Q1.3. Organised financial markets are structuredwith the intention of making information available. Amongst theinformation that firms must provide is all the financial information thatan investor needs to make an informed decision. Furthermore, if some -thing happens to the firm’s trading situation that might have a materialimpact on its financial position, that information must be disclosed atonce. But in addition to this, the strongest reason for expecting marketsto make efficient use of information is that it is irrational not to do so.Traders who are persistently badly-informed will be driven out of businessby those who know better. Hence there is intense competition to find thelatest news. This is the job of so-called analysts. And as soon as someonetrades on the basis of this ‘news’ the trade is instantly visible to everyone.

1.6 There are numerous ways in which the performance of an economicsystem may be linked with economic growth. The two that we havementioned here focus on increasing the amount of saving and investmentin an economy in the belief that the rate of economic growth is linked tothe expansion of the economy’s capital stock. On the assumption that thefinancial system is operationally and informationally efficient, this isreally an argument for having a financial system which expands with therest of the economy. But the system may not always be efficient, especiallyin less developed countries. where this is the case, savings may bediscouraged (by interest rate caps) and the resulting funds may not flowto their most productive use if the limited saving is rationed by non-pricemethods. Where these restraints exist, this is an argument for liberal -isation of the financial system.

21Copyright © 2010 University of Sunderland

Unit 1 An introduction to financial systems

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SummaryAs a result of studying this unit you should now understand what a financialsystem is and how financial markets work within that system. Specifically, youshould now be able to:

■ describe the key features of a financial system

■ distinguish financial markets from intermediaries and understand how bothhelp to mobilise savings for the purpose of investment

■ appreciate the importance of information in financial activity and wayimbalances of information may give rise to a need for regulation

■ understand the meanings of efficiency as applied to financial markets andappreciate how that efficiency improves the functioning of the real economy.

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23Copyright © 2010 University of Sunderland

‘Historic lows for Libor raise lending hopes.‘Financial Times (14 July 2009)

IntroductionIn this unit you will learn what is meant by the expression ‘moneymarkets’, what is traded in these markets and by whom. You will also seethat these markets are critical in the process whereby the policymakersets the general level of interest rates in the economy.

Unit learning objectives

On completing this unit, you should be able to:

2.1 Describe the characteristics and uses of money market instruments.

2.2 Price a selection of these instruments.

2.3 Show how the pricing of money market instruments can be linkedto a supply and demand framework.

2.4 Identify the key users of the money markets, including centralbanks.

Prior knowledge

The unit requires no prior knowledge but you will find section 2.1 and 2.2 easierif you have some basic mathematical skills. Section 2.3 will be easier if you arefamiliar with some microeconomics and the use of a supply/demand framework.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008:‘Money Markets’). In addition, Piesse, Peasnell and Ward (1995) has a chapter onthe money markets but is a bit dated. Howells and Bain (2007) also covers muchof the material but at a rather lower level. There are many other books aboutfinancial markets and institutions, but few of them refer specifically to short-term money markets. You will need a calculator and access to the internet.

Money markets – functionsand operations2Unit

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The characteristics and uses of moneymarket instrumentsIn Unit 1 we saw that financial markets existed for two main purposes: to helpin channelling funds from ‘surplus’ to ‘deficit’ units and to facilitate portfolioadjustment. Money markets, and the instruments traded in those markets, aremarkets which channel short-term funds. There is no strict definition of short-term, but generally speaking money market instruments have an initial maturityof less than one year. Notice that we say ‘initial maturity’. As time goes by, theresidual maturity of an instrument shortens. Hence a government bond with aninitial maturity of ten years will have a residual maturity of six months after aperiod of nine and a half years. However, we would not normally regard agovernment bond with a residual maturity of six months as a money marketinstrument since its initial maturity was much longer (and puts it firmly in thecapital markets category). We shall see later that there is a short-term moneymarket that features government bonds. This is the ‘repo’ or repurchase market.But we treat this as a money market because the repurchase deals themselveshave an initial maturity of less than a year, regardless of the maturity of thebonds that are being used as collateral. If the initial maturity of a money marketinterest has an upper limit of one year, it follows (a) that many will have aninitial maturity of much less (three months or 91 days is quite common) and (b)that the average residual maturity will be very short indeed. Most instrumentstrading in money markets will have a residual maturity of less than threemonths.

As a general rule (but there are exceptions) when it comes to pricing moneymarket assets it is residual maturity – the remaining life – that matters.

Figure 2.1 lists some money markets instruments. Notice that we have twogroups.

Figure 2.1: Money markets instruments

This is because the two groups of instruments differ in the way in which theirrates of return are calculated and expressed. Those on the left have their returnexpressed as a rate of discount. (They are discount instruments.) Those on theright have their rates of return expressed as a conventional rate of interest.(They are yield instruments.) We shall see what this means in the next section.Because they are short-term instruments, we can say that a further character -istics of money market instruments will be high liquidity. This is because wedefine liquidity as:

■ The speed with which an asset can be converted to money for a knownvalue.

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2.1

Recommended reading: ‘Money Markets’ in Howells and

Bain (2008 and 2007) and Piesse,Peasnell and Ward (1995).

.

■ Treasury bills

■ Commercial bills

■ Euro commercial paper

■ US commercial paper

■ Bank deposits

■ Certificates of deposit

■ Repurchase agreements(REPO)

initial maturity

residual maturity

discount instrument

yield instrument

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Because these instruments are never far from maturity, their price can never befar from the maturity value whatever shocks may hit the market. Furthermore,as we shall see in section 2.4, the issuers of money market instruments tend tobe governments, banks and large corporations. This gives the instruments avery low default risk.

Finally, because they all have similar maturities and a similar low level of risk,money market instruments tend to have rates of return that are very similar. Forthis reason, differences in money market returns are often expressed in basispoints.

(a) Describe the key characteristics of money market instruments.

(b) How do you think these characteristics affect their rate of return relativeto other financial assets?

(a) The key characteristic of money market instruments is that they are veryshort-term instruments, even when newly issued. Other characteristicsflow from this. They are highly liquid since any holder has only to wait ashort time to maturity. Furthermore, if they had to be sold prior tomaturity the price will always be known with a reasonable degree ofcertainty. This is because a change in market interest rates cannot havemuch effect on very short-dated assets. This stability of value thenmakes them low-risk and the low-risk is reinforced by the fact that theborrowers in money markets are governments, banks and other largecorporations.

(b) The low-risk, high-liquidity nature of money market instruments meansthat their rates of return are generally lower than can be earned in otherfinancial markets.

Pricing money market instrumentsIn this section we shall look at the pricing procedure for a discount instrumentand then for three yield instruments. Throughout this discussion, and in futureunits, we must remember that the present value of all assets is given by:

the present value of their future income stream, suitably discounted.

By ‘suitably discounted’ we mean adjusted by a discount factor which incor -porates the return that could be earned on similar, alternative assets and thisamounts to saying that we use a risk-adjusted rate of interest. The discountfactor is 1/(1 + i), where i is the risk-adjusted rate of interest.

In all the calculations relating to money market instruments we shall find thatwe need to refer to a ‘fraction of a year’ since money market instruments havematurities of less than one year. For this reason the discount factor becomes:

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Unit 2 Money markets – functions and operations

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2.2Recommended reading:

‘Money Markets’ in Howells andBain (2008 and 2007) and ‘Piesse,

Peasnell and Ward (1995).

basis point

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1[2.1]

(1 + i.nm)

where nm is the residual maturity of the asset expressed as a fraction of a year.

This introduces a complication since money markets in different countries havedifferent definitions of a year – strange as it may seem! Of the major tradingcentres UK, the Eurozone and Japan assume that a year is always 365 dayslong; in the US, however, it is assumed always to be 360 days. To see why thismatters, consider this example. Suppose that the rate of interest on an £100,000instrument for three months is quoted as six per cent. What does the holderactually receive? The answer is:

interest paid = 0.06 × 91 × 100,000 = £1496365

Clearly if we change the length of the year from 365 to 360 this will make adifference to the sum received and this in turn will make it difficult to makecomparisons of money market rates across different countries. Learning activity2b gives you an illustration.

Suppose that the return on UK treasury bills is quoted at 7 per cent while onUS treasury bills the return is quoted as 6.9 per cent. Which of these givesyou the best return?

Look at the illustration in the text. If we change 365 to 360 we shall get alarger fraction of the annual interest rate quoted. This means that 6.9 percent on a 360 basis will gives us more than 6.9 per cent on a 365 basis. Butwill it be enough to compensate for the quoted rate of 6.9 per cent beingbelow 7 per cent? Let us see:

interest paid = 0.069 ×91

× 100,000 = 1744.17360

interest paid = 0.07 ×91

× 100,000 = 1745.21365

It turns out that when we quote returns on money market instruments 7per cent in the UK is still slightly better than 6.9 per cent in the USA but theresults are very close.

We can convert returns calculated on different year bases by using the followingformulae;

i360 = i365 ×360

i365 = i360 ×365

365 360

[2.2] converts a ‘365 rate’ into its equivalent 360-day version; [2.3] enables usto see what a US ‘360 rate’ would be worth when compared with a UK 365-rate. For example, using [2.2] we find that the 6.9 per cent rate in the US isequivalent to 6.995 per cent in the UK – not quite 7 per cent.

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( )[2.2] [2.3]

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Pricing a discount instrumentWe look at the pricing of a discount instrument by looking at a treasury bill.A UK treasury bill is an instrument issued by the UK government to fund short-term borrowing. The initial maturity is most commonly 91 days, butoccasionally bills are issued with longer and shorter maturities. What makesthem discount instruments is the fact that they are issued at a discount to theirmaturity value. In other words, the gain to the holder comes in the form ofcapital appreciation – the difference between what it cost and what it is worthat maturity. The price is found as:

P = M – d(M.nm) [2.4]

where P is the market price, M is the maturity value, d is the rate of discountand nm is the residual maturity expressed as a fraction of a year. For example,a UK 91-day treasury bill (TB) for £1 million offering a rate of discount of fiveper cent will be offered for sale at:

P = £1m – 0.05 (1m × 0.25) = £987,500

It is a simple task to rearrange [2.4] so that we can find the rate of discountgiven the other terms.

d = M – P [2.5]M.nm

For example, a Japanese TB for ¥5 million is trading at 4,900,000, with 80days to maturity. Find the rate of discount.

d =5 – 4.9

=0.1

= 0.0912 = 9.12%5 × 80 1.096

365

(a) Take the UK treasury bill described above and calculate its price whenthere are 50 days remaining to maturity, assuming all else is unchanged.

(b) Does your answer suggest anything significant?

(a) P = £1m – 0.05 (1m × 0.137) = £993,150

(b) We said earlier that money market instruments have high liquidity partlybecause, being short-term instruments, their price can never be far frommaturity. What your calculation should show is that, all else being equal,the market price must converge on the maturity value as the period tomaturity gets shorter.

Notice that we have been talking about a rate of discount (rather than a rateof interest). [2.4] explains why. It is because it is the rate that is used to find thediscounted price at which the bill is issued or trading. In the case of the UK TB,the discount of £12,500 was calculated by taking five per cent of £1 million.This is not the same as a five per cent rate of interest. Learning activity 2dshows why.

27Copyright © 2010 University of Sunderland

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(a) What is the difference between a rate of discount and a rate of interest?

(b) What rate of interest would be equivalent to the five per cent rate ofdiscount above?

(a) A rate of discount is expressed as a fraction of the sum received. A rateof interest is calculated on the outlay, or sum invested.

(b) [2.4] is the formula for the rate of discount. If we were to use [2.5] tocalculate a rate of interest, then we should have to put P rather than Min the denominator. Notice that, since P < M the equivalent rate of rateinterest will be higher than the rate of discount.

Given the discount rate we can find the equivalent interest rate as follows:

i =d

[2.6]1 – d.nm

and, given the interest rate we can find the rate of discount.

d =d

[2.7]1 – i.nm

Finally, before leaving this discussion we need to confirm that the prices of thetreasury bills we have just looked at conform to the rule that they are equivalentto their discounted future income streams. At the beginning of this section wesaw that the appropriate discount factor is:

1M

(1 + i.nm) [2.8]

Notice that the discount factor (1/(1+i)) uses a rate of interest and that we haveto adjust for the fraction of the year that is left to maturity. Remember this rateof interest is not the same as a rate of discount (confusing as the terminologyis). So, if we take our UK treasury bill we have first to convert the five per centdiscount rate to its equivalent rate of interest using [2.6]:

i = 0.05 = 0.050632911 – 0.05(0.25)

Using this rate of interest in [2.7] we have:

1 1lm1 + 05063291(0.25)

= 1m1.012658

= 1m × 0.987500 = 987,500

which is the same result that we achieved using [2.4].

Pricing yield instrumentsInterbank deposits

Notice that we included bank deposits in Figure 2.1. This is because they arecertainly short-term instruments (indeed, sight deposits have zero residualmaturity) and because we do talk about ‘a market’ for bank deposits but thisis not a market in the conventional sense of lots of buyers and sellers trading

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assets between themselves. A bank deposit is an over the counter transaction –you can only ‘sell’ the deposit back to the bank. You cannot trade it (and yourbank can not sell it to a third party). One particular category of bank depositsis of interest when it comes to studying the behaviour of money markets. Theseare the ‘interbank’ deposits – the counterparts to interbank loans. This isbecause the return on these deposits (called ‘London Interbank Offer Rate’ orLIBOR) is used as a benchmark for setting the return on a variety of otherinstruments. This in turn is important for four reasons:

(a) The range of interbank-linked products is very large – it includes most retaildeposits and loans, for example.

(b) Where an instrument is a market-traded instrument, setting the returneffectively sets the price (as we saw under ‘Pricing a discount instrument’above).

(c) Because of the link from LIBOR to other market rates, it is LIBOR rates thatare the first target of a central bank’s monetary policy (as we shall see insection 2.4) and this explains why the conduct of monetary policy beginswith central bank money market operations.

(d) During the 2008 financial crisis the link between monetary policy rates andLIBOR rates broke down to some degree which made the operation ofmonetary policy quite difficult.

Although the deposits are not traded in a conventional sense, they do have aprice and it is determined in exactly the same way as any other financial asset:it is the present value of the future income stream. This income stream from adeposit depends on the rate of interest and the term to maturity. In the case ofinterbank deposits we are dealing with fixed-term deposits with an initialmaturity of up to one year. Suppose we are looking at a three-month interbankdeposit of £10 million which is about to be made at an agreed LIBOR rate of3.5 per cent. The future income stream will be:

£10 million × (1 + 0.035(0.25)) = £10.0875 million

To find the present value of £10.0875 in three months’ time we simply discountby the usual expression [2.1]. The question is what rate of interest do we usein [2.1]? Remember that this must be the rate of interest on similar assets, sothis reasoning is going to bring us back to the 3.5 per cent offered on thedeposit. And you have probably guessed the rest. (If not, guess now. What willthe present value be?) If we discount £10.0875 million by 3.5 per cent for threemonths we have:

1£10.0875m 1 + 0.035(0.25) = £10m!

What this shows is that the ‘price’ of a deposit is the initial payment to theborrower. And this makes perfect sense when we think about it. The ‘price’ ofthe loan to the UK treasury was the price that we paid for the treasury bill.Here, the price of the deposit is the initial outlay. The problem we have withthinking about deposits like this arises partly from the fact that they are nottradable. It is also due to the fact that we tend to think of the outlay (what wehand over to the borrowing bank) and the deposit itself as one and the samething. But this is not strictly correct. When we place funds with a bank we aredefinitely buying something. We are buying a deposit contract. And this

29Copyright © 2010 University of Sunderland

( )

over the counter transaction

LIBOR

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specifies what we shall get back at the end. Because we are buying something,there is a price – the initial outlay – and the link between this price and itsreward follows all the standard rules of finance.

Certificates of deposit

Our second yield instrument will be a certificate of deposit. This is a certificateof ownership of a time deposit. You will remember that we said at the beginningof this unit that bank deposits themselves are not tradable and so we were notgoing to discuss them further. But some time deposits come with a certificate ofownership and the certificate is tradable.

(a) What do you think is the advantage of a certificate of deposit to:(i) the depositor(ii) the bank?

(b) How would you expect these advantages to be reflected in the rate ofreturn on a CD compared with a simple time deposit?

(a) (i) the advantage to the depositor is that she can enjoy the higher rate of interest that goes with a fixed-term time deposit while knowing that she can gain instant liquidity by selling the certificate if the needarises.

(ii) the bank knows that it will retain the deposit for the full termbecause the depositor can meet a liquidity shortage by selling thecertificate.

(b) In effect the CD is more liquid that the simple time deposit, since it canbe sold in the market we are discussing. One would expect depositors topay for this advantage and therefore the rate of interest on CDs isusually slightly lower than the interest rate on the simple time deposit ofthe corresponding maturity. This means that the bank also benefits bygetting a fixed-term deposit for a slightly lower rate of interest than itwould have had to offer for a simple time deposit.

When it come to pricing a CD, we shall apply the universal principle in [2.1].But we need to know some of the characteristics of the instrument first. Theunderlying asset is a bank time deposit of given maturity. We shall assume 182-days (six month) initial maturity. This will pay a rate of interest (known as thecoupon rate) which is usually (but not always) fixed at the outset. Thus,compared with a TB, the first thing we must do here is to calculate what thematurity value will be. We can find this by:

M = D × (1 + c.nim) [2.9]

where M is the value of the deposit at maturity, c is the coupon or interest rateand nim is the initial maturity expressed as a fraction of a year. Notice that thisis one of the few cases where we use initial maturity in a calculation. Once wehave found M we can price it by using [2.1], as in learning activity 2f.

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(a) Find the value of a newly-issued six month CD for £100,000 where theagreed interest rate on the deposit is four per cent and the yield onother CDs in the market is 3.9 per cent.

(b) How do you interpret the price of the CD when compared with thevalue of the underling time deposit?

(a) Step 1: find M using [2.9]. M = 100,000 × (1+ (0.04 × 0.5)) = 100,000 × 1.02 = £102,000

Step 2: find the PV of £102,000 in six months discounted at 3.9 per centusing [2.1]

1 102,000102,000

(1 + (0.039 × 0.5)=

1.0195= £100.049

(b) The difference in value between the CD and the underlying deposit is£49. This slightly higher value has been caused by discounting at 3.9 percent when the time deposit was earning four per cent. The difference inthe two interest rates is saying that, other things being equal, investorswould rather have the CD because of its greater flexibility. The £49represents the price that they are prepared to pay for this.

In the case of our treasury bill we saw that its value increased as the residualmaturity shortened, other things remaining unchanged, and we established thisas a general principle. We can show this for our CD as well by, say, looking atits price after three months have passed. We do this in learning activity 2g. Butwe also want to show another general principle in the pricing of assets, namelythat their price will move inversely with interest rates. This should be obviousfrom [2.1] since the term i incorporates an appropriate rate of interest and a riskpremium and it appears in the denominator. Even so, it is worth seeing theeffect.

(a) Recalculate the price of the CD in learning activity 2f when there arethree months left to maturity.

(b) Suppose that market interest rates fall by 50 basis points on the dayafter your calculation. What is the value of the CD now?

(c) What is your interpretation of these two changes in price?

(a) 1 102,000P = 102,000

(1 + (0.039 × 0.25)=

1.00975= £101,015.10

The price has risen by £966.10.

31Copyright © 2010 University of Sunderland

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(b) For simplicity, we shall leave the residual maturity at 0.25 (strictly, itshould be 0.247). Then we have:

1 102,000P = 102,000

(1 + (0.034 × 0.25)=

1.0085= £101,140.30

The price has risen by £125.20

(c) The price of the CD rises as time passes because the investor has to waitless time for the benefit paid on the time deposit. (Instead of earning£2000 in six months, he or she will gain the £2000 in three months.)The shorter time horizon is worth paying for. The further rise in the valueof the CD when market interest rates fall is explained by the fact thatthis CD buys the right to £2000 in three months (the result of a four percent coupon rate) while £2000 in three months is no longer availablewhen market interest rates fall since new time deposits will be payingonly 3.5 per cent.

Repurchase agreements

A repurchase (or ‘repo’) deal is a short-term securitised (or ‘collateralised’) loan.The collateral takes the form of some readily tradable asset (usually governmentbonds, known as gilts in the UK) which the borrower sells to the lender for aspecified period with the promise to repurchase on a set future date at a setprice. The repurchase price is higher than the initial sale price and this differenceis the interest paid from borrower to lender. This can be seen clearly in [2.10]:

i =PR – PS

PS.nm[2.10]

where i is the rate of interest, PS is the sale price, PR is the repurchase price andnm is the term to maturity as a fraction of a year. In practice the sale price, PS,is usually rather less than the market value of the bonds or other collateral.This difference, known as a ‘haircut’, provides additional protection to thelender.

By way of illustration, suppose that Citibank sells £5 million-worth of USgovernment bonds to the Federal Reserve with a promise to repurchase in 30days for $5.03 million then the interest rate is:

d =5 .03 – 5

=0.03

= 0.0719 ≈ 7.2%5 × 30 0.4167

360

(Notice that a year is 360 days.) It is a fairly simple task to re-arrange [2.10] inorder to find the repurchase price, corresponding to a particular rate of interest,given the sale price.

PR = PS + i.PS.nm [2.11]

And we can re-arrange [2.10] to find the sale price, given the repurchase priceand other terms:

1PS = PR 1 + i.nm

[2.12]

The expression [2.12] is useful since it allows us to show that repo deals followthe rules that we have laid down for other assets. The price, PS, converges on

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PR as nm tends to zero while the price varies inversely with interest rates.Furthermore, expression [2.12] shows us that we are discounting the repurchaseprice by [2.1]:

1PS = PR 1 + i.nm

[2.12]

Pricing instruments in a supply anddemand frameworkLet us see now if we can convert this discussion of pricing into the familiardemand supply framework. In Figure 2.2 we show the market for treasury bills,though it could as easily be the market for commercial paper, or CDs or anyother money market instrument. This is the market for existing TBs, or whatis sometimes called the secondary market. However, the price (and return) fixedin the secondary market similarly fixes the price and return in the primary ornew issue market, since new issues will only be held if they match the termsoffered by existing TBs. Since we are looking at the existing stock of TBs, thesupply is fixed and this is shown by the vertical supply curve, S. (This curve willshift to the right whenever the flow of new issues exceeds the number ofmaturing bills and vice versa.)

The demand curve, D, is shown downward-sloping since, as we have just seen,a lower price means a higher return and we assume, other things being equal,that the demand for any asset increases with its rate of return.

Figure 2.2: The bill market

In order to draw a market diagram we have to decide exactly what TBs we arelooking at. Strictly speaking, each size of treasury bill and each maturity is aseparate market, though obviously bills of different size and maturity will beclose substitutes for one another and a change in one market will be felt instantlyin markets of adjacent maturity and size. In this illustration we shall assume thatwe are looking at three-month TBs for £1 million like the example at thebeginning of section 2.2. The diagram shows that, initially, the equilibrium priceis £987,500 and this is because the return (expressed here as a rate of discount)is five per cent. Now suppose that interest rates fall by 100 basis points and that

33Copyright © 2010 University of Sunderland

( )

2.3

Recommended reading: ‘Money Markets’ in Howells and

Bain (2008 and 2007) and Piesse,Peasnell and Ward (1995).

mar

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m

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, %

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0.9900

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Unit 2 Money markets – functions and operations

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this includes all money market rates. This means that existing TBs becomesuddenly more attractive. Demand switches from other money market assetsoffering four per cent. The demand for TBs increases, shown by the shift of D toD’. The increase in demand will cease when the price (and return) have adjustedto the new conditions. If the new conditions mean a TB discount rate of four percent, then we can calculate the new equilibrium price:

P = £1m – 0.04 (1m × 0.25) = £990,000

What this discussion tells us is that the formulae and pricing techniques that wehave looked at in section 2.2 all operate on the demand side of the market.They explain the equilibrium or ‘fair’ price that investors are willing to pay.The supply side of the market is given. It is the stock of assets that is already inexistence. Thus, when we talk about a change in interest rates leading to achange in asset prices in the opposite direction, this is shorthand for saying thechange in interest rates has an effect on the demand for assets such that thedemand curve shifts until a new equilibrium price emerges.

The users of money marketsRemember that money markets are a source of short-term finance. Wheremoney market instruments are being traded between third parties – all the itemsin Figure 2.1 except bank deposits – must be of reputable quality. This meansthat the issuers of the bills must be known entities that are trusted byparticipants in the market. This means that the instruments will be issued bygovernment, banks and other financial firms and large corporations. They willnot be issued by households or the personal sector.

This means that money market instruments are not only highly-liquid (as wesaw in section 2.1). They are also of large denomination, upwards of £100,000in the UK. This means that money market instruments are not widely held bythe personal sector either – they are too large. There are some ‘money marketmutual funds’ which take savings from households and invest them in themoney markets so that the personal sector has an indirect holding throughholding units in these mutual funds. But this still means that money markets aredominated by large organisations, including mutual funds.

We made the point in section 2.1 that money market instruments of any givenmaturity have very similar rates of return. This is because the issuers of theinstruments (the borrowers) are all of lowish risk – ranging from virtually risk-free in the case of government to low risk in the case of major banks (until2008 at least) and large corporations. Given the participants in these marketswe can add that rates will move quite closely together because the traders willbe well-informed professional dealers. This means that a ‘shock’ to rates in oneof the markets will be quickly transferred to all others. This is immenselyimportant since it means that any central bank with sufficient presence in themoney markets should be able to influence the general level of low-risk short-term interest rates by virtue of its own transactions.

This exactly what happens in most developed economies. In spite of the factthat economics textbooks are still fond of showing central banks controlling thequantity of money (usually through changes in the size of the monetary base),in practice central banks allow the quantity of money to be demand-

34

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2.4Recommended reading:

‘Money Markets’ in Howells andBain (2008 and 2007) and Piesse,

Peasnell and Ward (1995).

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determined. The money supply is endogenous. What central banks do insteadis to set the rate of interest at which they refinance past loans (and make newloans) of reserves to the commercial banking system.

Briefly, it works like this. Commercial banks operate on the basis of a fractionalreserve ratio. This means that they hold reserves (note and coin and depositswith the central bank) that are only a very small proportion of their customerdeposits. However, these reserves are absolutely essential to protect banks fromthe possibility of unforeseen net withdrawals of cash by customers. Hence thisratio must be maintained very carefully and as banks expand they will needadditional reserves. The quantity of reserves can always be ‘topped up’ byborrowing from the central bank. It can add to commercial bank deposits justas your bank can add to your deposits if you ask for a loan. These reserves aresupplied on demand. There is no quantity constraint. But there is a price andthis is set by the central bank as its policy rate. In the UK it is set by the Bankof England’s Monetary Policy Committee (MPC) (Bank, 2009); in the USA itis done by the Federal Reserve’s Open Market Committee (Fed, 2009) and atthe ECB it is done by the Governing Council (ECB, 2004 chapter 1).

The argument is that banks with accounts at the central bank have the optionwhen searching for reserves of bidding in the interbank market or borrowingfrom the Bank of England (BoE). Provided that commercial banks’ presence inthe interbank market is large enough, then the rate charged on reserves by thecentral bank must affect interbank rates and then (see section 2.1) all othershort-term rates.

The way in which this is commonly done is to establish what is called a‘corridor’ system. We shall describe the system as it has worked in the UK sinceMay 2006 but other systems are very similar. Banks are required to maintain atarget level of reserves (including deposits at the Bank of England). Providedthat this target is met (a small margin of error is allowed and the target is anaverage over a month) then the deposits at the BoE earn interest at the rate seteach month by the MPC. Reserves can be held in excess of the target but theseearn interest at MPC rate − one per cent; a shortage of reserves can be overcomeby borrowing from the BoE at MPC rate + one per cent (and these borrowedreserves do not earn the MPC rate). The BoE then conducts repo deals, at therate of interest set by the MPC, in order to help the banks maintain the centraltarget. As this rate changes, the whole structure of rates at the BoE shifts sincethe other rates are calculated from the MPC rate. Suppose, for example, thatthe MPC announces an increase in the policy rate from three to 3.5 per cent atits May meeting. We shall see in a moment how it changes its repo deals tomake this effective but first let us see what this does to interest rates moregenerally. Figure 2.3 may help.

Before the increase, commercial banks can deposit excess reserves at the BoEat two per cent and borrow from the BoE at four per cent. After the increase,the deposit rate is 2.5 per cent while the borrowing rate is 4.5 per cent. Imaginenow a commercial bank that wants to supplement its reserves. Before theincrease it could have gone to the BoE and paid four per cent or it could havepaid the going rate in the interbank market if that were less. Since they are closesubstitutes, we would expect the rates to be very close indeed. Now the officialrate has increased, borrowing from the interbank market will almost certainly

endogenous

fractional reserve ratio

35Copyright © 2010 University of Sunderland

Unit 2 Money markets – functions and operations

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be cheaper. But the additional demand for interbank funds will tend to pushinterbank rates up towards the new BoE lending rate. At the same time, therewill be changes at the lower band. Banks with a surplus might have depositedwith the BoE at two per cent or in the interbank market (at a very similar rate).Now that the official deposit rate is 2.5 per cent, banks with a surplus willswitch from the interbank market to the BoE, draining funds from theinterbank market and again tending to raise interbank rates. Hence interbankrates are pushed up by increasing demand for loans and a reduction in deposits.This is a process known as arbitrage and it shows how the BoE’s action on itsofficial or policy rate, is communicated to LIBOR rates and from there to othershort-term rates. Amongst the other short-term rates will be the rate chargedon commercial bank loans. Credit becomes more expensive, fewer peopleborrow, others increase their savings. These and other reactions lead to areduction in aggregate demand. This is the form that a restrictive monetarypolicy takes in the twenty-first century.

In order to see how this change in the central (or ‘policy’ or ‘MPC’) rate isimposed we need to go back to our discussion of repo deals. If we go back to[2.10] we can see how the rate of interest is related to the other features of thedeal.

i =PR – PS

PS.nm[2.10]

In Figure 2.3, the Bank of England initially sets a policy rate of three per cent.It does this by virtue of repo deals of various maturities, all priced to give aninterest rate of three per cent. Since 14 days is one common maturity for thesedeals we shall use that and we shall suppose that the sum lent by the BoE is£100 million per deal. This is the ‘sale price’ or PS. Using [2.11] we can find therepurchase price that the BoE needs to set to make three per cent effective:

PR =100 million+0.03(100 million)0.0384=100.1152 million or £100,115,200

Then, in May the MPC decides to raise the policy rate to 3.5 per cent. Learningactivity 2h invites you to find the new repurchase price that the Bank will haveto insist on in order to raise the rate.

Figure 2.3: The Bank of England’s corridor system

3.53.0

April May

Bank

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Find the repurchase price that a UK policymaker must set if it wishes to use14-day repo deals for £100 million to make a policy rate of 3.5 per centeffective.

Using the data from the three per cent example in the text and substituting0.035 for the interest rate we have: PR = 100 million + 0.035(100 million)0.0384 = 100.1344 million or £100,134,400

Table 2.1 shows a number of money market interest rates for three recentdates.

End-June End-June End-Sept 2007 2008 2009

Three-month LIBOR 5.96 5.91 0.58

Three-month gilt repo 5.82 5.2 0.43

Three-month CDs 6.08 5.91 0.48

Three-month treasury bills 5.77 5.1 0.4

Policy rate 5.5 5.0 0.5

Table 2.1: Money market ratesSource: Bank of England Interactive ‘Interest and Exchange Rates’ at:<http://www.bankofengland.co.uk/statistics/index.htm>

1. What happened to money market interest rates, in general, over theperiod?

2. How would you explain this?

3. Calculate the difference between the highest and lowest rates at eachdate. Do you notice anything?

4. Look at the ‘spread’ (the difference) between policy rate and LIBOR ateach date and comment on what you see.

5. Arrange the rates in descending order (highest rate first) at each date.Do you see any pattern? If so, how would you explain it?

1. Over the period money market rates fell quite sharply, from around sixper cent at end-June 2007 to about 0.5 per cent in September 2009.

2. The policy rate was reduced from 5.5 per cent to 0.5 per cent. Thisreflects the Bank of England’s loosening of monetary policy to try tostimulate aggregate demand to limit the depth of the recession thatbegan at the beginning of 2008. Section 2.4 shows how the

37Copyright © 2010 University of Sunderland

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policymaker can do this by trading in very short-term gilt repos. Section2.1 also explains that money market rates move closely together and sowe see the policy rate coming down to 0.5 and other rates followingvery closely.

3. The difference between highest and lowest rates was 0.58 (= 6.08 −5.5) in June 2007; 0.91 (= 5.91 − 5.0) in June 2008 and 0.18 (= 0.58 −0.4) in September 2009. Firstly, it is clear that the range is always quitesmall (less than 100 basis points). This is what we would expect whenwe look at a range of very similar instruments. But it is also clear that therange is very small in 2009. This is also what we would expect. With theaverage rate around about 0.5 per cent, the range must also be small.What is also noticeable is that the range is largest in June 2007. Lookingcarefully at the figures we can see that this is because the policy rate hascome down (from 5.5 to 5.0) and this is largely reflected in the interestrates on government debt (gilt repo and treasury bills) but the rates oncommercial or private sector debt (CDs and LIBOR) are little changed.

4. In June 2007 the spread is 0.46 (5.96 − 5.5), in June 2008 it is 0.91(5.91 − 5.0), in September 2009 it is 0.08. If we had a longer run ofdata we would see that the LIBOR-policy spread is normally about 0.1 or10 basis points. So, the spread in September 2009 is more or less‘normal’. What is truly remarkable is the gap of 0.91 (5.91 − 5.0) in June2008. As we said in (3) above, this arose because the Bank of Englandbegan cutting the official rate in late 2007 but to begin with LIBORscarcely changed. We commented in section 2.4 that this underminedthe effectiveness of monetary policy since market rates in general werelinked to LIBOR and so long as LIBOR was reluctant to change, thenother market rates remained stubbornly high.

5. CD rates and LIBOR rates tend to come at the top of the rankings;treasury bills and gilt repo at the bottom. Remember that LIBOR and CDrates are rates on bank deposits. Banks are private firms andconsequently they are exposed to a degree of risk. This risk was seen asespecially great in the financial crisis of 2008 (which is why LIBOR andCD rates stay high). But treasury bills are government liabilities and giltrepo are loans which are secured on government liabilities. These areregarded as virtually risk-free and this difference in risk is reflected inrates of return.

Self-assessment questions2.1 How do money markets differ from capital markets? Who are the main

users of capital markets?

2.2 What is the difference between money market instruments quoted on a‘discount basis’ and on a ‘yield basis’? Suppose that one month CDs andone month treasury bills are both quoted as having a rate of return offour per cent. Which gives the higher return to an investor.

2.3 Suppose that short-term interest rates are currently five per cent and thatyou deposit £200,000 with a bank in exchange for a three-month CDpaying five per cent. Suppose now that after one month, a liquidity crisisforces you to sell the CD and that interest rates at that point have risen to5.25 per cent.

Feedback

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(a) What price would you get for the CD?

(b) What effect has the rise in interest rates had on its value (hint:compare with its value if interest rates had been unchanged)?

2.4 Looking at Figure 2.2, assume that three-month UK treasury bills for £1million are trading at five per cent and a price of £987,500 (the originalequilibrium). Imagine now that the UK Government issues a very largenumber of new treasury bills. How would you show this in the diagramand what might the results be?

2.5 Suppose that the Bank of Japan becomes worried about a build up ininflationary pressure in the economy.(a) Explain what it might do with respect to the policy rate of interest

and why.(b) Work an example to show how the Bank of Japan might change the

repurchase price of one-month repos for ¥500 million in order toraise the policy rate from three to 3.25 per cent.

Feedback on self-assessment questions2.1 Money markets are markets for instruments, which permit short-term

lending and borrowing. There is no strict definition of ‘short-term’ butone year is a widely accepted upper limit. Capital markets are markets forinstruments, which permit lending and borrowing for longer periods. Theultimate borrowers in money markets are governments and large corpora -tions and the main ultimate lenders are large corporations. In addition tohelping ultimate lenders and borrowers, a lot of money market activityinvolves financial institutions lending to and borrowing from each other.The clientele of these markets is thus rather restricted and this is reflectedin the instruments traded, which usually have a large minimumdenomination. The personal sector has virtually no direct involvement inthe money markets.

2.2 When instruments are quoted ‘on a discount basis’, the gain is expressedin relation to the total sum received at maturity. When instruments arequoted ‘on a yield basis’ the gain is expressed in relation to the sumoriginally invested. Hence a four per cent discount is ((100 − 96)/100); thecorresponding yield calculation would be ((100 − 96)/96), which will beslightly more than four per cent. Four per cent as a conventional yieldwould be (104 − 100/100). So if both are quoted as giving a return offour per cent then the TBs are giving a slightly better return.

2.3 You need to calculate the market price of a three-month CD for £200,000with a five per cent coupon, with two months left to maturity with interestrates unchanged (at five per cent) (for (b)) and with interest rates at 5.25per cent (for (a)).

(a) the answer is £200,743. We calculate this in two stages. Firstly wecalculate the maturity value which is:

M = 200,000 × (1 + 0.05(0.25)) = 202,500

Then we discount this in the normal way:

202,500 202,500P =

(1 + 0.0525(0.1666) =

1.00875 = 200,743

39Copyright © 2010 University of Sunderland

Unit 2 Money markets – functions and operations

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(b) Without the interest rate increase the price would have been

202,500 202,500P =

(1 + 0.05(0.1666) =

1.0083 = 200,833

a difference of £90.

2.4 If the Government issues new treasury bills (in excess of the bills that arematuring) the stock will increase. This is shown by a rightward shift of thesupply curve, S, in Figure 2.2. The diagram suggests that this rightwardshift will mean that prices will fall and the return increases. This seemsreasonable since we would expect that in equilibrium investors areholding the current stock on just those terms that they find attractive. Ifthey are to hold more, then these must be more attractive. They mustoffer a bigger discount to their maturity value and therefore offer a higherreturn.

(a) If the Bank of Japan is concerned about the build up of inflationarypressure it will ‘tighten’ monetary policy. In most countries thepolicy instrument is a short-term rate of interest and so a tighteningof monetary policy means increasing this rate of interest in order toreduce the level of aggregate demand.

(b) If the current rate of interest is three per cent, then one month ¥500million repos must have a current repurchase price of

PR = 500 million + 0.03 (500 million) 0.0833 = 501.2495 million or ¥501,249,500

If the Bank of Japan wishes to raise the rate to 3.25 per cent, then therepurchase price will need to be:

PR = 500 million + 0.0325(500 million)0.0833 = 501.353625 million or ¥501,353,625

SummaryIn this unit we have looked at the characteristics of money market instrumentsand how to calculate prices and yields for a selection of them. We have seenwho the participants in money markets are and how the trading of moneymarket instruments can be fitted into a supply and demand framework. Havingstudied this unit, you should now be able to:

■ explain the characteristics of money market instruments as a group

■ price instruments which are reported on both a discount and a yield basisand show the connection between price and rate of return

■ show how the pricing of money market instruments can be interpreted asthe outcome of the forces of supply and demand

■ identify the main participants in money markets and, in particular, to showhow central banks conduct money market operations in their conduct ofmonetary policy.

2.5

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41Copyright © 2010 University of Sunderland

‘Downgrading of Greek bonds to“junk” raises fear of sovereign

risk.‘

IntroductionIn this unit you will learn what is meant by the expression ‘capitalmarkets’. In particular, we shall look at the trading of bonds. Unit 4 looksat the market for company shares.

Unit learning objectives

On completing this unit, you should be able to:

3.1 Describe the characteristics and uses of fixed interest securities.

3.2 Retrieve and understand data relating to fixed interest securities.

3.3 Price a selection of these instruments.

3.4 Link the concept of duration to the price elasticity of bonds.

3.5 Identify the key users of bond markets and the trading arrange -ments.

Prior knowledge

The unit assumes that you have studied Units 1 and 2. Otherwise, it requires noprior knowledge, but you will find sections 3.2, 3.3 and 3.4 easier if you havesome basic mathematical skills, and familiarity with basic economics is useful forsection 3.5.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008:‘Bond Markets’). In Piesse et al (1995) ‘The Valuation of Financial Instruments’deals with some of the financial calculations that we shall be doing, while ‘BondMarket’ covers institutional features of bond markets. Howells and Bain (2007)chapter 6 also covers much of the material but at a rather lower level. Mishkin2007 ‘Financial Markets’ covers the theory. You will need a calculator and accessto the internet.

Capital markets (I)3Unit

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The characteristics and uses of fixedinterest securitiesCapital markets, and the instruments traded in those markets, are marketswhich channel long-term funds. The instruments have an initial maturity ofmore than five years. ‘Fixed interest markets’ are markets where the instrumentsare bonds. Using ‘fixed interest’ to describe bonds is a bit misleading since somemoney market instruments also pay a fixed rate of interest (see Unit 2) andsome bonds actually pay a variable rate. Nonetheless the majority of bonds paya fixed rate and ‘fixed interest’ is widely used to refer to bond markets.

If we begin with simple, or ‘plain vanilla’ bonds, we see that these have a fixedmaturity value and maturity date and they pay a regular coupon which formsthe basis of the rate of return. A bond will usually be described in such a waythat these terms are clear. For example, ‘Treasury 5% 2012’ is a bond that pays£5 per year until it matures in 2012. £5 is the coupon and this is converted toa coupon rate by dividing by the par or maturity value which is always £100in the UK.

Bonds are often classified by residual maturity as follows:

■ <5 years’ residual maturity: ‘shorts’

■ 5–15 years’ residual maturity: ‘mediums’

■ >15 years’ residual maturity: ‘longs’

Variations on the simple ‘vanilla’ bond include:

■ Convertible bonds: carry the option to convert at some point in the futureeither to other types of bond issued by the firm, or more usually to its equity.

■ Floating rate notes (FRNs): pay a coupon which is adjusted in line withsome other, usually short-term, interest rate, such as LIBOR.

■ Index-linked bonds: have their par value uprated periodically in line with aprice index and the coupon payment increased by the amount of the recentchange in the index.

■ Zero coupon (deep discount) bonds: pay no coupon but are issued at asubstantial discount to their maturity value (rather like very long-dated bills– see Unit 2).

■ ‘Strips’: are entitlements to each individual cash flow from a bond (eachcoupon payment and the maturity value) sold at a discount.

Bonds will normally be issued in the domestic currency by firms based in thatcountry. However, bonds can also be issued in the domestic currency by non-resident firms (‘foreign bonds’) and the last twenty years has seen the very rapidgrowth of ‘eurobonds’. These are bonds denominated in a currency which isdifferent from that of the country of issue – US$ bonds issued in Hong Kong,for example. While most foreign and eurobonds will be plain vanilla bonds,they can take any of the various forms that we noted above.

Note that the coupon rate does not tell you the rate of return that you will earnfrom holding the bond. The rate of return will depend upon this (fixed) couponand the price of the bond. The higher the bond price, for a given coupon, thelower the rate of return and vice versa.

3.1

Recommended reading: Howells and Bain (2008) ‘The

Bond Market’; Howells and Bain(2007) ‘The Capital Markets’; ‘The

Bond Market’ (1995) chapters 5and 11; Mishkin (2007) ‘Financial

Markets’.

coupon

coupon rate

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Unit 3 Capital markets (I)

In recent years, it has become quite common for banks to ‘securitise’ some of theirloans (and other assets). This involves creating a portfolio of similar assets andselling this portfolio to another institution that finances the purchase by the saleof bonds. The bank collects the interest from the borrowers and then (afterdeducting a fraction for its own costs and profit) passes on the remainder to thebuyer of the loans, who uses some of it to pay the interest on the bonds. Thesebonds have become knows as ‘asset-backed securities’ (ABS) or ‘collateraliseddebt obligations’ (CDOs). As a rule, bondholders have a prior claim over a firm’sassets in the event of the firm becoming insolvent, In this sense, all bonds areABS/CDOs. But the terms are used to refer to bonds linked to a securitisa tionprocess where the underlying assets are loans rather than, say, physical plant andequipment. Where a firm has issued a range of bonds, their priority in the claimto interest payments and in the event of liquidation is sometimes indicated byterms like ‘senior’, ‘mezzanine’ or ‘junior’ debt.

Although bonds are relatively secure financial instruments, they nonetheless varyin their degree of risk. For large bond issues, the degree of risk is often indicatedby a rating from a credit ratings agency like Standard and Poor’s or Fitch orMoody’s. These use rating scales starting with grades like ‘AAA’ to indicate thevery best quality, down to ‘D’ to indicate bonds that are already in default or havefailed to make interest payments on time. Naturally enough, the riskier the bond,the higher the rate of interest it will pay. In normal circum stances, the differencebetween one risk level and the next would result in a yield difference of about 30basis points (= 30/100 of one per cent). But this can vary. Obviously, if peoplebecome more risk-averse (as during the 2008 financial crisis) these risk premia willbe larger. In more optimistic times they will be smaller.

Finally, the ownership of most bonds is kept on a central register by the issuer ofthe bonds (or an agent appointed for the purpose). This means that bondholderscan be paid the coupon without their having to claim for it. In fact, the term‘coupon’ come from the days when ownership was not registered. Possession ofthe bond itself was the only proof of ownership and this required the owner toclaim interest by detaching a dated coupon attached to the bond and sending itto the issuer for payment. Such bonds are known as ‘bearer bonds’ and manyeurobonds are still of this form.

Why are investors willing to hold bonds paying a four per cent coupon rate,when there are other bonds with five per cent, six per cent, seven per centand higher coupon rates?

The coupon rate tells us nothing about the rate of return on a bond. It tells usthe absolute size of the periodic payment but the rate of return depends onthe price that you pay for the stream of coupon payments. If you pay £100 foran eight per cent bond, your rate of return (ignoring tax and some otherdetails) will be the same as you would get from a four per cent bond for whichyou paid £50. The coupon rate on a bond may indicate something about thegeneral level of interest rates when the bond was first issued (the coupon ratewas probably close to the market rate of interest) but this is not guaranteed,and so the coupon rate (as opposed to the coupon amount) is of limitedconcern. (We see one example of where it matters in section 3.4.)

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Unit 3 Capital markets (I)Unit 3 Capital markets (I)Unit 3 Capital markets (I)

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Understanding the dataData showing bond prices and yields (rates of return) can be obtained frommany sources. Professional traders receive the data in ‘real-time’ from wireservices provided by Thomson/Reuters and Bloomberg. The financial press (theFinancial Times and the Wall Street Journal are examples) publish a selectionof bond price information each day and their own websites often carry moredetail and they are updated during the day. For government bonds (which inmany countries are the largest category of fixed interest securities), informationis often available from the central bank or the ministry of finance or some othergovernment agency. The important data is the same in all cases.

Table 3.1 shows typical bond data for five major corporations whose bondsare listed on the US($) bond market.

Table 3.1: Corporate bond dataSource: Compiled from Datastream

The information that we need (and its location in the table) is as follows:

■ name of the bond issuer (1)

■ maturity or redemption date month/year (2)

■ coupon (3)

■ credit ratings from three major agencies (4)

■ current buy price (5)

■ redemption yield calculated on the buy price (6)

■ change in yield since previous day (7)

■ change in yield over one month (8)

■ yield spread over yield on government bonds (9).

The significance of the first six items should be obvious. The purpose of (7)and (8) is to give us some idea of the bond’s trend or momentum (yield risingor falling). (9) tells us how the market views the risk of the bond whencompared with US government bonds of comparable maturity. A high spreadindicates high risk. The market’s perception of risk is not necessarily the sameas that taken by the ratings agencies in (4). Some reports include recent pricechanges and figures showing the amount of trading in the bond.

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3.2Recommended reading:

Howells and Bain (2008) ‘TheBond Market’; Mishkin (2007)

‘Understanding Interest Rates’.

1 2 3 4 5 6 7 8 9

Citigroup 01/11 6.50 A A3 A + 103.62 3.16 − 0.07 − 0.29 2.92

Morgan Stanley 04/12 6.60 A A2 A 109.10 2.53 − 0.03 − 1.19 1.81

Household Fin 05/12 7.00 A A3 AA – 109.55 2.91 − 0.15 − 0.47 2.19

HBOS Treas UK 06/12 5.50 A + Aa3 AA – 104.56 3.57 − 0.05 − 0.54 2.37

Verizon Global 09/12 7.38 A A3 A 114.22 2.00 − 0.03 − 0.45 0.83

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45Copyright © 2010 University of Sunderland

Read the following extract from The Independent 12.12.09 and answer thequestions below. (Hint: the discussion surrounding Table 3.1 may help you.)

‘After a week that saw the Greek sovereign debt downgraded below theprized A-rating for the first time in a decade, and the worst bond marketcollapse in the history of the Eurozone, Athens was scrabbling to restoreconfidence yesterday. At a two-day EU summit in Brussels, the PrimeMinister, George Papandreou, promised far-reaching cuts in his country’sbloated bureaucracy and an assault on its rampant corruption. LikeBritain, Greece’s problem is its debt – currently running at €300 billion(£270 billion), the highest since democracy was restored in 1974, andexpected to hit 113 per cent of GDP this year and more than 120 percent next. The latest crisis started on Monday when Fitch Ratingsdowngraded Greece by one notch to BBB+, and Standard & Poor’s put iton a “negative” outlook. Fears that it might become the first Eurozonegovernment to default on its debts sent yield spreads on 10-year bondsshooting up to an eight-month high above German equivalents, and byWednesday the Athens stock market was down by nearly 12 per cent.’

1. What does the report mean when it says that ‘Greek sovereign debt[was] downgraded...’?

2. What does the report mean when it says that these events caused yieldspreads on 10 year bonds to shoot up to an eight-month high aboveGerman equivalents and what is the link with the downgrade?

3. Why might cutting the country’s ‘bloated bureaucracy’ help to solve theproblem?

1. This is a reference to actions of the ratings agencies in column (4) ofTable 3.1. We are told later that the Fitch agency moved the rating downto BBB+. Many western governments have top ‘AAA’ ratings (orequivalent) and it would be very unusual for a government in theEurozone to have a rating which was not somewhere in the A category.

2. We expect return and risk to move together. Hence if a ratings agencygives a bond a lower rating (meaning higher risk) we would expect theyield in column (6) of Table 3.1 to rise. This occurs because the bond’smarket price (5) falls. In Table 3.1 column (9) tells us the differencebetween the yields on these corporate bonds and the yield on (perfectlysafe) US government bonds. The report does the same except that ituses the safest bonds in the Eurozone as the basis of comparison andthese are German government bonds. The report does not give us thespread but says that it jumped to an eight-month high.

3. Here we must be careful to distinguish between ‘debt’ (the outstandingstock of bonds which has accumulated as the result of past borrowing)and the current ‘deficit’ (the difference between this year’s governmentspending and income which will have to be financed by new bond issueswhich add to the existing stock). As regards the stock, the report saysthat it is currently equivalent to 113 per cent of GDP and will be morethan 120 per cent next year. This growth is the result of the current

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deficit, so if the growth rate of the debt is to be brought down, thencurrent deficits must be smaller. This can only be done by somecombination of reducing government spending and generating moreincome. The report suggests that Greece should start by reducingemployment in the public sector.

Figure 3.1: Treasury 6.25% 2010, 1998–2009Source: Office for National Statistics, Interactive Database, IDKX

Figure 3.1 is typical of any chart showing bond prices. In this case it shows theprice of a government bond called ‘Treasury 6.25 2010’ from 1998 to 2009.The term ‘Treasury’ indicates that it a government bond, ‘6.25%’ tells us thatthe annual coupon is £6.25 and it matures in 2010. In the next section we shallsee that the cause of price fluctuations is changes in interest rates and thatinterest rates and bond prices move in opposite directions. However, if we lookcarefully at the chart, we see that the price of this bond was falling during 2009when interest rates were unchanged (but very low). This reminds us that theprice of any asset must eventually converge on its redemption value since theonly value that it has at the end is its redemption or maturity value. For a UKgovernment bond, that is £100.

Pricing fixed interest securitiesIn this section we look at the pricing of bonds and how prices and yield (orrate of return) are connected.

PricesAs with any other asset, the price of a bond should correspond to the presentvalue of the future income stream and this is found by discounting the streamof payments in a suitable way. As always, ‘suitable’ means using a discount ratewhich recognises the rate of return on assets of similar risk (the ‘market rate’)and takes account of the time at which the payment is due. Remember that forsome bonds the final payments could lie a long way in the future. The generalexpression for finding the price is:

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90

95

100

105

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Pric

e (£

)

1998

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JUL

2000

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3.3Recommended reading:

Howells and Bain (2008) ‘TheBond Market’ Mishkin (2007)

‘Understanding Interest Rates’;Howells and Bain (2007) ‘Capital

Markets’; Piesse (1995) ‘TheValuation of Financial

Institutions’.

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P ∑ = Ct + M [3.1](1 + i)t (1 + i)n

This tells us that we find the price by discounting each of the coupon paymentsand the maturity value. We then sum these discounted values. Notice that eachpayment is discounted by:

1(1 + i)t

where t represents the time at which the payment is due. But the final payment,the maturity value, is discounted by:

1(1 + i)n

where n is the total number of periods in the sequence – the number of periodsfrom the time of purchase until the bond matures. Suppose therefore that wewere looking at the price of a five per cent bond maturing on 31 October 2012and that we were looking at this on 1 November 2009 (so that we can ignoreaccrued interest). If the going rate of return on similar assets is four per cent,then we have:

5 5 5 100P =

(1 + 0.04) +

(1 + 0.04)2 +(1 + 0.04)3 +

(1 + 0.04)3 [3.2]

≈ 4.81 + 4.62 + 4.44 + 88.88 ≈ £102.75

Notice that the effect of discounting the future cash flows is that what we callthe ‘present value’ of those cash flows is less than their face value. The facevalue in [3.2] is 5 + 5 + 5 + 100 = £115 while the present value after discountingis £102.75. Why do we make this adjustment? We do it because of what issometimes called ‘the time value of money’. This is just a formal way of sayingthat any payment received now is worth more than the same payment receivedat some time in the future; in other words, waiting for the payment reduces itsvalue. First thoughts might suggest that the value is reduced as a result ofinflation. Inflation certainly does reduce the real value of future payments buteven with zero inflation, future payments are worth less than if they werereceived immediately. Inflation merely increases the effect. The key to theexplanation is that if we had the payment now (instead of in the future) thenwe could invest the payment immediately and earn interest on it for the periodthat we would otherwise have been waiting. And the rate of discount representsthe rate of return that we forego by waiting. That is why it is important tochoose a rate of discount which incorporates the basic or risk-free rate ofinterest as well as a risk premium that reflects the riskiness of the asset inquestion. It is not appropriate to discount payments from a low risk investmentby a rate which assumes that we could have earned a much higher return byinvesting the payments in a much riskier asset. If inflation is positive, then thediscount rate must also include an inflation premium. (In fact, this will normallybe already incorporated in market interest rates.)

The calculation in [3.2] is not difficult to do (and a spreadsheet like Excel hasbuilt-in functions that make it very fast and easy). But if we are using a handcalculator, and if we are pricing a long-dated bond and if we remember thatthere should be two coupon payments per year then finding the price by [3.1]could be very slow and difficult. Fortunately, we can simplify by using:

47Copyright © 2010 University of Sunderland

n

t = 1

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C 1 MP = i

1 –(1 + i)n +

(1 + i)n [3.3]

which has the advantage that we have to do only one calculation in which weraise (1 + i) by some power (though n could be large). If we then wish to modifythis to take account of coupon payments in half-yearly instalments, we have:

C 1 MP = i

1 –1 + i

22n +

1 + i2

2n[3.4]

By way of illustration, we can take our five per cent, three-year bond from amoment ago, assume that it pays half-yearly coupons and assume again that weprice it immediately after the payment of a coupon. Then, n = 3 and 2n = 6.

5 1 M 1 100P = 0.04

1 –1 + 0.04 6 +

1 + 0.04 6 = 125 1 –(1 + 0.02)6 +

(1 + 0.02)6

2 2

1 100= 125 1 –1.126

+ 1.126

= 125 [1 – 0.888] + 88.81 = 14 + 88.81 = £102.81

[3.5]

Compared with our earlier result, this is very close (102.75 against 102.81).The reason for the difference is that by paying the coupon in half-yearlyinstalments we bring forward the cash flow very slightly and thus make itsubject to a very slightly reduced discounting effect.

The next thing we need to understand about bonds is that they have a cleanprice and a dirty price. So far, we have calculated the ‘clean’ price. Thedifference arises because of the way in which bonds pay interest. As we know,they pay a fixed coupon and they do this most commonly by paying one halfof the coupon twice a year. One of those coupon payments will occur on theday/month scheduled for its maturity. This means that one could buy a bondand wait 180 days for payment, or one day, or anything in between. Clearly,waiting 180 days for a payment of £4 (say) is much less attractive than waitingone day for it. Consequently, the seller of a bond which is close to the couponpayment day will expect to receive a higher price than the seller of the samebond in identical circumstances who sells with 180 days to the next coupon.This higher price compensates sellers for the fact that they may have done mostof the waiting for a coupon which will eventually be paid entirely to the buyer.The dirty price of a bond includes this accrued interest; the clean price ignoresit.

Imagine a bond that pays half the coupon at six-monthly intervals. Can youthink of a way in which the price of the bond might be adjusted betweencoupon payment days in order to provide a fair price to the buyer andseller?

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[

( )

( ) ( )

( )[ ]

]

[ ]

[ ][ ]

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dirty price

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49Copyright © 2010 University of Sunderland

One way might be to divide the coupon by 182 days and add 1/182 of thecoupon to the bond price for every day of the coupon payment cycle. Thismeans that the seller of a bond with one day left to go would receive aprice which included 181/182 of the next coupon payment’.

The adjustment of a bond’s price to reflect the sale date within the couponpayment cycle is known as the adding of accrued interest − as shown in learningactivity 3c. Adding accrued interest to the clean price gives us the dirty price.Hence:

Pd = Pc + AI = Pc + AI =C nlc [3.6]2 182

where nlc is the number of days since the last coupon payment. Notice that inthe UK we use 182 days as the measure of a half-year (= 365 ÷ 2). As with themoney markets we discussed in Unit 2, so with bond markets – differentcountries use different definitions of a year.

Imagine a six per cent bond which pays its coupon in two equal parts at sixmonthly intervals. It will mature on 12 September 2017. Suppose that thisbond is sold on 30th September 2010. Find the difference between theclean and dirty prices.

The difference between the clean and dirty prices will be the accruedinterest and this will be found as:

AI =6 17

= 3(0.093) = 0.28 or 28p.2 182

Since accrued interest is a matter of simple arithmetic, when we talk about thepricing of bonds we are usually thinking of the ‘clean’ price. It is this price thatis going to be affected by economic or financial events such as a change ininterest rates or the degree of investors’ risk aversion or their perception of riskin the economy at large or simply in the bond issuer and so on. When weobserve lists of bond prices, more often than not they will show clean priceseven though we would actually have to pay the dirty price if we chose to buy.

Fortunately it is a simple task to add accrued interest. Suppose that, instead ofbuying the bond on 1 November 2009 we delayed it until 2 January 2010, thenall else would be unchanged but the seller would be entitled to a higher priceto compensate for the interest earned (‘accrued’) between 1 November and 2January. Firstly the formula:

C 1 M C nlcP = i

1 –1 + i

22n +

1 + i2

2n + 2 182

[3.7]

followed by the calculation which is £102.81 + 2.05(62/182) ≈ £102.81 + 0.70= £103.51.

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Using [3.5] find the clean price of our five per cent three-year bond if therate of interest had been three per cent (instead of four per cent), all elseunchanged. What do you notice?

5 1 M 1 100P = 0.03

1 –1 + 0.03 6 +

1 + 0.03 6 = 125 1 –(1 + 0.015)6

+ (1 + 0.015)6

2 2

1 100= 166.7 1 –1.093

+ 1.093

= 166.7 [1 – 0.915] + 91.46 = 14.17 + 91.49

= £105.66 [3.8]

As a result of the fall in interest rates from 4 to 3 per cent, the price of thebond has risen from £102.81 to £105.66, a change of £2.85

So far we have seen that bonds are relatively low risk instruments since theirpayments are fixed and they have a fixed maturity value. Indeed we shall seein the next section that if you buy a bond and hold it to maturity, you have aguaranteed income stream. Apart from the possibility, the only risk the investorfaces is that of needing to sell the bond prior to redemption at a time wheninterest rates are high. In these circumstances, there is a good chance that thebond will be worth less than the purchase price and the seller will incur a capitalloss. What we have not seen yet is that the size of the effect on bond prices ofa change in interest rates varies with the characteristic of the bond. The keycharacteristic is the period to maturity. Roughly speaking, the longer the periodto maturity, the more sensitive are bond prices to interest rate changes. Wecome back to this in section 3.4. If you want a proof and an illustration of thiseffect, you will find it in an appendix at the end of this unit.

YieldsAs most textbooks will show the ‘yield’ on a bond can take a number of forms.The simplest is called ‘interest’ or ‘running’ yield. This is calculated by takingthe coupon payment and dividing by the clean price of the bond:

interest yield =C

[3.9]Pc

Of all the forms that ‘yield’ can take, simple yield shows most clearly that priceand yield must be inversely related.

Look at our calculation of bond prices in [3.5] and [3.8]. Calculate thesimple yield in each case and compare the results.

( ) ( ) [ ]

[ ][ ]

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51Copyright © 2010 University of Sunderland

For 3.9 the calculation is5

= 0.0486 or 4.86 per cent102.81

For 3.10 the calculation is5

= 0.0473 or 4.73 per cent105.66

Notice that the simple yield varies inversely with the price of the bond and islower than the coupon rate because the market price in each case is abovethe par value of £100.

The problem with interest yield is that it is a very poor guide to the rate ofreturn that a bondholder will receive if the bond is held to maturity. Forexample, if you bought the bond at, say, £102.81, and held it to redemption(£100) you would earn 4.86 per cent only by ignoring the fact of an eventualcapital loss of £2.81. You could, of course, hope to sell the bond again beforematurity for the same price that you paid. In this case, simple yield would bean accurate measure of your return, but if you plan to hold to redemption then,strictly speaking, you should find a way of spreading this £2.81 loss over thesix-year period. The effect will obviously be to give a yield which lies below thesimple yield. The easiest way to take some account of the loss is to calculate thesimple yield to maturity. The method is shown in [3.10]:

simple yield to maturity = C + 100 – P [3.10]P nm × P

where C is the coupon, P the clean price and nm is the period to maturity (inyears). A quick glance at the formula shows us that what we do is to take thesimple yield and then calculate the capital gain/loss (= 100 – P) which we spreadover the remaining years and turn into an annual percentage. We then add thispercentage gain/loss to the simple yield.

However, the normal way of expressing the yield on a bond is to quote theredemption yield. In principle, this is similar to the simple yield to maturity in thesense that it assumes that the investor holds the bond to redemption and musttherefore take account of the capital gain/loss. The redemption yield is theinternal rate of return that makes the discounted values of the bond’s cash flowsequal to the dirty price, Pd . If we let ry stand for redemption yield then findingthe redemption yield requires us to solve for it in the following expression.

1 2 MPd =(1 + 12 ry) ntc

× ∑ (1 + 12 ry)t +(1 + 12 ry)Q–1

182

where ntc is the length of time (in days) to the next coupon payment and Q is thenumber of coupon payments to be made before redemption. Unfortunately, this isnot a simple calculation without a programmable calculator, or a spreadsheet(Mishkin 2007, chapter 4). Without this equipment, it can really only be done bytrial and error (or ‘iteration’) combined with a process known as ‘interpolation’.The procedure involves choosing two values for redemption yield that we feelconfident will fall either side of (or ‘bracket’) the true rate. We then solve [3.11] foreach trial value of ry and if we have chosen wisely, we shall have one price aboveand one price below Pd. This completes the trial and error. We then look at thethree prices: the two trial prices and Pd which lies somewhere between the two. Bymeasuring the position of Pd between the two trial prices we can work out where

C

[ ] [ ] [3.11]Q–1

t=0

simple yield to maturity

redemption yield

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to find the correct value of ry between the two trial redemption yields. It is notparticularly difficult but it is time consuming. Care must be taken to ensure thatthe two trial rates really do bracket the true one, first time round. This means nottrying too hard to get the trial rates and prices too close to the true rate/price sincethis carries the danger that both trial rates/prices fall on the same side of the truevalues. In that case we have to start again. Howells and Bain (2008) work someexamples.

Bonds issued by the governments of major western economies are oftendescribed as ‘virtually risk free’. How can that be when the bonds are tradedand can fluctuate in price?

Such bonds are certainly low risk since it is extremely unlikely that the issuerwill default. As a last resort, governments can always raise taxes to find themeans of paying interest and repaying the principle, though this may beunpopular. But the bonds can be made virtually risk free by holding toredemption. This means firstly that the buyer knows for sure what the valuewill be at maturity. The fact that the price may fluctuate in the meantime isirrelevant if the buyer has no plan to sell. Secondly, the yield is also knownwith certainty since the coupon is fixed and any capital gain/loss that arisesfrom the difference between purchase price and maturity value is known atthe time the purchase is made. Thereafter, there is nothing that can happento change the cash flow. The only possible risk is that the rate of inflationmay differ from what was expected. This will cause a change in expectedreal return (unless the bonds are index-linked).

‘Duration’, price elasticity and the termstructure of interest ratesIn the previous section we calculated the price of a three-year bond wheninterest rates were four per cent and three per cent. The price rose from £102.81to £105.66, an increase of £2.85. In the appendix of this unit we show that ifwe do the same for a six-year bond with the same coupon we should find thatthe price changes from £105.24 to £110.95, an increase of £5.71. In thelanguage of economics, the ‘interest elasticity of bond prices’ increases with thebond’s residual maturity. This elasticity is defined (and can be measured) as thepercentage change in price divided by the percentage change in interest rate.Table 3.2 summarises our results.

Maturity P(i=4%) P(i=3%) ΔP %Δi %ΔP Elasticity

3yrs 102.81 105.66 + 2.85 − 25 + 2.77 − 0.11

6yrs 105.24 110.95 + 5.71 − 25 + 5.43 − 0.217

Table 3.2: Interest elasticity of bond prices

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3.4

Recommended reading: Howellsand Bain (2008) ‘The Bond

Market’; Mishkin (2007)‘Understanding Interest Rates’;

Howells and Bain (2007) ‘CapitalMarkets’; Piesse, Peasnell and

Ward (1995) ‘The Bond Market’.

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This characteristic of bonds is important when it comes to assessing their risk.It tells us that bonds which may be identical in all other respects will be subjectto a level of interest rate risk which varies positively with their term to maturity.Hence long-dated government bonds are riskier than short-dated governmentbonds, notwithstanding that both are issued by the same borrower (which hasvirtually no risk of default). Interest rate risk is one element in the term structureof interest rates which we come to in a moment.

Notice that we have been careful to say that the interest elasticity variespositively with maturity, other things being equal. This is because there isanother factor which plays a part and also gives us an important clue as to whyinterest elasticity varies. The other factor is the size of coupon. If we did somemore pricing exercises, we could show that if we priced two bonds with thesame residual maturity but different coupons, the bond with the larger couponwould have the lower interest elasticity.

The key to all this is the concept of duration. Formally speaking, duration isdefined as: ‘the weighted average maturity of a bond where the weights are therelative discounted cash flows in each period.’

This sounds more complex than it really is and Howells and Bain (2008) showhow duration can be calculated and how the result can then be used to calculateinterest elasticity. The intuition is certainly simple enough. The average maturityof a bond simply means the average length of time that it takes to receive all thecash flows. Recall that the cash flows are a series of payments some of whicharrive very soon while some (including the maturity value) are received in thedistant future. This immediately explains why maturity plays a part since (otherthings equal) the longer the residual maturity the longer we have to wait inorder to receive the average of the cash flows. It also explains the role ofcoupon. Other things being equal, a high coupon bond delivers the average ofits cash flows sooner than a low coupon bond, since a low coupon bond paysits largest cash flow (the maturity value) right at the end. So too does a highcoupon bond but it also makes significant payments in the early stages and sothis reduces the average time for the cash flows to arrive.

Notice that although term to maturity is a major component of duration, theyare different things. Provided that a bond pays coupons during its life, then theduration must be less than the maturity of a bond. However, by the samereasoning, a zero coupon bond of the kind we mentioned in 3.1 will have aduration which is equal to maturity. We now turn our attention to the yield onbonds with different terms to maturity and we shall see that duration (andinterest rate risk) play an important role.

The range of yields yield on assets (here bonds) differentiated solely by theirterm to maturity is called the term structure of interest rates. The yields inquestion are the redemption yields we discussed in section 3.3. A very easy wayof seeing the term structure is to plot the rate of interest available on bondswith different terms to maturity. Look at Figure 3.2 which shows the yieldincreasing with term to maturity.

53Copyright © 2010 University of Sunderland

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Figure 3.2: A time-yield curve

The curve in Figure 3.2 is often described as a ‘normal yield curve’. It is a yieldcurve because it shows the yield or rate of return on a range of assets and it isdescribed as ‘normal’ for the simple reason that we do, as a matter of fact, quiteoften see an upward-sloping curve when we plot the yield curve over assetswith different terms to maturity. We might think it ‘natural’ that (other thingsbeing equal) the rate of interest should be higher on assets with longer periodsto maturity but the way in which ‘term’ affects interest rates is not so obviousas it seems at first sight. We look at four possible explanations for the shape ofthe yield curve.

Liquidity premiaOur first thought might be that holders of longer-dated bonds require a liquiditypremium because they are giving up access to their funds for a longer period.(Recall that we saw in Unit 1 that lenders prefer liquidity.) But we shall see in3.5 that there is a very active market for bonds. They are bought and sold inlarge quantities on a continuous basis and therefore holders, even of the longest-dated bonds, can sell them at a moment’s notice. It is difficult, therefore, toargue that any premium can be explained by illiquidity.

The expectations hypothesisThere are other possible explanations of the term structure but in almost allcases there is a problem in explaining the dominance of an, upward-slopingyield curve. For example, the most commonly advanced explanation for asystematic relationship between yields and term, where bonds are concerned isexpectations of future interest rates or the expectations hypothesis. Theargument is that if people expect short-term interest rates to be higher (lower)than they are now, current long-term rates will be above (below) current shortrates; that is, expectations about future changes affect the current structure.Why the present should be influenced by events which have not yet occurredseems rather strange, but learning activity 3h might give you a clue.

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yield %

term to maturity

yield curve

liquidity premium

expectations hypothesis

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55Copyright © 2010 University of Sunderland

Suppose that two year bonds yield four per cent while four year bonds yield5 per cent. Assuming that you are able to invest for a four year period, canyou think of any reason why you would prefer to hold the two year bonds?

If you buy the four year bonds now, you will receive five per cent for each offour years. If you buy two year bonds you get four per cent for each of twoyears and then you can reinvest at whatever the two year rate is in twoyears’ time. Suppose that you think that two year rates are going to risesignificantly in about two years’ time. You might, for example, think thatthey could be around seven per cent. You would be better off by taking thelow two year rate now and being able to take advantage of seven per centfor two years in future.

That clue is that short-term assets will be attractive (and their yields will below) if we think that future short-term interest rates will be higher (and vice-versa). The next paragraph takes you through the argument in more detail.

We assume that most lenders have a choice about the period for which theycan lend or the term to maturity of the asset that they invest in. Suppose thattheir preference is for a five year investment. They can either buy a one yearbond and then buy another when that matures and then buy another and so onfor five years. Alternatively, they can buy one five year bond now. Assume thatthe yield curve is stable. This must mean that bondholders are broadly happywith the current pattern of interest rates and therefore we have an equilibriumposition. (If they were not happy, then there would be a general shift towardsbuying long-dated bonds, or towards buying short, and the yield curve wouldbe changing its shape.) If we have equilibrium, then it follows that investors arecurrently indifferent about whether they invest for a series of short periods orone longer period. If we ask ourselves, ‘in what circumstances would investorsbe indifferent between a series of short-dated assets loans and one long one?’,the answer ought to strike us quickly that they will be indifferent when thereis no difference in the return expected from adopting either strategy. In otherwords, the reward for the long strategy must be equal to what investors thinkthey will get from a series of short-dated assets. The reward for the long strategymust equal the average of the series of short-dated deals. This is where expectedfuture interest rates enter the picture. Since investors can only know the currentshort rate, they have to make an educated guess at likely future short rates. Itis this guess that must be responsible for any observed difference betweencurrent short and long rates. That is, expected future short rates are implicit inany difference between current long and short rates.

Suppose for simplicity that a short loan is for one year and a long loan is fortwo years. Suppose, furthermore, that the current short rate (is) is five per centwhile the current long rate (iL) is ten per cent. If this differential is stable thenlenders are happy with the prospect of what they will earn by lending for oneyear and then renewing at the expected one-year rate compared with what theywould get by lending now for two years. Formally, it must be the case that theyexpect:

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(1 + is) (1 + îs) = (1 + iL)2

where îs is the expected future short-term (one-year) rate.

Rearranging gives us:(1 + is) = (1 + îL)2 / = (1 + is)

Substituting actual values gives:

(1 + îs) = (1.1)2 / (1.05)= 1.21/1.05 = 1.152

If (1 + îs) = 1.152, then îs = 1.152 – 1 = 0.152 or 15.2%

In this example, therefore, we can see that if current short rates are five percent and long rates are ten per cent then this suggests that people expect shortrates to rise to 15.2 per cent before the second period begins.

In this example, therefore, the yield curve slopes upward and long-dated bondshave a higher yield than short-dated ones. Notice once again that this is notbecause they involve a greater sacrifice of liquidity than short-dated bonds. Itis because their current yield persuades those willing to invest for a longerperiod that they will do just as well from holding long-dated bonds as they willfrom holding a succession of short-dated ones, bearing in mind what is expectedto happen to interest rates on short-dated bonds in future. Conversely, if themarket expected short rates to fall in future, the yield curve would bedownward-sloping. The argument then would be that investors would still bewilling to hold (lower yielding) long-dated bonds because this would give themthe same return as a succession of short-dated bonds, bearing in mind that shortrates in future would be lower than they are now, and indeed lower than currentlong rates.

The problems with the expectations hypothesis are twofold. Firstly, wheninterest rates are examined retrospectively, the subsequent movement in short-term rates often differs from what one would have expected given the level oflong-term rates. Secondly, the expectations hypothesis cannot explain adominant shape for the yield curve since this dominant shape would suggestthat there was one expectation of future interest rates that dominated all others.But it is not possible for interest rates to keep moving in one direction, so suchan explanation would require people to have persistently wrong expectationsof interest rate movements. This seems unlikely.

Market segmentationAnother factor which might play a part in shaping the yield curve is marketsegmentation. We know that, in practice, some investors prefer to concentrateon certain parts of the maturity spectrum and are reluctant to move outsidethe territory they are familiar with. Life insurance companies and pensionfunds, for example, have liabilities which are very long-term. They need toknow with reasonable certainty now what they will be able to pay out at dateswhich lie a long way into the future. For this reason they prefer to hold long-dated bonds. Short-dated bonds are just not suitable. At the opposite end of thespectrum, banks and building societies hold only short-dated bonds. If thereare strong maturity preferences, then interest rates at any part of the maturity

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market segmentation

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spectrum will depend upon the strength of supply and demand in that particularpart of the spectrum. In other words we are saying that, instead of their beingone big market for government bonds (for example) of all maturities, themarket is segmented or divided into a series of sub-markets. Let us take anexample.

Suppose that a government decides for the next few years to fund its annualbudget deficit by the issue of bonds exclusively in the seven to ten year maturityrange (‘medium-dated’). This will create a steady increase in the supply ofmedium-dated bonds. Let us assume that investors have strong preferencesregarding term to maturity. In this case, the limited number of investorsfavouring medium-dated bonds will eventually find that they are holdingsufficient bonds. If the Government continues with its funding policy it willonly succeed if it offers higher interest rates on these medium-dated bonds. (Or,what amounts to the same thing, sells them at a lower price.) This will producea ‘hump’ in the yield curve in the seven to ten year range. There may well besome truth in the notion that some investors have preferences for particularparts of the maturity spectrum and therefore that the supply and demand forbonds with particular maturities will have some effect on prices and yields butagain we have the problem of explaining why longer maturities have generallyhigher yields. It does not seem plausible that there should be a chronicoversupply of long-dated bonds.

Duration and interest rate riskFinally, we are forced back to our discussion at the beginning of this section.Longer-dated bonds have a higher exposure to interest rate risk. This isinevitably the case and it comes from the mathematics of duration. It willalways be so. This makes duration a strong candidate when it come to thequestion of why the yield curve should normally slope upwards. However, westill need some words of caution.

Firstly, for duration and interest rate risk to provide the answer we have toassume that the bond market is dominated by investors who are capital riskaverse. In other words, the mathematics of duration are insufficient on theirown. It has to be the case that investors dislike the consequences of durationsufficiently to demand a premium by way of compensation. This may seem asafe assumption but it is not guaranteed. Remember learning activity 3g. Wesaw there that many government bonds are effectively risk-free if held toredemption. This is because the governments have a ‘triple A’ rating (so we canignore default risk), we know in advance the terminal value of our investment(the maturity value of the bond) and we know the yield if we hold toredemption. There will be investors like life insurance companies and pensionfunds who value these long-term certainties. So, if the market were dominatedby investors who were income-risk averse, the issue of duration and interestrate risk would be less important.

Secondly, we must keep in mind that these various explanations are notmutually exclusive. For example, it may be that capital risk aversion is strongand so gives the yield curve an upward-slope most of the time. But there maybe occasions when a decline in future short-term rates is so strongly expectedthat the yield curve becomes flat or even downward-sloping for a period. Andthen, on top if this, there may be some degree of market segmentation such

57Copyright © 2010 University of Sunderland

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that if there is a major issue (or redemption) of bonds in a particular part of thematurity spectrum this causes a small hump (or dip). The important conclusionis that we cannot tell, simply by looking at the shape of the yield curve, whatsingle explanation may be responsible.

Users and marketsThe users of bond markets are the ultimate lenders and borrowers that weidentified in Unit 1. In this particular case, the borrowers are Government andlarge corporations. The ultimate lenders are households, who can buy govern -ment bonds directly from the UK Debt Management Office and corporatebonds from market makers by using a broker. However, most bonds are heldon behalf of households by intermediaries who pool the bonds with other assetsin pension funds and other long-term savings plans. Many of these inter -mediaries also trade bonds on their own account as a source of profit. In mostcountries, the Government is the biggest issuer of bonds and trading in bondsis consequently dominated by trading in government bonds.

In economics a market is any device that allows people to trade together. Today,most financial markets consist of traders linked together only by high speedbroadband, sharing the same software which displays the bid/ask prices of themarket makers for all the stocks they deal in and for various sizes of trans -actions. The traders, usually employees of large financial institutions, place buyand sell orders sometimes on behalf of their clients and sometimes for theprofitability of their own firm. The few exceptions to this are the much smalleronline retail brokers who are buying and selling almost wholly on behalf ofclients. In order to have access to the software and the network, all the partiesmust be ‘members’ of the exchange. This means meeting a set of financial andother tests and paying a regular membership fee. The exchange (often a publiclyquoted company) provides the software and undertakes tasks likes therecording and registering of transactions and publicly reporting the prices ofstocks and the volumes being traded.

Everything that we have said so far applies to the trading of most financialinstruments whether it be equities, bonds, derivatives, foreign exchange orwhatever.

However, in the case of bond markets it is sometimes the case that only a subsetof market makers deal in government bonds. This usually places them undersome extra obligations for which they receive certain advantages, not availableto others, in return. The reason for this is that governments feel that they mustknow for certain that they can sell whatever quantity of bonds they require ata particular time. In the UK, these firms are known as ‘Gilt Edge MarketMakers’ (GEMMS) after the popular term ‘gilts’ for government bonds. Theyare authorised by the Bank of England and have borrowing rights at the Bankof England. Corporate bonds are traded in the normal way, by market makerswho will usually be dealing in the ordinary shares of the same companies.

The arrangements that we have just described set out the trading arrange mentsin what is called the secondary market for bonds. This is the market in whichexisting bonds are traded. But it is possible also to talk about a primary market– the market which deals with new issues. In most cases, the organisationsinvolved are the same as those that are making the secondary market though

Recommended reading: Howells and Bain (2008) ‘TheBond Market’; Mishkin (2007)

‘Understanding Interest Rares’;Howells and Bain (2007) ‘CapitalMarkets’; Piesse et al (1995) }The

Bond Market’.

market maker

secondary market

primary market

3.5

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in the case of bonds, the issuing of new bonds involves extra players. Firstly,new issues of UK government bonds are handled by the Debt ManagementOffice (DMO) which is an agency of the Treasury. Its website (<http://www.DMO.gov.uk>) is a useful source of information about the government bondmarket. In the case of corporate bonds, new issues are handled by investmentbanks but by a different part of the bank from that which is making marketsin existing bonds. Arrangements in other countries are broadly similar. In somecountries it is the central bank that is responsible for new issues of governmentbonds (as it was in the UK until 1998).

According to the London Stock Exchange (2009a) the value of new bond issuesin 2009 (to end-November) was £518 billion. By comparison the total tradingin fixed interest securities (corporate and gilts) was £8599 billion (LondonStock Exchange, 2009b). Since there were 625,661 trades, we can calculatethat the average size of each transaction was £13.7 million. The followingfigures relate to government bonds only. Two things are striking (and are similarto the figures for the bond market as a whole). This is that the total amount oftrading in government bonds (turnover) is very much larger than the amountof money being raised by the issue of new government bonds. This gives us arough indication of the size of the secondary market in relation to the primarymarket. Turnover is also very much larger than the outstanding stock of debt.The DMO provides its own calculation of this relationship which shows thatturnover amounts to nearly eight times the value of the total stock.

Turnover Market value of Turnover ratio Net new outstanding stock issues

4077.42 525.94 7.75 208.5

Table 3.3: UK government bond market data, 2008–09 (£bn)Source: UK Debt Management Office (2009a, b)

In economics, it is customary to analyse the functioning of a market within asupply and demand framework. We do this in Figure 3.3 where we show themarket for the three year bond that we priced in [3.5] and [3.8]. Firstly, we arelooking at the price (and yield) of existing bonds, so we are looking at thesecondary market where the quantity is fixed. Hence the ‘supply’ of bonds isshow by the vertical supply curve, S. Initially, demand is shown by D. Thedemand curve is downward-sloping because, other things equal, bonds aremore attractive at a lower price since (we know) their yield is higher. Initially,then we have an equilibrium price of £102.81 (calculated in [3.5]) on the left-hand axis. However, we know that for any price there is a corresponding rateof return. We can put this on the right-hand axis in order to emphasis that itvaries inversely with the price. For this purpose we could put any measure ofyield, even simple yield, though normally we would use redemption yield.Recall that the bond in [3.5] and [3.8] has no accrued interest and so the dirtyprice and the clean price are the same. This means (if we look at our explana -tion of redemption yield again) that the rate of interest in [3.5] and [3.8] is theinternal rate of return or redemption yield. So we can show this on the right-hand axis as four per cent.

In our pricing discussion we then introduced a fall in market interest rates tothree per cent. This means that many other assets now yield only three per cent

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but with a coupon of £5 and a price of £102.81 our bond has a redemptionyield of four per cent and is thus suddenly made more attractive by the fall inmarket rates. Inevitably, buyers will want to hold our bond in preference toother assets, so long as the price/yield combination remains superior to what isavailable. But inevitably, the increased demand for our bond pushes up the price(and lowers the yield). Where does the process stop? Demand for our bond willcease to rise when the return that it offers is no longer superior to that availableelsewhere on similar assets. in other words when the yield falls to three percent. And we know from [3.8] that this will be when the price rises to £105.66.

Figure 3.3: Bond prices in a supply and demand framework

The lesson to be learned from Figure 3.3 is that the pricing discussions insection 3.3 should be interpreted as operating on the demand side of themarket. When we calculate the present value of a futures income stream weare calculating what price holders should be prepared to pay. Any change inthat present value, corresponds to a shift in demand.

During 2009, there were rumours that the ratings agencies were about toreduce their rating of government bonds in a number of countries(including the UK). Suppose that a ‘downgrading’ were to occur. What doyou think would happen to the price of the bonds concerned and why?(Hint: In your explanation, make reference to a pricing equation (any of[3.1], [3.2], [3.3], [3.5] or [3.8] will do) and to Figure 3.3.

If bonds receive a downgrading, we would expect the price to fall (and theyield to rise) because the ratings agencies are telling us that they think thebonds have become more risky. Formally, we can show why this happens bylooking at any pricing formula for a fixed interest bond. In any of theseformulae we find the present value of the bond by discounting the futurecash flow by a discount rate that is the rate available on other assets ofsimilar risk. (Alternatively we could say that this rate incorporates the risk-

0

S

S0

3

4

105.66

102.81

D

D’

Quantity of bonds

Pric

e, £

Yie

ld, %

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free rate of interest plus a risk premium.) However we express it after thedowngrading the risk premium is bigger (so if we compare with otherassets, these should be riskier assets than before). The critical point is thatthe rate of discount rises. Since the discount rate appears in thedenominator, an increase must result in a fall in the price. In Figure 3.3, wewould show this by a downward shift of the demand curve.

Imagine that you are managing a UK ‘high income’ fund that is investedwholly in bonds. The average risk of your bonds according to the Standardand Poor’s rating agency is AA-. The simple yield to maturity on theportfolio is five per cent:

1. You are thinking of investing £1 million in the following bond (whichalso has an AA- rating):

■ issuer: ABC plc

■ coupon rate: five per cent

■ coupon payable: Six-monthly, in two equal instalments

■ maturity date: 28 August 2014

■ date of purchase: 28 January 2011

■ market interest rate: seven per cent.

Calculate the dirty price and then the simple yield to maturity and explainyour decision about whether to invest in the bond.

2. The national statistics office announces that inflation rose unexpectedlyto 3.5% last month. How might your understanding of duration guideyou in designing an investment strategy in these circumstances?

1. Using [3.7] to find the dirty price (including accrued interest) we have

7 1 100 7 154Pd =

0.04 1 –

(1.02)8+

(1.02)8+

2 182

1 100 Pd = 175 1 –

(1.172) +

(1.172) + 3.5(0.846)

175 [1 – 0.853] + 85.32 + 2.115 = 25.69 + 85.32 + 2.961 = £113.97

We then use [3.10] to find the simple yield to redemption: =C

+100 – P

p nm × P(Remember that P is the clean price). Then

sym =C + 100 – P

=7

+100 – 111.01

= 0.0631 + –11.01

P nm × P 111.01 4 × 111.01 444.04

= 0.0631 – 0.0247 = 0.0384 or 3.84%

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On the face of it, the ABC bond looks to be overpriced and we wouldnot buy it for the portfolio. We draw this conclusion because it has thesame risk as the portfolio as a whole (AA –) but its return is substantiallybelow what we can earn on AA- bonds. If the price were to fall to thepoint where the simple yield to maturity rose to five per cent, then wecould reconsider our decision.

2. Duration could be relevant here because it tells us how bond priceschange in response to a change in interest rates. Our first step is todecide whether there might be any useful information regarding interestrates in the announcement from the national statistics office. We knowthat inflation has risen unexpectedly. We know (from Unit 2) that thelevel of interest rates is set by the central bank in the light of itsmonetary policy objectives. Let us suppose, for example, that the centralbank has a policy of inflation targeting. The news that inflation has risenunexpectedly would then suggest the probability of a future rise ininterest rates. We know from our pricing exercises that bond priceschange with interest rates and so we must expect that a rise in interestrates will cause the value of our bond portfolio to fall.

However, duration tells us that some bonds will be more seriouslyaffected than others. These will be long-maturity bonds with lowcoupons. A sensible strategy therefore would be to sell these bondsbefore interest rates change and prices fall. Since we are committed torunning a bond fund (and there is probably a trust deed which preventsus from holding other assets instead of bonds) we have to continue tohold bonds of some sort. Again, duration helps by suggesting that weshould hold short-dated, high coupon bonds. Their price will still fall, butthe fall will be minimised.

Apart from the duration issue, there are two other lessons to be learnedhere. The first is that since changes in interest rates are critical to thebehaviour of bond prices and interest rates are set by central banks,bond investment strategies inevitably involve making judgements aboutmonetary policy and the likely next movements of the central bank. Thesecond is less obvious. This is that the response of bond prices to news(for example about inflation) depends upon whether the informationwas expected or came as a surprise. If the information were alreadyexpected it is likely that it was already incorporated in the bond price. Inthese circumstances the arrival of the information has no effect on price.The ability of assets to incorporate information before it actually arrivesis part of the efficient market hypothesis that we examine in Unit 5.

Self-assessment questions3.1 Suppose that Treasury 8.75% 2019 pays half-coupons on 1 May and 1

November and that it is 1 November 2010 now. Find the price if interestrates are 9.54 per cent. (Hint: use [3.5].)

3.2 Looking at [3.5], how could you simplify the formula if n=∞? What sortof bond would you have created by making n=∞?

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3.3 How would you expect bond prices to respond to the following(unexpected) events?(a) an increase in the balance of payments deficit in a fixed exchange

rate regime(b) a fall in the rate of inflation combined with fears of recession(c) the announcement of a large budget deficit.

3.4 Would your answers be different if these events were expected and if sowhy?

3.5 If the current (redemption) yield on bonds with one year to maturity is sixper cent, while the yield on bonds maturing in three years is eight percent, what does this imply about one-year yields in three years’ time?

3.6 If the coupon on a bond is increased, what effect does this have on itsduration and why?

3.7 In what circumstances might the shape of the yield curve tell yousomething about (a) the future level of interest rates and (b) the futurerate of inflation?

Feedback on self-assessment questions

3.1 P =8.75

1 –1 + 0.0954 8

+ 1 + 0.0954 8

= 52.07 + 43.24 = £95.300.0954

3.2 Looking at the formula in the previous answer we can see that if we maken (=8) infinitely large, then two things happen. The first is that thedenominator in the fraction within the square brackets becomes infinitelylarge, so that the fraction becomes 1/∞, or infinitely small. Consequently,the expression in square brackets becomes [1 − 0] or [1]. By the samereasoning, the denominator in the final part of the expression alsobecomes infinitely large. This gives us 100/∞ which = 0. So we are leftwith P = 8.75/i × [1] + 0. This, of course, reduces to P = 8.75/i or moregenerally P = C/i. This is the expression for the valuation of a perpetualor irredeemable bond – a bond with no maturity date.

(a) An increase in the balance of payments deficit would tend to causethe external value of the currency to fall. Since this is not allowedin a fixed exchange rate regime the central bank would have to raiseinterest rates in order to attract an inflow of funds to support thecurrency. The rise in interest rates, all else unchanged, would lead toa fall in bond prices.

(b) Expectations of recession should cause the central bank to cutinterest rates. If inflation is also falling, then the major obstacle toa cut in interest rates disappears and makes it even more likely. Bondprices will rise.

(c) The announcement of a large budget deficit will cause investors toexpect a large issue of government bonds. In Figure 3.3 the supplycurve will shift to the right and this will cause a fall in bond pricesand a rise in their yields.

3.4 If these developments were widely expected then it is quite likely that theireffects would be incorporated in the price/yield of bonds at the time of theexpectation so that when the events actually took place there would be nochange in prices/yields.

2 2

1 100

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3.5 These conditions describe an upward-sloping yield curve. We know thatlonger dated bonds have larger duration and increased exposure tointerest rate risk. It is possible therefore that this difference is a riskpremium to compensate capital risk investors. However, the difference inrates is quite large for bonds whose maturity differs only by two years.Another possibility is that it reflects expectations about future short-termrates. If there are investors willing to hold one year bonds at 6 per centwhile three year rates are 8 per cent, this suggests that there are manyinvestors who think that by selling their one year bonds in a year’s timethey will be able to reinvest for the next two years at interest rates thatwill give them an average of eight per cent pa overall. This implies thatinterest rates by year three will be higher than in year one, but not justhigher than six per cent but higher also than eight per cent if the averageover years one, two and three is to match holding a single three year bond.

3.6 If the coupon on a bond were raised at some point in its life (there aresome bonds like this) then its duration would be reduced at the point ofchangeover. This is because a higher coupon causes a higher proportionof the bond’s total cash flow to be paid ‘early’. Alternatively, we can saythat it reduces the average waiting time.

3.7 Firstly, with regard to interest rates the shape of the yield curve might tellus something about the future level of short-term rates if (a) the shape ofthe curve is determined by expectations and (b) if those expectations aregenerally correct. It is also possible that the curve could tell us somethingabout future inflation rates if we know that the real rate of interest isstable, that is that nominal rates represent a stable real rate plus aninflation premium. In these circumstances, we find the expected futurenominal rate, using the expectations hypothesis, then subtract the realrate – often estimated at around two per cent – and what is left is themarket’s estimate of inflation.

SummaryIn this unit we have looked at one of the major capital markets. We have seenwhat bonds are, how they are priced, used and traded. Having finished thisunit you should now be able:

■ to describe the key characteristics of bonds and their uses and to retrieve andunderstand bond market data

■ to price bonds of varying maturities and to show how the price varies withmarket interest rates

■ to distinguish different meanings of ‘yield’ and be able to show how yieldsvary inversely with price

■ to recognise the concept of duration and show how this affects the pricesensitivity of bonds and how it may also play a part in the term structureof interest rates

■ to understand something of the institutional arrangements for the tradingof bonds.

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Appendix: Bond price sensitivity andperiod to maturityWe mentioned in the text that the sensitivity of bond prices is influenced by theperiod to maturity. We illustrate this here by looking at a bond with six yearsto maturity. This is directly comparable to our pricing of a three year bond inthe text. We shall ignore accrued interest in order to keep the calculations asbrief as possible. Firstly, then, we find the price on 1 November 2009 of a fiveper cent bond maturing on 31 October 2015 when interest rates are four percent.

5 1 M 1 100P = 0.04

1 –1 + 0.04 12 +

1 + 0.04 12 = 125 1 –(1 + 0.02)12 +

(1 + 0.02)12

2 2

1 100= 125 1 –1.268

+ 1.268

= 125 [1 – 0.789] + 78.86 = 26.38 + 78.86

= £105.24

[3.12]

Compared with our three year bond, we see that the price of an identical sixyear bond is rather higher (£105.24 against £102.81) because the six year bondpays six more coupon-instalments of £2.50 each. Even when discounted, theseextra payments have some small value and the market price of the bond reflectsthis. What is going to be more remarkable is what happens when we re-pricefor the fall in interest rates from four to three per cent.

5 1 M 1P = 0.03

1 –1 + 0.03 12 +

1 + 0.03 12 = 125 1 –(1 + 0.015)12

100

2 2

+ (1 + 0.015)12

1 100= 166.7 1 –1.196

+ 1.196

= 166.7 [1 – 0.836] + 83.61 = 27.34 + 83.61

= £110.95

[3.13]

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‘Bank shares hit by Dubai World fears.‘Financial Times (14 July 2009)

IntroductionThis unit continues our discussion of capital markets by looking at themarket for company shares.

Unit learning objectives

On completing this unit, you should be able to:

4.1 Describe the characteristics of company shares.

4.2 Retrieve and understand data relating to share prices.

4.3 Price company shares by reference to a range of models.

4.4 Derive the required rate of return from the capital asset pricingmodel.

4.5 Compare the trading arrangements in a range of different countriesand compare the scale of activity in primary and secondary markets.

Prior knowledge

The unit assumes that you have studied Units 1, 2 and 3. Otherwise, it requiresno prior knowledge, but you will find sections 4.3 and 4.4 easier if you havesome basic mathematical skills, and familiarity with basic economics is useful forsection 4.5.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008: on‘Portfolio Theory’, ‘Valuation of Assets’ and ‘Equity Markets’). In Piesse et al(1995) ‘Structure of Securities Markets’ and ‘The Equity Market’ are mostrelevant. Howells and Bain (2007) ‘Capital Markets’ also covers much of thematerial but at a rather lower level. The first part of Mishkin 2007 ‘The Stockmarket…’ explains the Gordon growth model. You will need a calculator andaccess to the internet.

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The characteristics and uses of companysharesFirms can raise money in a number of ways. Short-term borrowing is usuallydone via banks or through issuing bills and other securities in money markets(see Unit 2). Long-term borrowing usually involves selling bonds (see Unit 3)or ‘shares’ in the firm’s ownership. Notice that while shareholders are effectivelylending to firms, they are doing so by taking a share in the ownership. This hasimportant implications for the rights and obligations of shareholders.

Firms which are financed by the issue of shares are known as ‘joint stockcompanies’ or ‘limited liability’ companies. Many of these firms are small ormedium-sized and their shares may be held by very few people (sometimes thefamily of the founder) and very infrequently traded. However, larger firmsrequire substantial capital – more than can be raised through family networks.The shares have to be made attractive to the largest number of holders and thismeans that they must be ‘listed’ on a recognised exchange where they can alsobe traded. Firms in this position are sometimes referred to as ‘corporations’.

The simplest shares are ‘ordinary company shares’ or ‘equities’ or what USmarkets refer to as ‘common stock’. From the point of view of their holdersthese shares give a number of advantages. Firstly, the holders have certain rightsregarding the management of the company – usually exercised through a boardof directors who are strictly speaking appointed through the votes of share -holders. Secondly, the shareholders are entitled to share in the profits (or‘earnings’) generated by the firm. This comes in the form of a dividend, whichmay be paid annually or in more frequent instalments. Notice that if the firmadopts a ‘fixed payout ratio’ (or ‘retention ratio’) it will distribute a fixedproportion of its profits as dividends (retaining the rest to reinvest in the firm)and therefore the dividends received by shareholders will vary with theprofitability of the firm. However, many firms prefer to ‘smooth’ the dividendpayments, preferring to see them grow steadily over time, even if this meansvarying the proportion of profit distributed each year. Thirdly, if the firmflourishes and grows, shareholders can expect to see the value of their sharesincrease since each share confers ownership of a fixed proportion of the firm.

On the other hand, there are drawbacks to share ownership. We have just seenthat the dividend payments can vary and if the firm runs into long-termdifficulties the dividends may cease altogether. Furthermore, if the firm fails, theshareholders rank last behind the firm’s creditors and bondholders. Sinceinsolvency is defined as an excess of liabilities over assets, this usually meansthat shareholders get nothing. The principle is that the owners of a firm shouldtake the risk of the firm’s operation and that means the shareholders.

As with bonds, there are variations on this basic type of share. For example,there are:

■ Preferred shares which pay a fixed dividend (and in that sense are like abond). Preferred shareholders rank behind bondholders, however. Thus, inperiods of low earnings bondholders may be paid when preferred share -holders (and ordinary shareholders also of course) get nothing. Predictably,there are many variations on the preference theme.

4.1

Recommended reading: Howells and Bain (2008) ‘The

Equity Market’; Howells and Bain(2007) ‘Capital Markets’; Piesse,et al (1995) ‘The Equity Market’;

Mishkin (2007) ‘TheStockmarket…’.

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■ Cumulative preferred shares, unpaid dividends are cumulated and becomepayable when earnings permit.

■ Convertible preferred shares carry rights to convert to ordinary shares onspecified terms and at specified times. And there are other variations.

The fact that the income stream from ordinary shares is uncertain naturallymakes share valuation more difficult (than, say, bond valuation). Thedifficulties are further increased because it is difficult to establish precisely thedegree of risk for any individual share and thus it is difficult to calculate anappropriate rate of discount. We shall see one way of finding a discount rate in4.4.

When firms make new issues of shares (in order to expand their capital)existing shareholders must be given the right to buy the new shares inproportion to their existing share of the firm. What can you see in thenature of shares that explains this?

It is explained by the fact that shareholders are the legal owners of the firmand the possibility that the fraction they own may be important to them.Therefore, the firm must not do anything to alter this fraction without theshareholder’s consent. For example, suppose a shareholder owns 10 millionshares out of a total of 500 million. This is equivalent to two per cent of thefirm. If the firm then issues another 500 million (a ‘one for one issue’) thiswould reduce the shareholder’s stake to one per cent, unless he decides tobuy another one million. He has the right to that opportunity.

Understanding share price dataShare price data can be found in numerous places. For most people, theconvenient sources are the newspapers with a major business section. TheFinancial Times and Wall Street Journal carry full listings of shares traded inLondon and New York. Other newspapers will have details for major firmsonly (for example, those in the FTSE-100 or Dow Jones indexes).

When it comes to electronic sources, the stock exchanges’ own websites willprovide data which is updated throughout the trading day, though it may beavailable for free only with a short time-delay. The websites of the financialnewspapers also provide a similar facility and some individual firms have an‘investor relations’ section on their own websites which may give the currentprice of the firm’s shares.

‘Hardcopy’ share price data will look something like that in Table 4.1.

The first column shows the name of the company. Notice that firms are groupedby the economic sector in which they specialise. This makes it easier to comparethe data for firms in a similar line of business. The second column shows thelatest price, normally in pence. (In a newspaper this will be the price at the close

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4.2Recommended reading:

Howells and Bain (2008) ‘TheEquity Market’; Howells and Bain(2007) ‘Capital Markets’; Piesse,et al (1995) ‘The Equity Market’;

Mishkin (2007) ‘TheStockmarket…’.

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of trading on the previous day.) The third column shows the price change fromthe previous day’s close. ‘High’ and ‘Low’ refer to the maximum and minimumprice so far during the year. ‘Yield’ is the dividend yield, the latest dividenddivided by the current price. ‘P/E’ is the price/earnings ratio. This shows the costof buying a share in the company’s profits. In the case of Carphone Warehouse,for example, buying a share for 188p gives the holder a claim to the firm’sprofits of 1/73.5 of 188 or 2.56p. The final column shows the number of sharesbought and sold in the previous day’s trading.

In Table 4.1, 188p buys 2.56p of Carphone Warehouse’s earnings.

1. What is the cost of buying a share of the Cable and Wireless earnings?

2. Why should shareholders be willing to pay such widely differingamounts?

1. The data says that one share costs 22 times the earnings purchased. Ifthe share costs 142p then the earnings must be 1/22 × 142p = 6.45. Forthe same price as a Carphone Warehouse share (188p) an investor inCable and Wireless could buy 188/142 × 6.54p = 8.65p.

2. One possible explanation for this difference could be the level of risk. Ifinvestors thought that Cable and Wireless earnings were very uncertain,then they would be willing to pay only a low price while investors mightbe willing to pay more for a reliable stream of earnings from CarphoneWarehouse. It could also be that the earnings in Carphone Warehouseare expected to grow very rapidly, while Cable and Wireless may be in aslow-growing part of the market.

Similar data, in tabular form. is sometimes available electronically as a pdf file.More usually, however, the electronic sources allow you to search for the dataone share at a time. In this case, there may be an option to display the shareprice movement in graphical form over various periods and even to show thisagainst the movement in some index or against movements in rival shares. Bysubscribing to some websites, it is often possible to get access not just to thedata but also to a range of analytical tools.

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2009

Telecommunications Price Change High Low Yield P/E Vol.000s

Carphone Warehouse 188 +2.10 216.10 88.25 2.4 73.5 3,350

Cable & Wireless 142 −0.50 170 125.10 6.2 22 21,246

Colt Tel 125 −0.60 138 65 – 12.8 1,194

Table 4.1: Share price data

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For example, Figure 4.1 shows the recent behaviour of the price of shares in BP,the oil producer, as it appears in the ‘markets data’ section of the FinancialTimes (FT) website (<http://markets.ft.com/markets/overview.asp>).

Figure 4.1: The BP share price

The price (in pence) is shown on the vertical axis and the horizontal axis showsthat the data relates to the last three months. Along the bottom of the chart, thevertical bars shows the volume of trading in the shares, day by day and thereis a summary of the price change in each month. Notice that the price changeis given as an absolute amount and as a percentage. This is important since agiven absolute amount may look large but be insignificant when we look at thelevel of the share price. In the case of BP, a 50p rise in price in mid-January2010 would be equivalent to a jump of about eight per cent. The same rise inthe price of Anglo-American mining shares would be equivalent to about 1.8per cent since the market price was £27.

When it comes to taking action, however, just looking at the price of a singleshare in isolation is not very helpful. We need some way of interpreting theinformation. Has BP done well or poorly by comparison with relevantbenchmarks? In order to answer this, the FT database also provides a facilityknown as ‘interactive charting’ whereby the researcher can compare theindividual share price against a number of indexes or against similar firms.(One can compare BP against Shell, for example.)

Figure 4.2 show the BP price against the FTSE-100 index of share prices. Noticethat in order to make the comparison, both series have to start at a commonpoint and that they have to be judged using a common standard which is thepercentage change from the starting point. Thus we see that the FTSE index fellto begin with while the BP price rose. By the end of November 2009, they wereclose together again, though the BP share price was showing a slightly largergain (of around 2.5 per cent). Neither series showed much change duringDecember 2009, but both moved upwards through January 2010, with the BPprice pulling further ahead. By using this facility we can now say that investorsin BP have done rather better over the period than those who invested in aportfolio of FTSE-100 companies. If we did a bit more research, on similarlines, we could discover that the Shell share price also did better than the FTSE-

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100 index, suggesting that part of BP’s performance is explained by a strongperformance across the oil sector as a whole. If we then plotted the BP priceagainst Shell, however, we would find that the BP performance was slightlybetter than Shell during this period suggesting that there must have been somefirm-specific factors at work in the BP company. The period of the comparisonis just one of many parameters that can be varied – from one day to five years.

Finally, notice that at the bottom of the chart, the daily trading volumes aregiven in absolute figures and it appears that the daily turnover in BP shares (thevertical bars) is normally between 20 million and 30 million. This may soundlike a very large number until we discover (from elsewhere) that BP has nearly19 billion shares in issue.

Figure 4.2: BP and FTSE-100 compared

Go to the FT homepage (<http://www.ft.com>), drop down the menuheaded ‘markets’ and click on ‘markets data’. Then select ‘companiesresearch’. Put ‘Barclays’ in the search box and then select the first ‘Barclays’on the list. Display the share price in a graph that enables you to describewhat happened to the share price during 2008. Then look at the databelow the graph and answer the following questions.

1. What happened to the Barclays share price during 2008. Can you thinkof any explanation?

2. How many shares does Barclays have in issue and what is the dividendpay date?

1. The share price fell from about 600p to 200p in the course of the year.2008 was the year of the financial crisis. At the beginning of the yearthere were serious fears that some banks might become insolvent and

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governments across the world introduced a number of emergencymeasures in order to ‘bail out’ their banks.

2. In November 2009, Barclays had 11.41 billion shares in issue. Thedividend pay date is shown as 11 December.

Statistics relating to whole markets – for example turnover or new issue activityon the New York NASDAQ, or the London Stock Exchange and so on canusually be downloaded from the website (see for example, <http://www.londonstockexchange.com/statistics/home/statistics.htm>).

The pricing of company sharesThere are, broadly speaking, two ways of approaching the valuation of com -pany shares. The first follows directly from our discussion of money marketinstruments and bonds and says the present value of a share is determined byits future cash flow and the risk associated with it. Hence, as before, we set outto calculate the present value of that cash flow when discounted by a termwhich incorporates the current level of interest rates plus a risk premium. Wecall this approach fundamental analysis since it focuses on what are regardedas the fundamental characteristics of a share, namely its ability to earn so muchincome for a given level of risk. An alternative approach is to look for patternsin past price movements in the belief that similar patterns emerging now tell ussomething about how the price of the share is likely to move in future. This iscalled technical analysis or sometimes chartism. Notice that it does not generatea definitive value for the share. It simply tells us whether the current price issustainable or likely to rise or fall. Technical analysis is controversial since itoffers no ‘reason’ for the change in share prices, other than the alleged patternsin the data. Neither does it provide any justification for the present price: it ismainly concerned with spotting the next movement.

Fundamental analysisIn fundamental analysis, we focus upon a share’s ability to earn a stream ofincome (its cash flow) in return for a certain level of risk. As with any otherasset we discount the income stream in order to find its present value and thediscount rate that we use incorporates the general level of interest rates andthen any allowance that we think we should make for the risk of the share. Thecash flow comes in the form of a dividend, D, and so fundamental analysisoften involves the use of dividend discount models. If we wish to discount astream of dividends we can write:

DtPV = ∑ (1 + K)t [4.1]

where K is the discount rate. Except for the use of the terms D and K and theabsence of any maturity value, [4.1] is the same as the expression that we usedfor the valuation of bonds in Unit 3. However, we must not take this equiva -lence too far. In Unit 3, D was replaced by C which was the bond’s coupon andwas fixed. But dividends are definitely not fixed. They fluctuate, though overtime they may be expected to grow and (we saw in section 4.1) firms oftensmooth their growth. Suppose that we assume a constant growth rate, g, then:

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4.3

t = ∞

t=1

Recommended reading: Howells and Bain (2008) ‘PortfolioTheory’, ‘Valuation of Assets’ and

‘Equity Markets’; Howells andBain (2007) ‘Capital Markets’;Piesse, et al (1995) ‘The EquityMarket’; Mishkin (2007) ‘The

Stockmarket…’.

fundamental analysis

technical analysis

chartism

dividend discount model

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PV =D1 +

(1 + g)D1 + (1 + g)2D1 +(1 + g)3D1

(1 + K) (1 + K)2 (1 + K)3 (1 + K)4 [4.2]

We can then simplify [4.2] by using the formula for the sum of a geometricprogression:

D1PV =(K – g)

[4.3]

Assuming that the market prices shares at their present value so that PV = P0,where is the current price then [4.3] is known as the constant growth model,or Gordon growth model after Gordon (1962).

1. Thornbury plc has been making chocolate and other high qualityconfectionary for a number of years. Its last dividend was 6p per shareand earnings have been growing steadily at 10 per cent pa. The rate ofreturn on shares in the luxury food sector is generally about 12 per centpa. What is the fair price of Thornbury’s shares?

2. Suppose that Thornbury then announces that it has decided to branchout into the riskier high class catering business. What do you thinkwould happen to the value of K

_and to Thornbury’s share price (all else

unchanged)?

6(1.01) 6.6 1. P =

(0.12 – 0.1) =

0.02 = 330p or £3.30

2. The immediate effect will be to raise the required return. Using [4.4] wecan see that this can only happen if the dividend yield rises and thisrequires a fall in price. In future, the higher risk activity should producehigher earnings (and dividends) and maybe a higher dividend growthrate. These will allow K

_to remain at its higher level with P restored to its

previous value.

If the share was not generating the rate of return required byshareholders we should expect a general move to sell the shares. Theprice, P0, would fall pushing up the dividend yield and raising the overallrate of return.

Notice that we can rearrange [4.3] with interesting results:

K =D1 + g

[4.4]P0

The right-hand side now consists of the share’s next dividend divided by thecurrent price followed by g, the rate of growth of earnings. These are the twocomponents of the return on a share: its dividend yield and the growth ofdividends (or the rate of capital appreciation). So we now discover that the rateat which we were discounting earnings is the rate of return on the share. Inequilibrium, that is to say where the share price is stable and investors appearto be happy with the price, then K must be the required rate of return and wecould write it K

_.

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The equivalence between the growth of dividends and the rate of capitalappreciation can be seen when we consider that if:

D1P0 =(K

—– g)

[4.5]

then the price in the next period must be:

D2P1 =(K

—– g)

where D2 = D1 (1 + g) [4.6]

Thus:

D1P1 =(K

—– g)

(1 + g) [4.7]

Substituting [4.5] into [4.7]:

P1 = P0 (1 + g) [4.8]

The change in price between one period and the next takes place at the rate (1 + g). That g is the percentage capital gain is then easily shown by rearranging[4.8]:

P1 = P0 + gP0 [4.9]

and thus:

g =P1 – P0 [4.10]

P0

What determines the growth of g? The answer is interesting because it revealsa surprising insight, namely that when it comes to valuing shares it is earnings(the firm’s profits) that are critical rather than the payment of dividends toshareholders. In certain circumstances dividend payments may be irrelevant toshareholder returns!The growth in a firm’s earnings depends upon (a) how much it adds to itscapital stock each year, c, and (b) the productivity of that new capital, r. (a) inturn depends upon how much of this year’s earnings the firm reinvests, that isupon its ‘retention ratio’, p, and the growth in earnings will be the productivityof these retained earnings, that is r × p.

In symbols we can write:

Et + 1 = Et + rp = Et [1 + rp]

And since Et [1 + rp] = Et [1 + g], then rp = g

In order to see why earnings and dividends may be equivalent when it comesto valuing shares, we need to go back to expression [4.5]. D1 is the nextdividend payment and this will be some fraction (= 1 – the retention ratio) ofearnings. Suppose that earnings are $10 per share and the firm retains 50 percent of earnings for reinvestment. Then D1 = (1 – 0.5)$10 = $5. Suppose that= 0.2 and that the productivity of the firm’s additional investment is also 0.2.g in this case will be 0.2(0.5) = 0.1. Expressing this in the form of [4.5] wehave:

0.5($10) $5P0 =0.2 – 0.2(0.5)

=0.1

= $50

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Suppose now that the retention ratio increases to 0.6. The firm now pays outonly 0.4 of its earnings as dividends and we might imagine that the share is lessvaluable. But remember that if the firm pays a smaller dividend, it is investingmore for the future which should increase its growth rate and so we have twoopposing forces. To see the result, we recalculate:

0.4($10) $4P0 =0.2 – 0.2(0.6)

=0.2 – 0.12

= $50

The two forces exactly balance. Changing the payout/retention ratio has noeffect on the share’s price. It is earnings that matter. In getting to this result, wehave made a number of assumptions. The main one is that the productivity ofthe firm’s reinvestment, r, is just equal to its cost of capital (the return requiredby shareholders, K

—). This is not unreasonable since, provided that the

productivity exceeds the cost of capital it pays the firm to increase its investmentuntil the productivity of the new capital just matches the cost . Another way ofunderstanding our result is to remember that funds retained within the firm forinvestment remain the property of the shareholders. For this reason, therefore,it is unimportant whether earnings are paid out or retained. Once again it is thesize of earnings that matter.

Notice that the basic Gordon growth model (and variations on it) are concernedto establish the absolute value of company shares. We have an absolute priceand we can trace this back to the expected future earnings, the riskiness of thoseearnings and the general level of interest rates. The fact that we have anabsolute value is another reason why we refer to this approach as fundamentalanalysis.

However, it is often the case that investment decisions are as much concernedwith relative as absolute value. This occurs, for example, where a portfoliomanager has decided on a strategy which involves allocating so much of theportfolio to certain sectors, for example oil. In other words, some part of theinvestment decision has already been taken and the question has become ‘whichoil companies offer the best value?’ If this is the question then there are short-cuts, or ‘rules of thumb’ that we can use which avoid some of the work involvedin calculating absolute values. (We shall learn more about rules of thumb whenwe discuss the efficient markets hypothesis and its critics in Unit 5). One ruleof thumb is the price/earnings ratio (or P/E ratio). If we go back to the dis -cussion surrounding Table 4.1 we shall recall that the P/E ratio was telling uswhat we had to pay in order to obtain a share of a firm’s earnings. On thisbasis, we might be inclined to say that a share with a high P/E was expensivesince the same claim on earnings could be bought more cheaply by buyinganother share. In Table 4.1, for example, we might think that shares inCarphone Warehouse are very expensive because we have to pay 73.5 timesthe earnings attached to each share whereas with Cable and Wireless we needpay only 22 times.

But we need to be very careful here in order to ensure that we are comparinglike with like. This is one of the reasons why share price tables usually groupshares into sectors, rather than listing them alphabetically. If we compare P/Eswithin the same sector this should help us to avoid being misled into thinkingthat a firm with a low P/E ratio must be good value when in fact it is a very low-growth sector with poor prospects of expanding its earnings in future. But even

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within the same sector, firms can have different characteristics. In our twoperiod growth model, we have already mentioned the possibility that youngfirms enjoy rapid growth but that growth declines as the firm matures.Nonetheless, used carefully the P/E ratio may provide a useful short-cut. Wetreat it as part of fundamental analysis since we assume that the price has beenarrived at in the market, by the same factors that we used in the dividenddiscount models.

Fundamental analysis points us towards a clearly defined set of variables thatdetermine a share’s price and knowing the part played by these variables, wecan now understand why share prices react to certain items of news andtherefore why the financial analysts and the media give so much attention tocertain types of news. Table 4.2 lists some typical events that cause share pricesto change, and links them to the key variables that we have discussed above.Remember that these key variables are the established level of dividends (D0),their likely rate of future growth (g), and the required rate of return or rate ofdiscount (K). Learning activity 4e gives you a chance to ‘decode’ a brief mediaexplanation to see if you can link it to the fundamentals we have discussed.The language used by journalists does not always make this easy!

Table 4.2: Linking fundamentals to the real world

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Event Acts on

A change in business activity K, since this is likely to change the riskiness of the firm and thus the return required by shareholders.

A startling new product g, since profits and dividends are likely to grow more rapidly.

Interest rates K, since returns on alternative assets will have changed. Possibly gtoo.

A profits surprise D1, since this is likely to be different from what was expected and possibly also g – depending on the reason for the profit surprise.

Forecasts of boom/slump in g, since we expect profits and dividends to grow more rapidly in a the economy boom.

An increase in inflation On the assumption that the central bank is inflation-averse, this will create expectations of higher interest rates. So, K and maybe g.

Rumours of conflict amongst K, since the future of the firm is more uncertain (riskier) and managers/directors investors will want a higher return.

Depreciation of the currency Exporting firms will benefit, while firms producing for the domesticmarket will face stiffer competition. In either case, g (but in opposite directions).

A general change in public This is likely to result in a changed attitude towards risk and risky confidence about the future assets and will be reflected in the required return, K.

Rumours of a strike If it goes ahead, this is likely to reduce this year’s profits and consequently D1. On the other hand, if it is a response to a management decision to cut costs or increase productivity in future, it may have little effect since there may be a compensating increase in g.

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So far, in this section we have focused upon the ‘fundamental’ factors thatdetermine the price of existing shares. These shares are sometimes said to betraded in ‘the secondary market’. As the figures and the discussion in section4.5 below show, it is this secondary market trading that dominates financialmarkets and it is this trading (and the prices) that are reported in the mediaeveryday. However, it occasionally happens that a firm wishing to expand (orto enlarge its capital base for other reasons) will issue new shares in what iscalled ‘the primary market’. These issues of additional shares are often referredto as ‘rights issues’ since existing shareholders have the ‘right’ to buy them firstin order to maintain their proportionate stake in the firm. The question then isat what price to issue the new shares. The first thing we can say is that the pricecannot exceed the price at which existing shares are trading. If, for example,shares in XYZ plc are trading at £3 each, no one is going to pay more than £3for a claim on the same earnings of the same firm. Indeed, since the totalnumber of shares in issue is being increased, the firm’s earnings have to bespread across more shares and therefore earnings per share will almost certainlybe less, at least to begin with. This suggests that the new issue price should bebelow the existing market price, which is indeed what normally happens. Andit should be possible to calculate a theoretically correct price by finding thenew dividend (or earnings) per share for the enlarged stock of shares, leavingeverything else as it is and then recalculating a price using [4.5].

However, other considerations can complicate the picture. Firstly markets maytreat the new issue as a ‘signal’ about the firm’s future prospects. The signal maybe positive (more capital sending, more profits and so on) or negative (the firm’sbankers are calling in loans). Secondly, there are ‘reputational’ issues. A firmdoes not like to read reports that its new issue of shares has not found readybuyers. This makes it look financially incompetent. A similar issue arises for theinvestment bank that is managing the new issue. As part of the managementdeal, the bank will have agreed to buy up any unsold shares. But the bank maynot want to hold these shares for long, especially if the new issue is interpretedas a negative sign and the market price of the shares starts falling. Furthermore,it too may feel that its reputation for managing new issues is damaged and thatit may not attract this business so readily in future. For all these reasons, newissues are always priced ‘at a discount’ to the existing market price andsometimes the discount is substantial.

The following is a typical report of a firm’s results and their effect on itsshare price and on the market as a whole. Read the report and answer thequestions below:

‘Intel’s results helped Wall Street shrug off an unexpected drop in retailsales and pushed it to a fresh 15-month high yesterday. After dippingin and out of the red throughout the day, the S&P 500 edged 0.2 percent higher to 1148.46. The Dow Jones Industrial Average gained 0.3per cent to 10,710.55 and the Nasdaq Composite added 0.4 per centto 2316.74. The market had opened lower after the latest officialfigures showed retail sales, excluding cars, had fallen 0.2 per cent inDecember. Analysts had forecast an increase of 0.3 per cent. Butduring the afternoon session the technology sector helped to lift themarket as investors prepared themselves for quarterly results from Intel.The chipmaker beat analysts’ expectations with profits of $2.3 billion,

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875 per cent higher than a year ago. Shares in the world’s largestchipmaker rose 2.5 per cent to $21.48 – its biggest daily gain in almosta month. They soon added to their gains in after-hours trading as thecompany beat estimates.’

1. What was happening to the US stock market before the Intelannouncement and why?

2. What was the good news from Intel and how does it relate to Intel’sfundamentals?

3. Why did Intel’s good news affect the rest of the market?

1. We are told that ‘The market had opened lower after the latest officialfigures showed retail sales...had fallen.’ The likelihood is that investorstook this bad news about retail sales to indicate that sales (and thereforeprofits and dividends) would be lower than expected in many parts ofthe economy and so share prices fell generally.

2. The news from Intel was an extraordinary increase in profits ‘...of $2.3billion, 875 per cent higher than a year ago.’ This almost certainlyindicates a larger dividend (D1) in future and may even indicate a morerapid growth rate, g, in future. The result was a rise in the Intel shareprice of 2.5 per cent.

3. We are not told why the market as a whole reacted so positively to theresult from a single company, but we know that Intel dominates themarket for computer and similar chips. Some of these chips are fitted toconsumer products but many are also fitted to equipment and machinesthat are bought by other businesses. This big increase in profits may,therefore, be an indication that other firms – spread throughout theeconomy – are buying new equipment. This is unlikely unless those firmsare reasonably confident about their own prosperity in the near future.

Technical analysisThe more popular name for technical analysis is ‘chartism’, since the core of theapproach involves making a visual study of recent patterns in the behaviour ofa share’s price. At the simplest level, it may involve no more than applying somesimple formula to the data in order to make it easier to understand. Forexample, calculating a moving average of a share’s price over a period of timemay make it easier to see a trend, especially if there is a lot of volatility in theday-to-day price. But a moving average is very simple and does not in itselfprovide very strong signal to buy or sell a share.

Hence technical analysis has created a large range of devices known as ‘technicalindicators’ which allegedly convey useful information about future pricemovements and therefore act as buy/sell signals. Like a moving average, however,they are all concerned with patterns in the data. Some of the best known havebeen given names like ‘wedge’, ‘head and shoulders’, ‘flags’ and so on, but newones are being developed all the time. (See <http://stockcharts.com/> for adetailed listing and explanation of these indicators and of the approach.) Figure

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4.3 illustrates the basic idea. It shows the behaviour of a share’s price over aperiod of time. In practice, the period of time should be as long as possible, sothat the maximum information about past behaviour is included. Let us supposethat the horizontal axis covers a 15 year period. Obviously, if we record the pricefor each trading day in a 15 year period we will have several thousand (approxi -mately 3750) data points in our graph and it will be very difficult to form anygeneral view about patterns. Hence the next step is often to calculate a trendline, showing the general direction of movement (up or down) as well as the rateof change (the steeper the trend line the faster the growth in the share price).This will tell us whether or not this share fits into our overall investment strategy,if that strategy is one of maximising capital growth. This is the dashed line inFigure 4.3. We might also calculate a moving average which ‘smooths out’ theday-to-day fluctuations in price. This is shown by the solid line in Figure 4.3.

Figure 4.3: Using a moving average

How does this help us to make a decision? In Figure 4.3, we are making ourdecision at time t0. At this point the share price is falling (and is about to crossthe trend line). Clearly, if we are interested in capital growth, our strategy willbe to buy when the share price reaches its lowest point and begins to recover.In technical analysis, such a point is known as a ‘support level’. According tothe chart, this support level could be a price of P1 since it is many years sincethe price has fallen below that level. So our strategy should be to wait a whilefor the price to fall further but be ready to buy as soon as the price approachesP1.Similarly, the chart may be able to give us a ‘sell’ signal. This happens whenthe price reaches a ‘resistance level’. In Figure 4.3, this is shown as P2. This hasbeen the maximum price in four of the last five peaks. Certainly, if the price risesabove P2, we should be ready to sell the moment that the price starts to fallback.

The problem with chartism for many economists is that it conflicts with theefficient market hypothesis that you will study in the next unit. This says thatmarkets use information very efficiently. By efficient we mean that anyinformation that is relevant to an asset’s price is incorporated into the priceimmediately it becomes available. Hence, if there is any information in the past

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price of a share that indicates what its price should be now that information willalready have driven the price to what its price should be. This seems toundermine the idea that patterns can be found in the data that point to futureprice movements,. For example, if a ‘head and shoulders’ pattern means that theprice is pausing before a major fall, and it is known that this is what a head andshoulders pattern means, then shareholders will sell instantly and the price willfall so quickly that no one can take advantage of the information.

Furthermore, technical analysis does not seek to explain the price of a share. Itis mainly concerned with generating buy/sell signals for traders. In Figure 4.3,for example, technical analysis is not seeking to justify the price P1 as the lowestprice at which the market will value this share. There is no suggestion that P1

reflects any fundamental characteristics of the share. It merely says that‘however the market values shares, recent experience tells us that the price ofthis share is unlikely to fall below P1’.

Nonetheless, in spite of its lack of intellectual foundation, technical analysisremains very popular.

Compare the information required in order to judge whether a share shouldbe bought (or sold) using fundamental analysis and technical analysis.

Fundamental analysis claims to be able to explain the ‘fair’ or ‘correct’ priceof a share. If the market price is below (or above) the fair price, then that isa signal to buy (or sell). The calculation of the fair price is based upon theability of the share to generate future income for the holder. Hence the firstissue is the size of dividends that the share is likely to deliver in future andthat in turn depends upon the starting level of dividend payment (the mostrecent dividend paid) and the rate of growth of dividends in future. (It issometimes argued that it is the future level of profits rather than dividendsthat matter since profits retained within the firm still belong to theshareholder). However, because the income lies in the future, each paymentis worth less than it would be if received now and so it has to be convertedto a present value by the process of discounting. The rate at which thedividends are discounted depends upon the rate of return on assets ofsimilar risk and this can be broken down into the risk-free rate of interestplus a risk premium. In summary we need to know: the latest dividend; thegrowth rate of dividends (or profits); the risk-free rate of interest and therisk premium.

Technical analysis makes no claim to provide a fair or correct valuation of anasset. Instead, it looks at the current pattern of price behaviour andcompares it with the past. This history has then to be made to revealpatterns. This is done by using a number of statistical tools like trend lines,moving averages and so on which, when applied to the data, may show upsignificant patterns. However, what constitutes a ‘significant’ pattern is amatter of judgement, and may not be the same for all shares. For example,one share may show that after it has met the ‘resistance level’ three times it

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breaks through on the fourth occasion. This need not be true for another.Hence the requirements of technical analysis are: a detailed record of pastprice behaviour; a range of statistical techniques, and individual‘judgement’.

The required rate of returnIn section 4.3, we established that the term, K, with which we discount thefuture cash flow in order to find the fair value of a share is also the required rateof return, K

_. We need now to consider how this is arrived at.

We already have some clues. We have said that the rate at which we discountany future cash flow from an asset must incorporate the general level of interestrates and a risk premium. This is because our required return must be basedupon what we could earn on similar assets. It makes no sense to discount at arate which can only be earned on another asset with, say, twice the level of risk.Hence, our choice of discount rate must focus on these two elements: thegeneral level of interest rates and a risk premium.

In orthodox finance theory it is generally assumed that all the essential featuresof financial assets can be described under just two headings: return and risk.Since an investment decision is concerned with return and risk in the future wehave to form some expectation. One simple way of doing this (but it is notwithout dangers) is to look at what has happened in the past. Hence if we areinterested in the rate of return on an asset that we might be considering forpurchase we might look at the average of a series of outcomes measured overa period of time. Hence if we let Ke stand for the rate of return that we expect,then:

Ke =∑ Ki [4.11]

nwhere Ki is each one in a series of returns and n is the number in the series.In finance we think of risk as:

‘the probability that the out-turn is different from what is expected’.

Different from what is expected means different from K and once again we canlook at past data and see how widely dispersed around the average K were theindividual Kis. This is done by calculating the variance (or standard deviation)of returns around the mean value. The variance is found by:

Var = σ2 =∑ (Ki – Ke)2 [4.12]

n

and the standard deviation is the square root of the variance, σ.

You are given the following returns on two shares, A and B, for the lasteight years. Find the expected return and the variance and standarddeviation for each.

A: 5, 8, 3, 6, 9, 11, 7, 6

B: 3, 7, 2, 8, 14, 13, 9, 4

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4.4Recommended reading:

Howells and Bain (2008) ‘PortfolioTheory’, ‘Asset Pricing’ and ‘The

Equity Market’; Howells and Bain(2007) ‘Capital Markets’; Piesse

et al (1995) ‘Valuation of FinancialInstruments’.

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A: Expected return = 55/8 = 6.875

Variance = (5 – 6.875)2 3.516(8 – 6.875)2 1.266(3 – 6.875)2 15.016(6 – 6.875)2 0.766(9 – 6.875)2 4.516(11 – 6.875)2 17.016(7 – 6.875)2 0.016(6 – 6.875)2 0.766

σ2 = 42.878 σ = 6.548

B: Expected return = 60/8 = 7.5

Variance = (3 – 7.5)2 20.25(7 – 7.5)2 0.25(2 – 7.5)2 30.25(8 – 7.5)2 2.25(14 – 7.5)2 42.25(13 – 7.5)2 30.25(9 – 7.5)2 2.25(4 – 7.5)2 12.25

σ2 = 113.00 σ = 10.63

In the light of this discussion, we might therefore think that if we want ourrequired rate of return to incorporate some recognition of the riskiness of theasset, we should look to the variance (or standard deviation). But we do not.This is because the standard deviation measures the riskiness of an asset heldin isolation. And this is not what people do. They hold assets in combination– in a portfolio and this has major consequences for the risk that we areconcerned with.

In fact, we get both the general level of interest rates and the price of risk fromwhat is called the capital asset pricing model (CAPM).

Our starting point is that no rational investor will hold risky assets in isolation.This is because, by combining assets in a portfolio, we can reduce the level ofrisk associated with any particular rate of return. This is a process known asdiversification and the way in which this works is demonstrated in anytextbook dealing with finance or financial markets (see Howells and Bain,2008). Briefly, diversification yields benefits because risky assets suffer fromrisk which is unique or specific to that asset and risk which arises from eventsthat affect the whole market for risky assets. Events giving rise to market riskwill affect the return on all assets in that market. By contrast, events giving riseto specific risk will only affect the asset concerned. While each asset in theportfolio will be subject to its own specific risk events these will occur to somedegree independently across assets. When one asset receives a negative shock,there is a chance that another asset will experience a positive shock.Consequently, there will be some tendency for these shocks to offset each otherand thus to stabilise the return to be expected from the portfolio.

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Imagine that you are analysing shares in a pharmaceutical company. Canyou think of two events that represent market risk and two events thatrepresent specific risk?

Examples of market risk are a change in interest rates (which causes all assetprices to move in the opposite direction). A slowdown in the economywould be another. An increase in taxation would also have a negative effecton prices as would a rise in the general level of uncertainty about the futuredirection of the economy.

Examples of specific risk could be the results of the trial of a new drug, theexpiry of a patent protecting the profits from an existing drug and a changein public policy towards the approval of drugs for use in a publicly-fundedhealth service.

Figure 4.4 shows the risk-reducing effect of diversification. Notice that it ismarket risk that is progressively reduced as the portfolio is expanded and thatthe maximum effect is achieved with about 20 assets in the portfolio.

Figure 4.4: Benefits of diversification

The capital asset pricing model starts, therefore, from the idea that the relevantrisk that we have to consider in pricing an asset is not the asset’s total risk –since some of this will be eliminated by its being added to a portfolio. What iseliminated is the specific risk. What remains, and what really matters, is thedegree of market risk in the asset. And we can assess this by asking does itrespond to market fluctuations in line with some average or benchmark, or isit more or less sensitive? Since we have established that a rational investor willonly add the asset to a fully-diversified portfolio, then the obvious benchmarkis the riskiness of the portfolio. And since the fully-diversified portfolio is aportfolio containing the whole set of risky assets, the benchmark must be setby the way in which this whole market portfolio responds to marketfluctuations. When we know this, we can then compare our asset with thisbenchmark and this will give us an assessment of its relevant risk.

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Portfolio risk σp

Market risk

Specific risk

0 5 10 15 20

Number of assets

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Figure 4.5 is a scatter diagram. It plots the return on the whole marketportfolio, KM on the horizontal axis. On the vertical axis, we have the returnon the individual asset, call it Z. We can then draw a line of best fit in order tosee how a change in KM is related to a change in KZ. The relationship will becaptured by the slope of the line. Alternatively, we could run a statisticalregression of KZ on KM and the relationship would be expressed by a term called‘beta’ (the beta coefficient). This is the slope of the line in Figure 4.5. In thepresent case, the slope of the line appears to be rather steeper than 45-degreesand so the value of βZ appears to be slightly greater than one. An asset with β = 1 has the same exposure to market risk as the whole market portfolio whileβ < 1 indicates less exposure (a ‘defensive’ asset) while β > 1 suggests greaterexposure that the whole market portfolio. For purposes of illustration, we shallsuppose that the value of βZ is 1.1

Figure 4.5: The beta coefficient

This takes us half-way to finding a price for the risk in asset Z since we nowknow the quantity of relevant risk. To complete the price calculation we nowneed to know the unit price of relevant risk. We can find this also by referenceto the whole market portfolio.

Remember that the whole market portfolio is exposed only to market risk,therefore, whatever is the return on the whole market portfolio, over and abovethe risk free rate, must be the market price of risk. For example, suppose thatthe whole market return is 12 per cent pa while the risk-free rate is four percent, then we may say that the market price of risk is eight per cent. And if thequantity of relevant risk in asset Z is 110 per cent of the whole market, thenwe can say that the price of risk in Z is 1.1 times eight per cent or 8.8 per cent.This is the return that is required over and above the risk free rate and so thetotal return that we should expect to earn from Z is 8.8 + 4 = 12.8 per cent. Ingeneral terms, we can write the calculation as follows:

KZ = Krf + βZ(KM – Krf) [4.13]

where KZ is the required return on Z, Krf is the risk-free rate of interest (whichwe might take to be represented by the policy rate or something similar that wediscussed in earlier units), βZ is the quantity of relevant risk in Z and KM – Krf

is the market risk premium or the market price of risk. Expression [4.13] isknown as the capital asset pricing model.

return on market, KM%

return on assset Z, KZ%

ΔKZ

∞KZ

∞KM

ΔKM =Z

beta coefficient

market risk premium

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Learning activity 4i gives you the opportunity to work another example.

(a) Assume that the risk free interest rate is three per cent while the wholemarket return is 14 per cent. What rate of return would you requirefrom an asset, Q, with a β-coefficient of 1.15?

(b) What rate of return would you require if the risk-free rate rose to fourper cent, all else unchanged.

(a) KQ = 3 + 1.15(14 − 3) = 3 + 12.65 = 15.65%.

(b) KQ = 4 + 1.15(15 − 4) = 4 + 12.65 = 16.65%.

Notice that ‘all else unchanged’ means that the market risk premium isunchanged and therefore the return on the whole market portfolio mustincrease from 14 to 15. And this is sensible enough, since risk free assets nowpay an extra one per cent, one would expect risky assets also to pay more.

Now that we can find the required rate of return on assets with differing degreesof market risk, we can go back to [4.3] and see how things like the risk-freerate, the share’s beta-coefficient and the market risk premium all enter into thefundamental determination of share prices. For an illustration, we go back tothe case of Thornbury plc in learning activity 4d. You will recall that Thornburyhad paid a last dividend of 6p while its earnings had been growing steadily atabout 10 per cent pa. We used the 12 per cent rate of return required by sharesin this sector as a guide to what we needed from Thornbury and we calculateda price of £3.30. But we can now do better than that since we can decide exactlywhat rate of return we require in the light of its risk and other factors. Forexample, suppose that when plotted against the whole market rate of return forthe last ten years, Thornbury appears to have a beta-coefficient of 0.9. The riskfree rate of interest at the moment is three per cent while the return on thewhole market portfolio is 14 per cent. All else remains as before. Then we canfind the fair price of Thornbury in two stages. Firstly, we find the required rateof return as follows (where the subscript T stands for Thornbury).

KT = 0.03 + 0.9 (0.14 − 0.03) = 0.03 + 0.099 = 0.129 or 12.9% [4.14]

Notice that we have done the calculation using percentages expressed asdecimals rather than whole numbers. This is because we need the result in thatform for the next step which takes us back to [4.3]. To find the price, we do aswe did before:

6(1.01) 6.6PT =

0.129 – 0.1=

0.029= 227.59 or £2.28 [4.15]

Notice that the slightly higher return required from Thornbury in this case hasresulted in quite a significant fall in Thornbury’s share price.We can now summarise the CAPM as follows:

■ The market will price an asset such that its rate of return will be equal to therisk-free rate of interest plus a risk premium which depends upon the marketprice of risk and the quantity of market risk contained within the asset.

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In learning activity 4d, we saw what would happen if Thornbury expandedinto a new line of business which was rather more risky than themanufacture of chocolate. We predicted that the required return would goup and therefore that Thornbury’s share price would fall. W can now bemore precise about this.

Using the data that we had in learning activity 4d, what would happen tothe required return and the share price if Thornbury were reorganised sothat 80 per cent of the firm continues in chocolate making while 20 percent of the firm is switched to luxury catering? The beta-coefficient of firmsin the luxury catering industry is 1.1. (Hint: think about Thornbury’s beta-coefficient.)

Step one: Recalculate Thornbury’s beta. When 100 per cent of the firm wasmaking chocolate βT was 0.9. Under the new structure, the beta-coefficientmust be a weighted average of the two betas:

βT = 0.8(0.9) + 0.2(1.1) = 0.72 + 0.22 = 0.94.

Step two: Find the required return:

KT = 0.03 + 0.94 (0.14−0.03) = 0.03 + 0.1034 = 0.1334 or 13.4%

Step three: Reprice the share using the new rate of return:

6(1.01) 6.6PT =

0.1334 – 0.1 =

0.0334 = 197.60 or £1.98

The trading of company sharesThe users of equity markets are the ultimate lenders and borrowers that weidentified in Unit 1. In this particular case, the borrowers are large corporations.The ultimate lenders are households, who may hold company shares directly or,more usually hold them indirectly through financial intermediaries that managepension or mutual funds or life assurance policies. In the UK, most equities arebought from and sold to market makers, directly by large financial corporationsor for households via a broker. Market makers hold stocks of all the companyshares in which they make a market and it is a condition of their membershipof the exchange that they quote ‘continuous two-way prices’ at which they areprepared to deal. This means that sellers can always find a buyer for their sharesand buyers can always find a seller. The price at which they are prepared todeal (in fact a ‘spread’ between a buying and selling price) is up to the marketmaker. Hence, when sellers exceed buyers, market makers will reduce theirprice in order to restore a balance and the media report the ‘market falling’ (orrising). The consequence of this trading arrangement is that London is knownas a ‘quote-driven’ market, meaning that what ‘drives’ or causes a transactionis the price that is quoted. Buyers and sellers are motivated. by what they thinkis a ‘good’ price.

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4.5Recommended reading:

Howells and Bain (2008) ‘TheEquity Market’; Piesse et al (1995)

‘The Equity Market’.

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This is not the only way to organise trading in shares. New York StockExchange (NYSE) Euronext, which calls itself ‘the first global stock exchange’was a pan-European exchange with subsidiaries in Paris, Amsterdam, Brusselsand Lisbon until it merged with the New York Stock Exchange in April 2007.The Euronext exchanges work on a matching principle. This means that buyersand sellers place their orders without knowing the price at which thetransaction will take place. (They know the price of the last transaction andthey can place upper and lower limits to the price they will accept.) Theexchange technology then tries to match the order with an opposing one sothat shares are passing directly from buyer to seller without an intermediatemarket maker. If the order is not filled after a certain time it can be withdrawn.In London, investors have the option to trade the top 100 shares in this way,or through a market maker. Such markets are known as ‘order-driven’ marketssince what causes a transaction to take place is an order to buy or sell. Thereis no clear-cut advantage to either system. Quote-driven markets tend to havehigher transaction costs since the market makers must cover their costs andearn a profit which provides an adequate return to compensate for the risk theyface by holding large stocks of securities on their own books. On the otherhand, the same markets have the advantage that buyers and sellers can becertain about the price at which the deal will take place before thy issue theinstruction.

The arrangements that we have just set out describe the trading arrange mentsin what is called the secondary market for shares. This is the market in whichexisting shares are traded. But it is possible also to talk about a primary marketas we saw in 3.5 – the market which deals with new issues. It is the primarymarket that channels new funds from lenders to borrowers; trading in thesecondary market involves the transfer of ownership of existing shares. In mostcases, the organisations involved are the same as those that are making thesecondary market.

When it comes to trading, secondary market activity dwarfs new issues (as wesaw in the case of bonds). Table 4.3 shows recent data from the London StockExchange.

Notes: 1. At end October 2009; 2. 1 January to 31 October 2009

Table 4.3: The London Equity Market, 2009Source: London Stock Exchange (2009) Market Statistics, November

The table shows new issues raising £60.4 billion in the ten months to the endof October 2009 while total transactions in the secondary market amounted tomore than £10,000 billion. The difference between the two shows just howmuch trading is the consequence of portfolio adjustments – investors sellingone existing stock and buying another – and it also gives us an understandingwhy, in spite of being strictly speaking irredeemable instruments, company

No. of listed Market cap. Funds raised by Turnover No. of trades, companies1 £bn1 new issues £bn2 £bn2 mn2

1,458 3,252.3 60.4 10,229.1 144.8

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shares are made highly liquid. The table also shows the number of companieswhose shares are listed on the exchange and the total market value of thosecompanies.

Table 4.4 allows us to make some rough comparisons of size. Unfortunately thisdata is available only at end-October 2008. Furthermore, national values areconverted into $US which facilitates comparisons within the table but in orderto make comparisons with Table 4.3 the monetary values in Table 4.4 shouldbe divided by about 1.6.

Notes: 1. At end-October 2008; 2. 1 January to 31 October 2008

Table 4.4: Selected stock marketsSource: Focus, November 2008 (Paris: World Federation of Exchanges), pp36−48.

As well as notable, but expected, differences in size, there are some otherinteresting points to note. Firstly, the US NASDAQ market (a market for mainlyhi-tech firms) has a large number of firms each with a relatively small value. Atthe same time it is a very active market since the total value of trading to end-October 2008 was over five times the market capitalisation at the end ofOctober. This compares with rather more than three for London and barelyover one for Hong Kong.

In most exchanges, the value of funds raised in any period is dwarfed by theamount of trading in the secondary market. What useful purpose (if any) isserved by this high volume of secondary market trading?

The existence of an active secondary market is essential if shares are to haveany liquidity. Without an active market, investors would be very unwilling tohold shares and firms would have to pay a much higher price for theircapital. Related to this an active market helps investors to adjust their

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Exchange No. of listed Market Turnover, No. of companies1 capitalisation, US$bn2 trades mn2

US$bn1

NYSE 2,382 10,312.7 30,214.8 3,476.5

NASDAQ 2,999 02,579.5 13,618.6 1,826.6

Hong Kong 1,254 01,228.5 1,458.6 92.1

Shanghai ,863 01,341.0 2,184.0 1,034.2

Euronext (exc NYSE) 1,026 02,083.6 4,050.9 0 165.6

Deutsche Börse ,855 01,097.0 3,526.2 0 128.2

Tokyo 2,414 02,884.4 4,902.6 –

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portfolios in response to what they see as profitable opportunities or inresponse to their own changing needs.

The price of shares is set in the secondary market and the movement in shareprices may convey useful information. First of all it tells the firm what it willhave to pay if it wishes to raise new funds. It also tells the firm how itsperformance is judged by the market. For example, a declining share pricemay be an early warning to management that investors have lost confidencein the current strategy and that there should perhaps be a rethink.

In economics, it is customary to analyse the functioning of markets within asupply and demand framework. We do this in Figure 4.6 which is essentially thesame as Figure 3.2 in our discussion of the bond market. Firstly, we are lookingat the price of existing shares, so we are looking at the secondary market wherethe quantity is fixed. Hence the ‘supply’ is shown by the vertical supply curve,S. Initially, demand is shown by D. The demand curve is downward-slopingbecause, other things equal, shares are more attractive at a lower price since (weknow) their rate of return is higher. For purposes of illustration, let us supposethat we are looking at the market for shares in Thornbury plc. Then initially,then we have an equilibrium price of £2.28 (from [4.17]). In learning activity4j we then looked at what would happen to the Thornbury share price if itchanged its business model by moving into luxury catering. This increased itsrisk and we saw that the price fell to £1.97. This is shown in Figure 4.6 by thedownward shift of the demand curve from D to D’. We could, if we wished plotthe corresponding rates of return on a right-hand axis.

Figure 4.6: The equity market

As with bonds, the lesson to be learned from Figure 4.6 is that the pricingdiscussions in section 4.3 should be interpreted as operating on the demandside of the market. When we calculate the present value of a future dividendstream we are calculating what price holders should be prepared to pay. Anychange in that present value corresponds to a shift in demand.

Pric

e, £

quantity of shares

1.97

2.28

0

D

S

D’

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Case Study

Wilton Wanderers plc is a football club. Its shares have just paid adividend of 30p. Nine years ago, the dividend was 10p. The shares have a β-coefficient of 1.3. Assume that three-month treasury bill rates are sixper cent and the return on the FT All Share index is 18 per cent.

1. Estimate an appropriate price for the shares today. Explain anyassumptions you have had to make. Using a supply and demanddiagram (like Figure 4.3) show the equilibrium price for WiltonWanderers plc on the vertical axis.

The board of Wilton Wanderers announces that it has just signed a newstriker whose addition to the team will help ensure promotion at theseason’s end. The likely effect of promotion will be a big increase inprofitability. If the club maintains its current dividend policy, for example,next year’s dividend is likely to be of the order of 40p. Assume thateverything else is expected to be largely unchanged.

2. Use the diagram to discuss the likely immediate effect upon the shareprice.

Suppose that Wilton Wanderers is not successful in its bid forpromotion, and that several other football clubs who have spent largesums of money on star players also fail to get promotion, win trophiesand so on when they were widely expected to do so.

3. Explain how this is likely to affect the price of shares in football clubsgenerally, using the terms in [4.3].

1. The required return can be estimated as 0.06 + 1.3(0.18 − 0.06) = 0.216or 21.6%. The growth rate of dividends is such that they have grownfrom 10p to 30p in nine years. We can use a compound interest table tofind the rate of growth, which would cause a value to triple in nineyears. The table tells us that this is 13 per cent to a very closeapproximation. The next dividend therefore we would expect to be 33.9(= 30 × 1.13). We can now solve for the price. P = 33.9 + (0.216 − 0.13) = 33.9 + 0.086 = 394.2 or £3.94. In arrivingat this figure, we have had to take three-month treasury bill rate as aproxy for the risk free rate and the return on the FT All Share index as aproxy for the whole market portfolio. Neither of these is absolutelycorrect in theory, but both are commonly used as the best measures thatare readily available. In using compound interest tables to find thedividend growth rate, we have assumed that dividends have grown at aconstant rate and, more importantly, we have assumed that thatconstant growth rate will apply in the immediate future.

2. The news of the signing suggests the possibility of higher profits andshareholder dividends in future. Assuming that investors share themanagement’s optimism about promotion and its estimate of the effecton profits, the shares will be more attractive compared with those of

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other football clubs. The demand curve will shift out and the price willrise. Since we are told that everything else is expected to remainunchanged (once in the higher division, for example, the dividendgrowth rate will be much as before), we can calculate a new price bysubstituting the new dividend. In the diagram, the demand curve shiftsout and the new equilibrium price on the vertical axis will be £4.65.

3. We would expect their share prices to fall. If the question related only tothe share prices of the individual clubs whose achievementsdisappointed, then we might explain the fall by reference to lowerdividends, D1 (and possibly lower future earnings growth, g). But thequestion asks how and why the shares of all football clubs might beaffected. The most promising explanation is that the degree of riskinvolved in earning profits in football is made clear to shareholders.Notice it is not necessary that there is any objective change in the levelof risk – it is investors’ perceptions that drive prices. If, for some reason,they had become complacent (because large transfer deals had hithertoseemed to pay off) then a run of contrary cases may serve to remindthem that football is a very risky business. If we are right, then the effectfalls upon the β-coefficients of shares in football clubs. This means thatinvestors in football shares require a higher risk premium in future andthis, in turn, results in a higher overall required rate of return. In [4.3],the value of K increases (and share prices fall).

Self-assessment questions4.1 Explain the terms:

(a) market capitalisation(b) dividend yield(c) price/earnings ratio.

4.2 A security with a β-coefficient of 0.8 has a return of 16 per cent pa whileanother security with β-coefficient of 1.2 has a return of 20 per cent pa.Assuming that both securities are correctly priced:(a) find the risk free rate of interest(b) find the return on the whole market portfolio.

4.3 You have £100,000 to invest and you propose to create a portfolio of fiveshares. The distribution of the portfolio and the β-coefficients of theshares are as follows:A: 10,000 1.1B: 30,000 1.4C: 25,000 0.9D: 28,000 0.8E: 7000 0.7Given the risk free rate and whole market returns in Q4.2, find the rateof return required on this portfolio as a whole.

4.4 A close friend has £20,000 invested in the shares of XYZ plc. The lastdividend was 17p while earnings have been growing at nine per cent pa.The risk free rate is eight per cent while the whole market return is 18 percent. The shares have a β-coefficient of 1.13 and are currently trading at200p. What advice would you give her?

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4.5 Wilton Wholefoods plc is a catering company which operates threedivisions. The following table shows the amount of capital allocated toeach activity. The table also shows the beta-coefficients for the shares ofcompanies which specialise in these activities.

Division Capital £m Beta

Cafés 30 1.2

Wholesale supply 50 0.8

Restaurants 20 1.4

Table 4.5: Capital and beta for Wilton Wholefoods divisions

(a) If the risk free rate is current six per cent while the whole marketreturn is 15 per cent, calculate the rate of return that shareholdersin Wilton Whole foods will require.

(b) Suppose that Wilton decides to reduce its wholesaling activity andstart up a natural fruit juice brand using £20 million of existingcapital. The shares of firms specialising in health drinks show betacoefficients around 1.0. What effect is this restructuring likely tohave on the return required by Wilton’s shareholders?

4.6 Explain what is meant by a ‘quote-driven continuous market’ for securities.What advantages does it have over other types of trading arrangement?

Feedback on self-assessment questions4.1 Market capitalisation usually refers to the current market value of a firm.

For an all-equity firm this is found as ‘share price × number of shares inissue’. Occasionally, market capitalisation refers to the value of all thefirms quoted in the market (that is it is one measure of market size).

In this case, we merely sum the market capitalisation of all firms.Dividend yield measures part of the rate of return on a share. It is foundas ‘dividend payment per share ÷ share price’. It ignores the return thatmay come in the form of capital appreciation, but is obviously importantfor investors looking primarily for income from their shareholding. Theprice/earnings (or P/E) ratio expresses the price of a share relative to theearnings (profits) of a firm per share. Thus, it expresses the price one hasto pay to buy a share of the firm’s profits. Notice that we are interestedin the price of profits rather than dividends. This is consistent with theview that it is profits that increase shareholder wealth whether they arepaid out as dividends or not.

4.2 (a) You have the data for two versions of the CAPM: 0.20 = x + 1.2(y) (i)0.16 = x + 0.8(y) (ii)Subtract (ii) from (i) and we have 0.04 = 0.4(y). Therefore y = 0.1.Next, substitute 0.1 in (i) which gives us 0.20 = x + 1.2(y) and 0.2= x + 0.12.Therefore x = 0.2 – 012 = 0.08 and so the risk free rate is 0.08 oreight per cent.

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(b) We can now write (i) as: 0.20 = 0.08 + 1.2(KM – 0.08) and then 0.2− 0.08 = 1.2(KM – 0.08).

0.2 – 0.08 = KM – 0.08. Then 0.1 = KM – 0.08 and KM = 0.18 or 18%.

1.2

4.3 The weighted average of the beta values = 1.028.Therefore: 0.08 + 1.028(0.1) = 0.1828 or 18.28%

4.4 Firstly, find the required return. K = 0.08 + 1.13(0.18−0.08) = 0.193

Then the fair price is:

17(1 + 0.09) = 179.9

0.193 – 0.09

So the correct price is 180p.

The advice should be to sell and this could be explained either in termsof the required return (the return is insufficient at 200p) or in terms of riskof capital loss (the price will fall when the market discovers the mistake).

(a) We first need to find a beta-coefficient for Wilton. This is theweighted average of the betas for its three divisions. So, β = 0.3(1.2)+ 0.5(0.8) + 0.2(1.4) = 0.36 + 0.4 + 0.28 = 1.04.

We then use this in the CAPM formula: K = 0.06 + 1.04(0.15 −0.06) = 0.06 + 0.0936 = 0.1536 or 15.36%

(b) We do the same for the four divisions of the restructured firm.

β = 0.3(1.2) + 0.3(0.8) + 0.2(1.4) + 0.2(1.0) = 0.36 + 0.24 + 0.28 +0.2 = 1.08

We then use this in the CAPM formula: K = 0.06 + 1.08(0.15 −0.06) = 0.06 + 0.0972 = 0.1572 or 15.72%

4.6. A quote-driven market is one where buyers and sellers are confronted byprices (‘quotes’) at which market makers are prepared to deal. The priceis known before the deal is made and thus the quoted price could beregarded as the central factor triggering the decision to buy or sell (hence‘quote-driven’). Such a market requires dealers to hold inventories of thestocks in which they are prepared to deal. When they buy from sellers,they add to these stocks and when they sell to buyers they reduce thesestocks, at least temporarily. Because of the cost and risk involved inholding these stocks, quote-driven markets tend to be more expensive tooperate than auctioneer markets. ‘Continuous’ means that prices mustalways be quoted for the stocks in which dealers are prepared to makemarkets. They cannot, for example, stop quoting a buying price whenthey find that they have surplus stock. The requirement that marketmakers quote continuous two-way prices is a strict rule of membership ofany stock exchange which uses this type of trading. Much trading on theLondon Stock Exchange is carried out in this way as it is also on theNASDAQ exchange in the USA. The main advantage of these arrange -ments to shareholders is that they know what price they will deal at beforedeciding to deal. This limits their exposure to the risk that the price maychange between the moment of their decision and the recording of thedeal. If prices do move in this period, the effect falls on the market maker.In auctioneer markets, by contrast, there is usually some uncertainty

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about the final price at which the deal will be carried out. If limits areplaced on the price then it may be that no deal will be done. In thesecircumstances, shareholders face a degree of risk which is not present inquote-driven markets. Quote-driven markets have the advantage of lowerrisk to shareholders but this is compensated by the higher transactioncosts that we referred to above.

SummaryIn this unit we have looked at another of the major capital markets. We haveseen what company shares are, how they are priced, used and traded. Havingfinished this unit you should now be able:

■ to describe the key characteristics of shares and their uses and to retrieveand understand share price data

■ to price shares according to their ‘fundamentals’ and to show how, otherthings being equal, the price varies with the rate of return

■ to analyse the role of risk in determining the required return on shares

■ to show how that required return helps determine the share price

■ to understand something of the institutional arrangements for the tradingof shares.

Appendix: More on divided valuationVariations on the basic Gordon model include dividend discount models withdifferential rates of growth. For example, rather than assuming a constant rateof dividend growth, we might think it more realistic for firms to go through arapid growth phase (in its early years) followed by a slower rate of growth inits maturity. Or we might even add a third, possibly slow or even decliningphase, when the growth rate is slow or negative. If we are pricing the shares inany phase but the final one, we need to take account of the fact that the growthrate will change at some point in the future. For example, if we assume a twoperiod growth model, then we do two separate valuations and then add themtogether. We value the dividends received in the first phase and then find aseparate value for the subsequent phase, discount this back to the present andadd it to the value for the first. This sounds more complex than it is. Considerthe following example where the last dividend payment was 55p and this isexpected to grow rapidly for two more years at ten per cent when the firm willenter a long-term slower growth phase of six per cent pa. The required returnis 14 per cent. The formula is shown below.

P0 = ∑D0 (1 + g1)1

+1 . DT+1

(1 + K)1 (1 + K)T K – g2

In [4.11] the rapid growth takes place for T periods, and so the first part of theexpression values the dividends growing at the rapid (g1) rate. At time T weare then faced with a slow rate of growth (g2). Thus, the final part of theexpression values this infinite stream of dividends in the same way that we didin the constant growth model [4.3]. But to find the present value of the dividendstream at T we need to discount this back to the present by the middle part ofthe expression, 1/(1+K)T.

T

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This sounds more complex than it is. Consider the following example where thelast dividend payment was 55p and this is expected to grow rapidly for twomore years at ten per cent when the firm will enter a long-term slower growthphase of six per cent pa. The required return is 14 per cent.

P =0.55(1.1)

+0.55(1.1)2

+1 . 0.55(1.1)2 × 1.06

1 + 0.14 (1.14)2 (1.14)2 0.14 – 0.06

=0.605

+0.6655

+1 . 0.70543

1.14 1.2996 1.2996 0.08

= 0.5307 + 0.51208 + (0.7695 × 8.8178)

= 1.04278 + (6.785) = £7.83

If we had priced this on the assumption of the single, slow growth rate (using[4.3]) the value would have been £7.29. The difference is the result of the twoyears of rapid growth.

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‘We all invested in a few [dotcoms]. Youlook at it now and think you must have

been crackers.’London fund manager speaking on BBC radio in 2002

IntroductionIn the last three units we have seen how selected assets are priced byreference to their fundamentals. In this unit we look at the argumentthat this is generally the case and hence that assets are, in general,correctly priced.

Unit learning objectives

On completing this unit, you should be able to:

5.1 Explain the basis and the implications of the efficient markethypothesis.

5.2 Provide a critical analysis of the hypothesis using data from the 2008financial crisis and elsewhere.

5.3 Demonstrate an understanding of recent contributions from thefield of behavioural finance.

Prior knowledge

The unit assumes that you have studied Units 1–4. Otherwise, it requires no priorknowledge, but some basic mathematical skills and familiarity with basiceconomics and finance is helpful throughout.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008:‘Financial Market Efficiency’). In Piesse et al (1995) ‘The Structure of SecuritiesMarkets’ and ‘The Equity Market’ have some relevance. Mishkin (2007) ‘TheStock Market … and the Efficient Market Hypothesis’ deals with the efficientmarket hypothesis in some detail, as do many other finance textbooks.

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The basis and implications of the EMHWhen we use the term ‘efficient’ in everyday language we describe somethingwhich works well. It delivers the service or the action that we require and it doesso with great reliability, and perhaps quickly and cheaply as well. Clearly, wewould like a financial system to be efficient in this sense. We would like toknow that if we instruct a bank to make a payment to someone on our behalf,the payment is made promptly and goes to the right person. Equally, if we aska broker to make a bond sale or purchase for us we do not expect the brokerto lose the contract note or the exchange to fail to record the transaction. Wemight call this kind of efficiency operational efficiency.

In Unit 1 we made the point that a fundamental purpose of a financial systemis to channel funds from lenders to borrowers. When it comes to connectionsbetween the financial system and the real economy, therefore, we should like toknow that financial markets and institutions will generally channel funds totheir most productive use. Generally, this means ensuring that funds go to theirmost profitable use. If this happens, then firms that are producing goods andservices that are in high demand will find it easier to raise new funds than firmswhose output is less valued by society. This kind of efficiency might be calledallocative efficiency, since it refers to the way in which financial resources areallocated. But the ‘efficiency’ with which we are concerned in the EMH issomething different. This efficiency refers to the way in which information isused and is called informational efficiency. The EMH says that financialmarkets make the best possible use of all available information. Notice thatalthough the EMH is often discussed by reference to equity markets and testsof the EMH often study share price behaviour, the principles underlying theEMH apply to all financial (and even to non-financial) markets. There arenumerous studies of the EMH that use evidence drawn from foreign exchangemarkets.

What is meant by ‘best’ is not often spelled out carefully. We all know that‘best’ means ‘quickly and completely’ so that all relevant information is incor -porated into asset prices so quickly that no one enjoys a sustained informationadvantage from which they can earn a rate of return in excess of the normalreturn for a given level of risk. However, the EMH is often presented asmeaning that information is quickly incorporated and that the information isused in such a way that prices are generally ‘correct’ according to theirfundamentals. This is another way of saying that the users of the informationare incorporating the relevant information into the ‘correct model’ of assetpricing and that this model is like those we used in Units 2–4. And it is thetwo propositions together: speed/completeness and correctness, that give theEMH its immense significance. If the EMH holds in its entirety, then it followsthat the way that markets behave cannot be improved upon and thefluctuations in prices that we see are somehow ‘correct’. Everything is for thebest. This has always been a controversial claim and it has become doublycontroversial since the 2008 financial crisis. In the rest of this section, we lookat the two propositions separately (in section 5.1). We then look at theimplications of the EMH, before going on to consider the EMH in the lightof evidence (section 5.2) and in the light of some alternative explanations ofbehaviour (section 5.3).

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5.1Recommended reading:

Howells and Bain (2008) ‘FinancialMarket Efficiency’; Mishkin (2007)

‘The Stock Market … and theEfficient Market Hypothesis’.

operational efficiency

allocative efficiency

informational efficiency

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Distinguish between the meanings which can be attached to ‘efficiency’when applied to financial markets.

Operational efficiency: The market carries out its functions, quickly,accurately and with low transaction costs. In the case of financial markets,security is an additional characteristic of operational efficiency.

Allocative efficiency: The market allocates resources to their most productiveuse. ‘Resources’ in the case of financial markets can be read as ‘funds’.

Informational efficiency: The market makes the most efficient use of allrelevant information.

Most debates about financial market efficiency are about informationalefficiency.

Being well-informedThe starting point of the EMH is that agents are:

■ rational

■ self-interested.

Together, these assumptions mean that agents will always try to do the bestthat they can for themselves, and this includes using information as effectivelyas possible. This includes learning. If one situation is known to lead to another,and we use that information in order to anticipate the second state, then our‘rationality’ says that we do this all the time; we do it consistently. We do notuse the information sometimes and then ignore it at others. And the reason thatwe use this information consistently is guaranteed by our ‘self-interest’. If wetreated our learned information in a casual way, using it sometimes andrejecting it at others, we should be forgoing profitable opportunities. We shallcome back to criticisms of these assumptions in section 5.3 but it is worthmaking the point that they are very attractive assumptions and that thefoundations of most economics rests upon them. This makes it difficult to rejectthe EMH. Rejection seems to require either that we think people do not behaverationally and/or that that they are not fundamentally motivated by self-interest. Economists are reluctant to accept either.

If we confine ourselves now to security markets then the EMH says that:

‘security prices fully reflect all relevant information’

and since we know (from Units 2–4) that prices and yields are inversely-related,then the EMH tells us that yields (or rates of return) also incorporate allrelevant information. At this point we set aside what exactly might be meantby ‘relevant’ and examine more carefully this notion that information can beprocessed so quickly and effectively that no one has an information advantage.Looking at rates of return first, we know from Unit 4 ([4.4]) that the totalreturn on a company share is the sum of its dividend yield (dividend divided byprice) plus any capital appreciation (or loss). Thus, where K is the rate of return,

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P0 is the purchase price, D1 is the dividend paid during the holding period andg is the rate of capital appreciation:

K =D1 + g [5.1]P0

Recall then that the rate of capital appreciation is merely the change in pricedivided by the price paid, then:

K =D1 +

P1 – P0 [5.2]P0 P0

where P1 is the price in the next period.

Imagine a security, where the next dividend, D1, is known. (In practice of courseit will not be known with certainty but if the EMH holds then it will be forecastcorrectly on average.)

Then the rate of return, Ke, expected at the beginning of the period, is uncertainby virtue of the fact that we do not know, but can only form expectations of,P1. Thus:

Ke =P1 – P0 + D1 [5.3]

P0

Since efficient market theory argues that people use all available information informing expectations of future events, then Ke is an optimal forecast of K, andsince making an optimal forecast of K requires that we make an optimalforecast of P1, then Pe

1 must be an optimal forecast of P1. Thus:

Ke = K† and P1e = P1

† [5.4]

where ‘†’ signifies an optimal forecast.

As we have just seen, this is an attractive argument since the alternative meansthat agents do not try to make the best forecast of returns and this goes againstour deep-seated beliefs that agents are rational wealth maximisers.

Another way of looking at the forces that push agents to make optimumforecasts based on all information is to think of ‘equilibrium’ prices or returns.By ‘equilibrium’ we mean those prices which produce rates of return that arejust equal to what people require, K

_. Let us call the equilibrium return K* and

the corresponding equilibrium price P*. Then it follows that if an optimalforecast of K exceeds the required rate of return, informed investors will wishto buy the corresponding asset in order to benefit from the abnormally highreturn. Buying the share will cause the price to rise and the forecast return tofall until the optimal forecast just equals the required or equilibrium return.Conversely, if the optimal forecast of returns is that they are below whatinvestors require, then well-informed investors again will try to benefit, thistime trying to avoid a capital loss, by selling the corresponding asset. Its pricewill fall until, again, the optimal forecast return rises to that required by themarket. Using our symbols, we can summarise:

If K† > K_, P↑→K†↓

If K† < K_, P↓→K†↑

Failing to make the optimal forecast means that an investor will be exposed tocapital loss or may fail to participate in capital gain. Once more, there seems

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to be a strong case for the idea that agents make the best use of all relevantinformation, since they have strong wealth-maximising incentives to make thebest forecast they can, whether this is a forecast of rates of return or of price.

Notice, however, that while agents may have strong incentives to make optimalforecasts, it does not follow that they will always succeed. This is important,since one way of attacking the EMH is to look for exceptions. But to identifygenuine and relevant exceptions we have to be very clear about the limits of theEMH, otherwise we reject it for things that it does not claim.

Firstly, the EMH does not say that people use all information in forming theirexpectations. This would be realistic only if information were costless. Wenoted above that one of the forces that drives markets towards efficiency is themotivation of traders in those markets. Their incentive to trade efficiently isthe desire not to miss profitable opportunities. But it makes little sense to paymore in order to acquire information than what the information is worth whenit comes to making a profit. It seems likely that there will be some informationthat is so costly to acquire that it is not worth using. Hence, we should bettersay that the EMH implies that prices reflect all that information whosemarginal cost is less than the marginal benefit from incorporating it in thedecision. In section 5.3 we shall see that behavioural economics, much of whichis critical of the EMH, lays great stress on the costs and difficulties of acquiringinformation and argues that agents give up the effort at quite an early stageand rely on ‘rules of thumb’ or ‘heuristics’ with the result that prices/returnsmay behave quite strangely.

Secondly, the EMH does not require everyone to behave as well-informed,rational, risk-averse wealth maximisers. The fact that we can always find sometrader somewhere who makes a questionable decision, or that we can showthat private investors are often impressed by trivia does not disprove the EMH.Market prices are determined by the actions of the majority. The power of themajority can be argued in either of two ways. The first approach is to argue thatwhile some investors may not be well-informed (often referred to as ‘noise-traders’) their irrational trades cancel and leave prices and returns to bedetermined by investors who are rational and well-informed. Note that thisamounts to saying that the decisions of noise-traders are uncorrelated.Alternatively, even if noise-traders do behave in the same way (their decisionsare correlated and they reinforce each other rather than cancelling) thenprofitable opportunities for arbitrage will force noise-traders out of business,leaving pricing to well-informed investors. In section 5.3 we shall see that wecan find evidence of correlated irrational behaviour. In these circumstances, theargument that profitable arbitrage means the well-informed will drive out theill-informed, takes on the role of ‘argument of last resort’ for the EMH. Weshall come back to it.

Thirdly, the EMH does not say that prices will always be correct. It merely saysthat the expectations that people form are the best possible forecasts in theprevailing situation. Thus, it will frequently be the case that our forecast ofprice in the next period, P1

†, will be:

P1† = P1 + ε [5.6]

where ε is an error term. What the EMH does say is that there is nothing inthe behaviour of the error term which enables us to improve our forecast. If, for

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example, ε were always positive this would mean that our forecast of the pricewas always too high. In these circumstances, we could improve the forecast byadjusting it downwards. In this example, the error term is systematicallypositive. In fact, we can always improve the forecast if the error term behavesin any way that suggests a systematic connection with the forecast. We simplyhave to find out how the error term behaves and make the appropriateadjustment. This leads to an important conclusion which is best stated formally.If our forecasts are to be optimal forecasts (and the EMH holds) then it mustbe the case that the forecast errors have a mean value of zero and that theyhave zero covariance with the forecast. Thus, a market can make forecast errorsof future prices (and yields) and still be efficient, provided that there was noway of doing anything better.

Our presentation of the EMH so far has treated it as a single hypothesis whichapplies to all ‘relevant’ information without distinction. However, we havealready made the point that information can be costly to obtain and thereforeit seems quite likely that if we distinguished some categories of relevantinformation ranging from the ‘easy to find’ at one end to the ‘highly specialised’at the other, we might well find that the EMH applied more readily to theformer than the latter. In fact, since Fama (1970) it has been common practiceto talk about three levels or forms of the EMH ranging from ‘weak’ to ‘strong’,on the basis of the information being used as shown in Table 5.1. We assumein the table that the EMH is being applied to equity markets.

Form Information

Weak Past changes in share prices and any information that isin those price movements

Semi-strong Past changes in share prices and any information that isin those price movements +all other publicly available information

Strong Past changes in share prices and any information that isin those price movements+all other publicly available information+all relevant private information

Table 5.1: Levels of efficiency

The idea that share prices could incorporate not only all public information, butprivate information as well, obviously makes the strong form of the EMH verydemanding and perhaps hard to believe without some consideration of whatexactly may be involved. ‘Private’ does not mean ‘secret’. It refers toinformation that can only be obtained from the firm itself and is not directlyavailable to the public. Typically it is information that can be obtained byprofessional analysts who specialise in reporting on selected companies. Theseanalysts will have access to all public information but they will also be briefedby the managers of the firm as to the firm’s plans and progress. Furthermore,since they are being paid to write reports on these shares for their clients whoare major investors, they will want to write the most accurate reports and this

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will involve using their knowledge of the industry to put the briefing infor -mation into context that enables them to make an informed prediction aboutfuture sales, earnings or whatever. The point that the strong form EMH ismaking is that the moment these reports are sent to clients, the share priceadjusts. Notice that if the strong form holds, this calls into question the valueof paying for analysts’ advice. We return to this when we discuss implicationsof the EMH.

Before ending this discussion of the strong form of the EMH, we need to takea look at the practice that is sometimes described as insider trading since thissometimes causes confusion in connection with the EMH. Insider trading refersto the trading of securities by individuals with potential access to non-publicinformation about the company. In most jurisdictions this is illegal although itis defined and enforced with widely differing degrees of strictness. The USA isgenerally regarded as taking the strongest line on insider trading though evenin the USA there are those like Friedman, Manne and others who argue thatinsider trading should not be prohibited (Harris, 2003, chapter 19) on thegrounds (a) that the trade based on inside information automatically releasesthat information to the market and (b) that the law is inconsistent in prohibitingthe use of inside information in connection with financial markets whilepermitting it elsewhere.

2009–10 saw some notable cases of insider trading being prosecuted in the USAand the UK in what was regarded as a co-ordinated ‘crackdown’ by UK and USauthorities. The most spectacular case involved the Galleon hedge fund. In thiscase US federal prosecutors eventually charged 21 people, including a numberof corporate executives, employees of investment banks and the founder of thefund himself with the illegal use of inside information in connection with tradesin IBM, Sun Microsystems, Google and Hilton in order to net profits of morethan $20 million. By January 2010, eight of them had entered into a pleabargain – effectively admitting their guilt. At the other end of the spectrum, inNovember 2009 the UK’s Financial Services Authority brought a successfulprosecution against a dentist and his son who had made £110,000. In this casethe son had been employed by a City broking firm on a temporary placementand was passing information about forthcoming corporate announcements.The FSA explained its actions thus: ‘Insider dealing is not a victimless crimeand we remain committed to stamping out this type of fraud by those trustedwith inside information. Insider dealing damages the very confidence thatunderpins the integrity of our markets’ (Financial Times, 4 November 2009).

However, while insider trading may (or may not) be damaging to the integrityof financial markets, it needs to be kept separate from discussions about theEMH. It certainly must not be used as evidence for or against strong formefficiency. No one has ever doubted that it is possible to profit from criminalbehaviour. The EMH is concerned with the use of information obtained legallyin properly constituted and well-ordered markets.

Imagine that you are an analyst working for GRQ investment bank. Youspecialise in the shares of major retail (non-food) stores. You have six majorclients to whom you provide advice. You have just been to a meeting (withother analysts) at the head office of a major chain of department stores. It ishalf-way through the financial year. At the meeting, you learn:

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■ that the firm’s earnings so far this year suggest they will meet theirtarget for the full-years profits

■ that they are planning in future to make a large expansion of theirteenage fashion department

■ that the finance director will be retiring shortly and will be replaced bythe finance director of a rival chain.

How might you use this information to make a recommendation to your clients?

The target for full year profits will have been announced at the beginning ofthe year and this will be known. It is quite likely that the current share pricereflects this target (if the target was believable). So there is no reason for thenews that earnings are on track to cause you to make a buy/sellrecommendation.

But the news about the change in business focus might be interesting. Youmight go and look at the recent performance of stores that specialise wholly inteenage fashion. How have they performed in the last year or so? What is theoutlook for consumer spending over the next year. Do forecasts suggest boomor recession? Do we expect a change in interest or VAT rates that might affecthousehold incomes? Does the company have strong leadership in the area offashion?

Similarly with the appointment of a new finance director. What has been thefinancial record at the firm that he is coming from? What about his earlierhistory/performance? Is this a good fit with what your company requires?

Overall, you are trying to use your experience of the sector and your knowledgeof the firm and the wider economy to judge whether these developments arelikely to improve the performance of the firm in future, or not.

Using the informationWe know now that a large part of the EMH is concerned with the speed andextent to which information is incorporated in asset prices and yields. The otherpart of the hypothesis is that this is ‘relevant’ information and that immediatelyraises the question of what information is required and the answer to this liesin the ‘model’ of pricing that is being used.

The EMH is usually presented in such a way that, if it holds, then prices (andyields) are somehow ‘correct’ prices and yields and this means, among otherthings, that funds will be allocated to their most efficient use. In other words,the model is taken for granted – it is the correct one, it focuses on fundamentalsand involves discounting future earnings using a discount rate that recognisesthe market risk to which the asset is exposed. In short, the model is the onethat we have been using in Units 2–4. The ‘relevant’ information referred to inthe definition of the EMH is therefore information relating to fundamentals.But although it commonly assumed that the EMH treats ‘relevance’ as‘relevance to fundamentals’ this does not have to follow from the fact thatinvestors are very well-informed and that information is rapidly incorporatedinto prices and yields. It could be that the information that agents are using

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has nothing at all to do with fundamentals. It can still be very rapidlyassimilated. We shall see in section 5.3 that behavioural economics suggeststhat investors (and therefore prices and yields) are driven by a number of factorswhich have nothing to do with fundamentals. One of these, for example, is thebelief that there is always someone prepared to pay a higher price whatever thefundamentals may be (the ‘bigger fool’ hypothesis). Hence when prices arerising, investors buy because prices are rising, regardless of what the funda -mentally ‘correct’ price might be.

The definition that we have given of an efficient financial market, where thisrefers to the use of information (even if we add the word ‘relevant’) does notitself guarantee the happy outcomes that are often claimed for the EMH. Theseoutcomes depend upon what information is relevant and therefore on thepricing-model being used. If we want markets to be allocatively efficient, wewant them to be informationally efficient but we also need to know that therelevant information that is playing its part is information about the asset’sfundamentals, since it is these fundamentals that are linked to productivity andsocial rates of return. The situation where markets are informationally efficientand the information involved relates to fundamentals is described by Elton andGruber (1995) as market rationality. There may be strong evidence forinformational efficiency but the evidence for market rationality, as we see later,is much weaker.

Company A has two million and Company B has six million shares in issue.

On day one prices per share are £2 for A and £3 for B.

On day two, a private meeting of the management of B decides on a cashtakeover bid for A at a price of £3 per share. The meeting is told that amerger of the two companies will produce operating savings with a presentvalue of £3.2 million. No public announcement is made either that themeeting has occurred or of the matters discussed at it.

On day three, Company B announces an offer to buy all outstanding sharesin Company A for £3 each on day 15.

On day ten, Company B announces details of the operating savings thetakeover is expected to produce.

Determine the day two, three and ten share price of the two companiesassuming that the market is (a) semi-strong form efficient and (b) strongform efficient.

(a) semi-strong form (b) strong form

A price B price A B

Day two 2 3 3 3.2

Day three 3 2.67 3 3.2

Day ten 3 3.2 3 3.2

Table 5.2

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Explanation:Eventually, the surviving firm will be firm B. Its value will be the combinedvalue of the two firms, plus the savings from the merger, less the costs to Bof buying A. Hence the final value of B will be:

Initial market value of A = £2 × 2 million 4

Initial market value of B = £3 × 6 million 18

plus PV of savings 3.2

less cash paid for A = £3 × 2 million – 6

19.2

Value of B shares = 19.2÷6 = 3.2

Table 5.3

The issue then is how quickly prices adjust.

According to the semi-strong EMH, the price of A will adjust as soon astakeover announcement is made (that is day three) but if EMH is strongform efficient, A’s price changes as soon as the bid decision is made.

If the market is only semi-strong form efficient it will not know about thesavings until they are announced (day ten). Thus on the day of the takeoverannouncement, B will be valued at (19.2 − 3.2) = 16.2 and 16.2÷6 = £2.67.If it is strong form efficient, savings will also be known as soon as decision ismade (that is on day two).

Implications of the EMHThe implications of the EMH are considerable. Since a market involves buyersand sellers (borrowers and lenders) these implications affect investors but theyalso affect the ultimate borrowers. If we continue with examples from equitymarkets, this means that some of the implications relate to corporate financeor the decisions that firms make about how to manage their finances. We takesome of these first and then we’ll consider some implications for investors.

Firstly, consider firms’ growth strategies. A firm can grow ‘organically’ – that isby expending its current activities by reinvesting in additional and newer capacity– or it can grow by merger and acquisition. In the latter case, it takes over anotherfirm and adds that firm’s capacity to its own. If the EMH is true this means thereare no ‘bargains’ when it comes to takeovers. By ‘bargain’ we mean another firmwhich is underpriced. There will be firms that are cheap. Their share price willbe depressed. But the EMH tells us that this is because it is making small profitsand/or paying small dividends, or its growth rate is very low or its risk is veryhigh. It is cheap because its fundamentals are weak. If the EMH is correct, maybefirms should concentrate on organic growth rather than takeovers.

In the case of contested or hostile takeovers the firms concerned often try topersuade shareholders to back their case by releasing information about thebenefits from the merger. And if this doesn’t work the first time, there will be

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subsequent releases of information about the future prospects for profit andgrowth. If markets are strong form efficient, there is no point in managinginformation in order to influence shareholders and the share price. Theinformation will already be known and be in the price.

For a company that is financed entirely by equity, the return required byshareholders is the firm’s cost of capital. This is the return that it has to payshareholders if it wishes to raise new capital and so this is the rate of return thatit has to earn from its investment projects. Even if equity is only part of thefirm’s financing, it will be a component in the overall cost of capital. If theEMH holds, then its shares and its cost of capital will be correctly priced. If theshare price is too high or too low, then the cost of capital will be too low or toohigh and this will lead the firm into making the wrong assessment of capitalprojects.

Related to the cost of capital, the EMH suggests that there is no point in firmstrying to manipulate information when they are launching a new issue ofshares. Ideally, they would like these shares to sell for the highest possible price(to give the lowest cost of capital) but this will not be possible if the EMHholds, at least in its strong form. The analysts will know what the true positionof the firm is. They will have advised their clients and the information will bein the price.

When we turn to the implications for investors, they are rather different, butno less dramatic. One fundamental implication of the EMH is that if marketsare efficient then it is impossible for investors to exploit information in orderto earn excess returns over a sustained period of time. ‘Excess’ here means inexcess of the equilibrium or required rate of return, howsoever that isdetermined. In these circumstances it is sometimes said that the processdetermining security prices makes for a fair game.

Secondly, if all existing information is in share prices, those prices will only bechanged by new information or ‘news’. By definition, this news is unknowableuntil it arrives. It will sometimes be good and sometimes bad, with the resultthat the change in share prices will be random. An exception to this could bewhere a firm is changing its business model and moving into higher (or lower)risk activities. During the period of transition there will be more upward (ordownward) changes. Even so, the fair game principle still holds since it still willnot be possible to use share price movements to earn consistent excess returns.

In recent years some economists have become interested in the possibility thatshare price behaviour may be ‘chaotic’ rather than random. ‘Chaotic’ here hasa rather special meaning, not that the behaviour is completely disorganised butthat it is very complex. If share price behaviour is chaotic, then in principle itcan be explained. There will be some equation that links today’s price totomorrow’s price but it is such a complex equation we do not know what it isnor what are the coefficients. Empirically, it is very difficult to find evidence ofchaotic behaviour but this may be because it is very difficult to test for chaoticbehaviour.

If the market is semi-strong form efficient, a third implication is that there isno advantage to the individual investor in monitoring public announcements,

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press releases, company reports and so on since any decision drawn from thisinformation will already have been drawn by others and will already be in theprice. This raises an interesting issue that centres on the ‘free-rider’ problem. Ifall investors believe in the EMH, they will know that there is no advantage insearching out information since others will have done and the information willalready be in the price. Since it is only ever possible to buy correctly-pricedsecurities, there is no point in trying to beat the market. It makes sense to letothers do the work (to ‘free-ride’). But if all investors opt out of the pricediscovery process by leaving it to someone else, then no one will do it.Information will not be in the price and the market will not be efficient. So, itis the belief that there may just be a small chance of beating the market thatkeeps the free-rider problem at bay and, in so doing, makes the market efficientand the research pointless.

Fourthly, if the market is strong-form efficient then it is not clear why it is worthpaying for professional fund management. Under strong-form efficiency itshould not be possible for anyone to beat the market consistently. Mutual fundsmay still offer an advantage to investors in the reduction of transaction costs.Their managers may be able to assemble a widely diversified portfolio of assetsmore cheaply than individual investors could do it for themselves but this is anargument for investors only buying into a mutual fund where they do not haveto pay for active investment management. This means buying into a low-costtracker fund, for example, where the manager simply buys shares that replicatesome index and then holds those shares, avoiding expensive attempts to searchout winners and losers.

Finally, the EMH suggests that the best strategy any investor can follow is adiversified ‘buy and hold’ strategy. In Unit 4, we saw that most specific riskcould be eliminated by holding about twenty shares, provided these have lowcorrelations with each other. According to the EMH these will be correctlypriced and the returns will be correct for the level of risk. Since it is impossibleto spot bargains consistently and buying and selling involves transaction coststhere is no point in ‘actively’ managing this portfolio.

How might an investment strategy appropriate for a market which isinformationally efficient differ from one appropriate for a market which isinefficient?

An informationally efficient market is one in which no one has aninformational advantage which enables them to earn returns which areconsistently above those which are justified by the level of risk to which theinvestment is exposed. It is often said that the EMH means that one cannotbeat the market. However, this does not mean that no investment strategyis required.

Decisions have to be made about the desired combination of risk and returnand assets being added to a portfolio have to be selected in the light of theeffect that they have on the characteristics of the portfolio. Above all, aninvestor will wish to ensure that the portfolio provides the maximum return

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for a given level of risk. But there is no point in studying information aboutindividual firms with a view to selecting shares which will perform betterthan others with a similar level of risk. If the market is informationallyefficient there will be no advantage in the frequent trading of shares sincethey will all be correctly priced. It is better to avoid transaction costs byadopting a ‘buy and hold’ strategy.

If markets are informationally inefficient, then it may be possible to findassets which are underpriced (and therefore provide a return which is abovethat which one would expect for the level of risk). It might be possible to dothis by studying past trends in share prices (if the market is weak forminefficient). Or it might be possible to do it by studying a firm’s currentactivities and its markets (if the market is only semi-strong form inefficient).

Evidence on informational efficiencyThe EMH has always been controversial. Firstly, this is because some fluctua -tions in asset prices appear to be more dramatic than can be explained bychanges in fundamentals and these fluctuations are not rare. There have beenquite a number of which the 2008 is only the latest. Secondly, researchers havefound a number of ‘anomalies’ in the behaviour of share prices, even in normaltimes. These ‘anomalies’ are patterns of behaviour which seem to offer thepossibility of excess returns – something which the EMH says is impossible.We shall look at this critical evidence under these two headings.

Booms and crashesThe first recorded example of what is generally regarded as a speculative bubbleis the Dutch tulip mania of 1636–1637. Cultivation of the tulip, which wasregarded as a luxury item, had begun in the Netherlands around 1600. Popularity(and prices) grew slowly through the early years of the seventeenth century andincrease in the 1630s as two things happened. The first is that the tulip becamea fashion item in France and there was a surge in demand for a subset of tulipbulbs – those that could produce multi-coloured flowers (probably the result ofa virus, but of course relatively rare). Interestingly, the ‘spot’ market (for realbulbs) was supplemented by what was, in effect, a futures market. Traders signedcontracts for the future sale and delivery of bulbs and eventually these contractsthemselves began to be traded. According to one account (Thompson, 2007) anindex of tulip bulb prices which stood at 10 in November 1636, reached 200 inFebruary 1637 and fell to about 10 again in May 1637.

Another famous historical example is the South Sea Bubble of 1720. Thisfeatured a joint stock company, the ‘South Sea Company’, which was originallyestablished in 1711 with monopoly trading rights in Spanish South America. Themonopoly was granted by the UK government in return for undertakings by thecompany to buy government debt built up during the War of the SpanishSuccession. For several years, the company barely made a profit though itcontinued to promise the prospects of vast wealth in the future. However, thecompany’s share price began to rise early in 1720, in response partly to theextravagant claims that were being made about imminent profits and alsobecause a number of public figures had been encouraged to buy shares. Fromabout £120 at the beginning of 1720, the shares had risen to £550 by May.

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Howells and Bain (2008) ‘FinancialMarket Efficiency’; Mishkin (2007)

‘The Stock Market and theEfficient Market Hypothesis’.

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Developments then took on one classic symptom of a bubble. Shares continuedto be sold to politicians and other public figures who, instead of paying for them,sold them back to the company after the price had risen, paying the purchaseprice from the proceeds of the sale and pocketing the difference. There was nointerest here in the fundamentals. This was buying on credit simply to takeadvantage of the higher price. (The ‘bigger fool hypothesis’ that we met earlier.)

While all this was going on, other joint stock companies were floated, severalwith prospectuses that were barely plausible. To begin with, their shares rose inprice alongside those of the original company. It is always difficult to know whatcauses a bubble to burst. Wiser investors, maybe, knowing that the foundationsare insecure, start to sell in order to take their profit. What is for sure is thatonce the share price stops rising, it must fall, because much of the demand isdependent on continuing price rises. The South Sea Company stock peaked ataround £1000 in August and collapsed to £120 by the end of the year. Manywere ruined, especially those who had bought on credit. The bankruptcies led todefaults on bank loans and many banks became insolvent and a major financialcrisis followed.

More recent examples of dramatic rises and crashes in financial markets includethe UK railway mania in the 1840s, the years leading up to the US Wall StreetCrash in 1929 (perhaps the best-known of all financial panics), the dot-combubble of 1995–2000 and the crisis of 2008. If we included booms and crashesin commodity and real estate prices, the list would be much longer.

Why do these events pose a problem for the EMH? Figure 5.1 shows theevolution of the UK FTSE-100 index of the share prices of the largest 100companies from 1996–2009. It shows the steep rise and falls of 2000 and 2008.The issue is whether or not rapid rises and falls can be explained by funda -mentals. The fall in the index from October 1999 to October 2002 is 43 per cent;the fall from August 2007 to March 2009 is about the same. The upswings ofsimilar amplitude (from roughly 4000 to roughly 7000) prior to the crashes arerather more gentle but still quite rapid.

Figure 5.1: The FTSE-100 index 1996–2009Source: Office for National Statistics (2009) code HSEG

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On the basis of fundamentals, we have to look for explanations in terms of risk orcurrent profits or growth of profits. In effect, this requires changes in the riskinessand/or productivity of UK firms. The question is do we think these fluctuations of40 per cent or so reflect that degree of change in risk and productivity over fairlyshort periods? In the case of 2008, we might be sympathetic to the idea that firms,especially financial firms had become much more risky as a result of having takensome very risky assets in the form of asset backed securities and credit defaultswaps on to their balance sheets. As we know, the UK and US banking systemswere virtually insolvent. Since this information came to light in the summer of2007, it is not surprising that the downturn was very rapid. However, this stillleaves the problem of why the risk was not spotted in the upswing. Why did banksexpand so rapidly in the mid 2000s by taking up high-risk assets of doubtful valueand markets fail to realise this? If we take the view that the very low share pricesof banks after the crash were entirely deserved because they incorporated allrelevant information about the toxic nature of the assets, then the high prices inearly 2007 could not have been correct. In their major study of financial crises,Reinhart and Rogoff (2009, esp. chapter 17) show how early warnings of financialcrisis are repeatedly ignored by investors determined to delude themselves intothinking that ‘this time it’s different’. This does not sound like a very determinedeffort to make the best use of all relevant information.

A similar argument could be made with respect to the dot-com boom/bust. Butthere are some additional features of interest in this episode. The shares whoseprices rose dramatically were shares in mainly new companies that promised toexploit the advantages of new technology, especially the internet. The shares insome of these companies were so popular that the firms earned a place in the FTSEindex of largest companies and, consequently, caused the FTSE to rise quite sharply.But some of these were firms that had earned no profits and paid no dividends. Atthe same time, long-established utilities like Thames Water were pushed out of theindex as their share prices failed to keep pace. A serious aspect of thesedevelopments which is often overlooked concerns the cost of capital. The point isnicely illustrated by the launch of Lastminute.com. Initially, the investment banksponsoring the initial offering of Lastminute.com’s shares announced a likely priceof 190–230p. However, during the preparations for the launch, the demand forshares began to look much stronger than expected and so the investment bankraised the price to 320–380p. The effect is to raise 60 per cent more capital pershare for Lastminute.com and this is a company with no immediate prospect ofprofit. By the same token Thames Water, a company with a long and steady streamof earnings (and providing a vital commodity), was finding it harder and moreexpensive to raise new funds.

Pricing anomaliesThese are big events. And while they are not rare, they are limited in number.However even when asset prices are stable it has been suggested that they oftenshow behaviour which is to some degree inconsistent with the EMH. Recall thatthe EMH comes in three levels or forms. Whether or not a certain type ofbehaviour raises questions about the validity of the EMH, often depends uponwhich version we are concerned with. We take each in turn.

When it comes to testing the weak-form of the EMH, one common approach is tolook for evidence of serial correlation. In other words we look to see whether thedirection of price change on one day is correlated with the direction of change on

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adjacent days. We can do this by running regressions or we can do it by ‘runs’tests. In a runs test we plot the price changes ‘+’ and ‘−’ on successive days. A setof successive ‘+’s (or ‘−’s ) is a ‘run’. Statistical tables will tell us the probability ofa given number of runs for a given number of observations. For example, if thecritical value for the number of runs at a confidence interval of at five per cent isten, and we have only eight runs, we know there is only a five per cent change ofonly eight runs by accident. There is a 95 per cent chance that it is not accidental.Another batch of tests are called filter tests. These are tests that have beenundertaken to determine whether a trading strategy could be developed thatproduces excess returns from charting price movements. For example, such astrategy might be ‘buy when the price rises from a low point by five per cent andsell once it has fallen by five per cent from a high’. As well as being a test of theweak-form of the EMH, this is to some degree a test of typical chartist techniques.

As a general rule, for developed markets at least, such tests appear to find that theweak-form EMH holds to the extent that it is not possible to profit from any ofthese strategies once the costs of trading are allowed for. However, some interestinganomalies have been widely reported. Firstly, it seems that many markets exhibita ‘Monday effect’ in that prices are less likely to rise on Mondays than on otherdays. There is also a ‘January effect’ in that returns on average seem to be higherin January than in other months. Returns from smaller companies appear to behigher (even when allowing for their additional risk) than returns from largercompanies. These all suggest trading strategies that would yield excess returns andthus, under the EMH, one would expect the strategies to be exploited until theadvantage was eliminated. The fact that they persist is a challenge to the EMH butagain it is doubtful that the trading strategies would be profitable after dealingcosts were taken into account.

The fact that the weak-form EMH appears to hold in the financial markets ofdeveloped economies is, perhaps, not surprising. Recall that the EMH is about theefficient use of information. Specifically, it requires a high level of price discovery(resources devoted to finding the key information) as well as a system capable ofrapid communication. Both of these are typical of developed economies.

The question becomes more interesting when we look at emerging markets –especially those in countries where free access to information is unusual – especiallyif those emerging markets are growing very rapidly and attracting the attention ofinvestors in more sophisticated markets where high-quality information is taken forgranted. In recent years, the so-called ‘BRIC’ countries (Brazil, Russia, India andChina) have become popular with international investors and the question ofinformational efficiency in China, where the state has a long history of controllingand managing information, is an obvious one to raise.

Studies of the weak-form EMH in China go back at least to Wu (1996), whoused serial correlation tests of the kind we described above and concluded thatthat the Shanghai and Shenzhen markets were weak form efficient. Since then,the balance of research has pointed in the opposite direction. Wu (1996) appliedthe tests to a selection of shares. Mookerjee and Yu (1999) applied serialcorrelation and runs tests to an index for each market and concluded that bothmarkets were inefficient. Following that Laurence et al (1997) examined indicesin four Chinese markets and found some evidence for market efficiency among‘A’-shares but not among ‘B’-shares as well as some evidence that the Chinese

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markets were influenced by price movements in Hong Kong and New York. Ina larger study, Ma and Barnes (2001) also concluded that Chinese markets werenot weak form efficient.

Testing the semi-strong form of the EMH usually involves what are called eventstudies. These involve a day-by-day (or even hour-by-hour) study of pricemovements in the close vicinity of a public announcement. If the adjustment ina share’s price is concentrated in the period immediately prior to theannouncement, then the market is semi-strong form efficient. On these tests,markets seem to be semi-strong form efficient, especially where the tests involveshares in large companies.

Two companies, ‘large’ and ‘small’, announce their half-yearly results on thesame day, ‘t = 0’. The table below shows the behaviour of their share pricesfor 10 days on either side of the announcement.

1. To what extent does the market appear to be semi-strong for theseshares?

2. How might you explain any difference that you see?

Day Share price of large plc (p) Share price of small plc (p)

t + 10 176 177

t + 9 178 175

t + 8 176 176

t + 7 177 177

t + 6 175 175

t + 5 176 176

t + 4 175 175

t + 3 174 174

t + 2 175 175

t + 1 176 175

t = 0 175 173

t − 1 174 163

t − 2 173 162

t − 3 170 163

t − 4 168 165

t − 5 166 162

t − 6 163 160

t − 7 161 161

t − 8 162 162

t − 9 161 160

t − 10 160 161

Table 5.4

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1. The adjustment of the share price of large plc is complete by the date ofthe announcement (t=0). If we look at the price on t−6 it starts to riseand continues to rise until it settles at 175 on the day of theannouncement. After the day of the announcement there is no markedchange. This suggests that the market for large plc is semi-strong formefficient. By contrast, the price of small plc shows little direction until t=0when it jumps from 163 to 173, suggesting that the information in theannouncement was ‘news’ and not incorporated in the price.Furthermore, the price continues to rise a little after the announcementwhile the news is fully digested. This suggests that the market for smallplc shares is not semi-strong efficient.

2. The difference between the two may be due to the difference in size. A‘large’ firm which has a large number of shares in issue will be subject tomore study and analysis than a small firm because its shares will be heldby many more investors. The reduced scrutiny given to small firms maymean that information is not so readily available and that there are moresurprises.

Tests of the strong form of the EMH look for evidence that well-informedprofessionals can ‘beat the market’. The obvious test involves looking atmanaged funds which promise to earn a ‘superior’ return for investors.Remember that ‘superior’ does not simply mean a higher return than someother fund; it means a higher return than could be expected for the level of riskinvolved. For this reason, the test usually involves a comparison of fundperformance with other funds of similar kind, or with an ‘index’. If managedfunds do not beat the index, then markets are strong form efficient (and theredoes not seem to be much point in paying for professional analysis and fundmanagement). In this case, the evidence suggests some degree of inefficiency.Some funds do do better than others for a while. But when it comes tocomparing the return on the ‘best’ funds with a ‘buy and hold’ strategy ofsimilar shares, privately chosen, the benefits are again eliminated by the fund’scharges.

So, in summary, we have a number of tests which suggest that markets do makereasonably efficient use of information. It is not surprising that they are betterat doing this when the information is widely available (historic rather thanprivate) and when the information refers to the shares of large firms. Given the‘small companies’ effect, it may be that analysis tends to be focused more onlarge firms and therefore anomalies get overlooked with smaller firms. But theseare tests of the market’s ability to incorporate information into individual shareprices in fairly normal times. We are left with the fact that there may be generaland large fluctuations in asset prices as a whole that are difficult to explain byfundamentals. This suggests that markets may be very good at incorporatingrelevant information – so good in fact that no one has an information fromwhich they can create a profitable trading strategy. But it also suggests that therelevant information may not be limited to fundamentals. We turn to thispossibility next.

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The following text appeared recently in a broker’s recommendation toinvestors to buy into a UK equity income fund. (The identity of the fund and its manager have been changed.) What does the recommendationsuggest to you about the broker’s view of the EMH?

‘Tricia Fisher, who manages the Oldtown Higher Income Fund, standshead and shoulders above many of her peers. The fund has animpressive yield of 6.9% (net, variable and not guaranteed); more than double the current FTSE All Share yield of 3.3%. She has grown this dividend by a remarkable 11.3% this year (on a like-for-like basis) during a period when income from the UK stockmarket has fallen (by 9% in 2008, and forecast to fall by another 11%in 2009). Importantly, she has maintained the fund’s excellent record of 9 consecutive years of income growth and expects another rise next year...’

The recommendation is based partly on the reputation of the fund manager.This suggests that the broker believes that there are fund managers whocan consistently beat the market. This is not consistent with the EMH. It alsosuggests that the past behaviour of the fund is some indication of what itmight do in future. This is not consistent either.

Behavioural financeOrthodox economics (and finance) begins from the assumption that agents arerational, risk-averse, wealth maximisers. The approach adopted by behaviouralfinance is to avoid these assumptions and ask what do we know about agents’motivation? Much of the knowledge used in behavioural finance comes fromexperimental psychology.

The earliest papers in this field appeared in the 1960s. But the literature hasexpanded rapidly in recent years and we now have a number of books whichprovide surveys of the field. These are by Shleifer (2000), Shiller (2001) andThaler (2005). We can start with a definition:

‘At the most general level, behavioural finance is the study of humanfallibility in competitive markets.’

(Shleifer, 2000)

The fallibility gives rise to the mis-pricing of assets which persists. The fallibilityand the persistence relate to two issues that we have already discussed. Thefirst is the cost of information. Behavioural finance takes the view that decisionsare made under conditions of such uncertainty that the cost (in time and money)of acquiring the necessary information is prohibitive. As a result, agents useshort-cuts, ‘rules of thumb’ or ‘heuristics’ to guide them. The mis-pricing thatresults then persists because in practice arbi trage does not drive noise-tradersout of the market and does not drive prices to their ‘correct’ level. We look ateach in turn.

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Mis-pricing and heuristicsWhy does mis-pricing occur? This is where a theory of how investors processinformation and form judgements is required and the contributions frompsychology are fundamental. Two important behavioural hypotheses in thecurrent literature are ‘conservatism’ (Edwards, 1968) and ‘representativeness’(Tversky and Kahneman, 1974). Together they show (as the result of experi -mentation) that people are slower to modify or update their under standingthan is warranted by the evidence but that once they cross this threshold, theyregard what may be random occurrences as confirming a pattern. The classicexperiment involves the tossing of a coin which is known to the experimentalsubjects to be unfair in the sense that it has (say) a 70:30 bias. But the subjectsdo not know in which way it is biased – 70 per cent heads or 70 per cent tails.So far as the subjects are concerned, therefore, the pro bability of each bias is0.5. The experimenter then begins tossing the coin (which we will assume isheads-biased). At each successive toss the outcome is the same and subjectsare asked after each toss to give their estimate of the probability that the biasis indeed heads. Predictably, their estimate of the probability, beginning at 0.5,rises quite quickly in the face of repeated out comes of heads. But the strikingthing is that in the early stages it does not rise as quickly as it ‘should’ if thesubjects were following truly Bayesian principles. Equally interesting is thediscovery that after a few tosses the underestimate of the Bayesian probabilityswitches to an overestimate. The early tosses in a series seem not to have theimpact that they warrant, while the later ones are seized on as evidence thatthe world is more certain than it really is. The first is evidence of‘conservatism’: news has to be repeated until its real significance is appreciated.The second is evidence of the ‘representativeness’: if news recurs often enough,it is treated as belonging to a pattern and the possibility of randomness isdiscounted.

It is not difficult to see how these tendencies could be translated to a financialcontext. For example, we assume that investors have a particular view about acompany and the value of its stock. They then receive news about the firm towhich their response is less than would be the case if they acted according totrue Bayesian principles. But the news keeps coming and eventually is inter -preted, falsely, as part of a trend which is going to continue forever. In the firstphase, investors underreact to the news and in the second phase they overreact.

Evidence that this is in fact what happens comes from numerous studies but theeasiest to understand are those where a stock which experiences a sustainedperiod of poor news subsequently outperforms stocks which have been thesubject of good news. This evidence suggests that the firm with consistent goodnews and earnings has become overvalued while the stocks with a run of badnews are undervalued. Investors can therefore earn abnormal returns by bettingagainst this overreaction to news by buying the bad news stocks and selling thegood news stocks. The best known of these studies was carried out by De Bondtand Thaler (1985) who, for each year since 1933, constructed a (‘losers’) port -folio of the worst performing stocks and a (‘winners’) portfolio of the bestperforming stocks judged by their performance in the three previous years. Theythen computed the performance of each portfolio in the five years following itsformation. Averaging the results across the approximately fifty ‘winner’portfolios and fifty ‘loser’ portfolios showed a clearly superior return for the‘loser’ portfolios. It is impossible to avoid the conclusion that the good news

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portfolios had been overvalued while the bad news portfolios were under -valued.

‘Representativeness’ and ‘conservatism’ are not the only heuristics canvassed bythe psychology literature. The classic paper in this field is by Tversky andKahneman (1974), who endorse the representativeness guideline. But theyfound experimental evidence for two others which are widely accepted inpsychology and might well be relevant to economics (financial or more broadlydefined). One is what they call the ‘availability’ heuristic. People estimate thefrequency of an event by the ease with which instances can be brought to mind.This causes biases when some events are more publicised than others. The otherthey called the ‘anchoring’ or ‘reference point effect’. This suggests that thestarting point or frame of reference for an estimate is important. For example,when two groups, randomly drawn, were separately asked ‘Is the Mississippimore or less than 70 miles long? How long is it?’ and ‘Is the Mississippi moreor less than 2000 miles long? How long is it?’ the mean answers were 300 milesand 1500 miles. In the same spirit, Frey and Eichenberger (1989) discuss eight‘anomalies’ which they say are clearly evident in persons’ processing ofinformation. These include the four heuristics listed above as well as, amongothers: the ‘opportunity cost effect’ – explicit monetary costs are given greaterweight than opportunity costs of the same value and the ‘sunk cost effect’ –people tend to include foregone costs in their decisions.

The ‘availability’ heuristic causes people to think that events that are highlypublicised occur more frequently than is genuinely the case. Can you thinkof some non-financial examples of this heuristic at work?

Typical examples occur with people’s perceptions of safety. Because railcrashes are spectacular and receive a lot of publicity, people think rail travelis more dangerous than it is. Similarly, they overestimate the risk of burglaryand assault because these receive a lot of media coverage.

The failure of arbitrageIn section 5.1 we described ‘arbitrage’ as the last resort argument for the EMHbecause it suggests that if noise-traders persist in making pricing errors, they willbe forced out of the market because they will make persistent losses while thewell-informed make profits.

A common definition of arbitrage is that it involves the simultaneous purchaseand sale of the same asset in two different markets at advantageous prices. Thisis just a rather formal way of saying that if the same asset has a different price intwo different markets, there is a (riskless) profit to be made by buying the cheapasset and selling the expensive one. Clearly such trades will tend to bring pricesin the two markets into equality, so arbitrage is an important under pinning of thelaw of one price. Just as important, however, is the fact that an arbitrage dealdelivers a riskless profit and therefore traders who are well-informed and cancarry out these trades will make a profit. At the same time, the ill-informed, ornoise-traders, will be the one’s who are buying the overpriced securities sold by

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the arbitrageurs (and selling the underpriced securities to them). This cannot goon forever. Eventually, the noise-traders must lose all their wealth, drop out ofthe market and leave pricing to the well-informed arbitrageurs.

But behavioural finance asks us to think more carefully about what arbitrageinvolves in practice. For the trade to be riskless, the arbitrageur has to be able tosell (or sell short) an asset which is overpriced and buy (ideally) the same assetcheaply. The practical problem to which this gives rise is that there is often no(underpriced) close substitute available for the asset which is overpriced. Supposea trader thinks that stocks in the FTSE-250 index are generally overpriced. He canborrow (and sell short) those stocks in the anticipation that the price will later fall.To make the deal riskless, however, he has to be able to buy the same portfolio ata lower price. This is because he has to return the FTSE-250 stocks to the lenderat the end of the deal at their then market value. Suppose he holds no alternativeat all. In other words he has simply sold shares which he has borrowed. If(unexpectedly) the portfolio is hit by good news between the day of the sale andthe date for their return to the lender, then the trader will have to enter the marketand buy the shares at a higher price than that for which they were sold. The onlyway that the arbitrageur can be sure to make a riskless profit is if he was able tobuy at the beginning, at a lower price, the same set of shares that he has sold (orsold short). In these circum stances, any unexpected news that affects the price ofthe borrowed shares, will automatically affect the value of the shares which areheld. This is the problem of being able to find a suitable ‘hedge’. Obviously, thistends to be easier when the arbitrage involves a single security and increases indifficulty as we try to hedge portfolios.

Another practical problem is one of time. If an arbitrage deal is done withimperfect substitutes (or no substitute at all) then there is the risk that prices whichare expected to converge eventually might diverge before the deal has to be closed.For example, the arbitrageur borrows and sells short an asset which is overpricedat the same time buying another (but not identical one) which seems underpriced.The loan will be for a specified period. During that time the overpriced asset mightrise further in price. And if the hedge is imperfect, it will not move in the same wayand will not offer full protection to the holder. Alternatively, it might be that thehedge itself, while underpriced, falls further.

The point of these (and other possible examples) is that the riskless arbitrage dealis more plausible in theory than in practice. In practice, arbitrageurs are forced totake risk and this will limit their ability to guarantee the elimination of mispricing(see Shleifer, 2000, 13–16).

The end of efficient markets?Read the following and answer the questions below.

‘Capital market theory after the efficient market hypothesis’Dimitri Vayanos and Paul WoolleyVoxEU.org. 5 October 2009

Have capital market booms and crashes discredited the efficient markethypothesis? This column says yes and suggests a new model that explains

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asset pricing in terms of a battle between fair value and momentumdriven by principal-agent issues. Investment agents’ rational profit seekinggives rise to mispricing and volatility.

Forty years have passed since the principles of classical economics werefirst applied formally to finance through the contributions of Eugene Fama(1970) and his now-renowned fellow academics. Over the interveningyears, capital market theory and the efficient market hypothesis have beendeveloped and modified to form an elegant and comprehensiveframework for understanding asset pricing and risk. But events have dealta cruel blow to these theories, as John Authers argued in his recent FT[Financial Times] column. Capital market booms and crashes, culminatingin the latest sorry and socially costly crisis, have discredited the idea thatmarkets are efficient and that prices reflect fair value.

Some economists still insist these events are simply the lively interplay ofbroadly efficient markets and see no cause to abandon the prevailingwisdom. Other commentators, including a number of leading economists,have proclaimed the death of mainstream finance theory and all that goeswith it, especially the efficient market hypothesis, rational expectations,and mathematical modelling. The way forward, they argue, is tounderstand finance based on behavioural models on the grounds thatpsychological biases and irrational urges better explain the erraticperformance of asset prices and capital markets. Presented this way, thechoice seems stark and unsettling, and there is no doubt that theacademic interpretation of finance is at a critical juncture.

The need for a science-based, unified theory of finance

At stake is the need for a scientifically based, unified theory of financethat is rigorous and tractable; one that retains as much as possible of theexisting analytical framework and simultaneously produces credibleexplanations and predictions. This is no storm in an academic teacup. Onthe contrary, the implications for growth, wealth and society cannot beoverstated. The efficient market hypothesis has beguiled policymakersinto believing that market prices could be trusted and that bubbles eitherdid not exist, were positively beneficial for growth, or could not bespotted. Intervention was therefore unnecessary, and regulation could belight-touch. By contrast, a theory of asset pricing that did a good job ofexplaining mispricing would provide policymakers with a strongerrationale for intervention and more scepticism about mark-to-market,index-tracking, and derivative pricing, to name but a few examples.

Principal-agent investment problems: Mispricing withrationality

We believe that a first step in the search for a new paradigm is to avoidthe mistake of jumping from observing that prices are inefficient tobelieving that investors must be irrational, or that it is impossible toconstruct a valid theory of asset pricing based on rational behaviour.Finance theory has combined rationality with other assumptions, and it isone of these other assumptions that has proved unfit for purpose. The

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crucial flaw has been to assume that prices are set by the army of privateinvestors, the ‘representative household’ as the jargon has it. Householdsare assumed to invest directly in equities and bonds and across thespectrum of the derivatives markets. Theory has ignored the real worldcomplication that investors delegate virtually all their involvement infinancial matters to professional intermediaries – banks, fund managers,brokers – who dominate the pricing process.

Delegation creates an agency problem. Agents have more and betterinformation than the investors who appoint them, and the interests of thetwo are rarely aligned. For their part, principals cannot be certain of thecompetence or diligence of their appointed agents. The agency problemhas been acknowledged in corporate finance and banking but hardly atall in asset pricing. Introducing agents brings greater realism to asset-pricing models and can be shown to transform the analysis and output.Importantly, this is achieved whilst maintaining the assumption of fullyrational behaviour on the part of all concerned. Such models have moreworking parts and therefore a higher level of complexity, but the effort isrichly rewarded by the scope and relevance of the predictions.

By doing this in our recent paper (Vayanos and Woolley, 2008), we havebeen able to explain momentum, the commonly observed propensity fortrending in prices, which in extreme form causes bubbles and crashes.Momentum is incompatible with an efficient market and has proveddifficult to explain in the traditional framework. Indeed, it has beendescribed by Fama and French (1993) as the ‘premier unexplainedanomaly’ in asset pricing. Central to the analysis is that investors haveimperfect knowledge of the ability of the fund managers they invest with.They are uncertain whether underperformance against the benchmarkarises from the manager’s prudent avoidance of over-priced stocks or is asign of incompetence. As shortfalls grow, investors concludeincompetence and react by transferring funds to the outperformingmanagers, thereby amplifying the price changes that led to the initialunderperformance and generating momentum.1

The dot-com boom

The technology bubble ten years ago illustrates this well. Technologystocks received an initial boost from fanciful expectations of future profitsfrom scientific advance. Meanwhile, funds invested in the unglamorous,value sectors languished, prompting investors to lose confidence in theability of their underperforming value managers and switch funds to thenewly successful growth managers, a response which gave a further boostto growth stocks. The same thing happened as value managersthemselves began switching from value to growth stocks to avoid beingfired.

Through this conceptually simple mechanism, the model explains assetpricing in terms of a battle between fair value and momentum. It showshow rational profit seeking by agents and the investors who appoint themgives rise to mispricing and volatility. Once momentum becomesembedded in markets, agents then logically respond by adopting

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strategies that are likely to reinforce the trends. Explaining the formationof asset pricing in this way seems to provide a clearer understanding ofhow and why investors and prices behave as they do. For example, itthrows fresh light on why value stocks generally outperform growthstocks despite offering seemingly poorer earnings prospects. The newapproach offers a more convincing interpretation of the way stock pricesreact to earnings announcements or other news. It also shows how short-term incentives, such as annual performance fees, cause fund managersto concentrate on high-turnover, trend-following strategies that add tothe distortions in markets, which are then profitably exploited by long-horizon investors. At the level of national markets and entire asset classes,it will no longer be acceptable to say that competition delivers the rightprice or that the market exerts self-discipline.

Note: 1. We show that as long as fund flows are gradual, as in the real world, price changesare also gradual. Intuitively, rational long-term investors are eager to buy an undervaluedstock even when the stock is expected to become more undervalued in the future becauseof the risk that undervaluation might instead disappear. We term this the ‘bird in the hand’effect.

1. The authors accept that ‘classical’ finance theory, including the efficientmarket hypothesis, has a problem explaining recent asset pricemovements. How do they view behavioural finance as an alternative?

2. What view do the authors take on the rationality of investors?

3. What do they mean by ‘momentum’?

4. What is the ‘principal-agent’ problem?

5. How do they argue that mispricing occurs if agents are rational?

1. They argue that behavioural finance claims to offer better explanations‘on the grounds that psychological biases and irrational urges’ are thekey to agents’ behaviour. But they go on to say that the first step inbuilding a new theory is ’to avoid the mistake of jumping from observingthat prices are inefficient to believing that investors must be irrational’.

2. Investors do behave rationally, or at least they try to make decisions onthe basis of the fundamentals we have discussed in this unit, but theultimate investors are not the people that make the investmentdecisions. Households have to delegate these decisions to fundmanagers and this is where the problem lies.

3. Momentum refers to the ‘trending’ of prices – the tendency of prices tokeep rising once they have begun (or to keep falling). The authors callthis the ‘premier unexplained anomaly’ of orthodox finance.

4. The principal-agent problem refers to the fact that households (theultimate investors) must delegate the decision-making to others. Theprincipals are poorly-informed about their agents actions and motives.The authors say that this is a widely-recognised problem in corporatefinance and banking but has received little notice in fund management.

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5. When fund managers perform poorly against an index, the principals donot know whether it is incompetence or sound judgement to avoidoverpriced stocks. Eventually, they decide that it is incompetence andswitch their funds to managers who appear to perform better. The dot-com boom is offered as an illustration. Investors lost confidence inmanagers of funds invested in slow growth stocks and switched tofunds which were invested in dot-com stocks whose prices were risingfaster. This increased the differential between dot-com and traditionalstocks. Eventually, the cautious managers of slow-growing funds areobliged to buy stocks which they know are over-valued, or risk beingfired.

Self-assessment questions5.1. Decide whether the hypothesis that the market is semi-strong form

efficient is contradicted in each of the following situations:

(a) On average stock market investors are expected to earn a positivereturn this year and some will earn considerably more than others.

(b) The development of a complex computer-based method of analysingcompany data has enabled a firm of stockbrokers to predict pricesaccurately enough to earn a consistent profit three per cent abovenormal market returns.

(c) You have discovered that the square root of any given share pricemultiplied by the day of the week (Sunday = 1 and so on.) providesan indication of the direction of its next movement with aprobability of 0.7.

(d) An oil company’s employees made unusually high profits on theirpurchase of company shares after exploratory drilling in a newoilfield had started but before the announcement of the discovery ofmajor oil deposits in this field.

5.2. If share price movements are unpredictable, should portfolio managersselect stocks with a pin?

5.3. You suspect that directors’ purchases/sales of shares in their own firms arean indicator of future share price movements. How would you testwhether such information could be profitably exploited?

5.4. Explain why arbitrage may fail to eliminate mispricing.

Feedback on self-assessment questions(a) No. EMH does not suggest that investors cannot make positive

returns, only that they cannot make consistently abnormal returns(returns greater than those required to compensate for risk). Analternative way of putting it is that investors cannot consistentlybeat the market. But the market is quite happy to provide a positivereturn for risk. The fact that a few people make abnormal returnsfrom time to time is also allowed, provided they are not the same

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people all the time. Windfall gains are allowed. EMH only deniesthe consistent earning of abnormal profits.

(b) No, provided that the three per cent is the ‘normal’ return for thecosts and risks involved in all this extra activity.

(c) Yes, provided that your formula works consistently for an extendedperiod (that is to say it is not just coinciding with windfalls). Theessence of the EMH is that any ‘knowledge’ that can be used topredict prices will be used and this will make consistent abnormalreturns impossible to earn. If you discover this formula and it isdiscovered and used by everyone else, the gains will disappear (andthe EMH holds). If you discover this formula and others do not useit then the market is inefficient

(d) No. Semi-strong form efficiency only says that market is efficientregarding public information. This is not public information so it isirrelevant as a test of semi-strong form efficiency. (However, thesituation is inconsistent with strong form efficiency.)

5.2. No. Even if the EMH holds, the manager needs to consider the risk/returncomposition of the portfolio bearing in mind his/her clients’ preferencesand to ensure that the portfolio provides the best return for the level ofrisk. (that is that it is an ‘efficient’ portfolio).

5.3. It may help to think of this question as raising two issues. The first iswhether or not there is a correlation between directors’ shares sales/ pur -chases and movements in the share price. The second, which is thequestion directly relevant to the EMH, is whether an investor, knowing ofthis correlation, can use it for profit. Let us suppose that directors’behaviour is connected with share price movements. For most investors,the question then is whether they can make abnormal profits by acting onthis information as soon as it becomes public. The answer depends onwhether the EMH holds in its semi-strong form. One way of testing forthis is to use the event-study type methodology (see learning activity 5cabove). If the share price movement is largely complete by the time theannouncement is made, then the EMH is semi-strong efficient and noexcess return can be earned. It might still be possible to make a profitfrom this information if one could get access to it prior to publicannouncement (the EMH might not hold in its strong form).

5.4. The idea that arbitrage should eliminate mispricing is based upon the ideathat the mispricing gives rise to two different prices for the same security.For example, if Ford Motor Co. shares are trading at £4 in London andat (the US$ equivalent of) £4.20 in New York, then a profit can be madeby buying 1000 Ford shares in London and selling them in New York.This will eventually drive the prices together and the mispricing will beeliminated. Notice that if we ignore transaction costs and the possibilityof exchange rate fluctuations, the arbitrage is riskless. Because it is risk -less, only the most irrational investor would fail to take the opportunityto make a profit. Riskless arbitrage is central to the law of one price – theidea that the same item cannot sell at two different prices. Notice that itis the fact that two prices are available at the same time that (a) alerts usto the fact that something is wrong and (b) enables it to be corrected byarbitrage. But is this always the way in which mispricing reveals itself?The notion that arbitrage will always eliminate mispricing is often calledin to help protect the efficient market hypothesis – the hypothesis that

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says that security prices (for example) will always incorporate allinformation relevant to their fundamental values. And the reason why isbecause (as a last resort) arbitrageurs will buy any security where it isunderpriced and sell it where it is overpriced, making a riskless profit asin the Ford Motor Co. example. But what happens if someone thinks thatall shares are overpriced and that prices will shortly fall? Or, as a lessextreme example, that a whole sector of the securities market isovervalued? Unlike the Ford example, he cannot buy the underpricedsecurities to sell in the overpriced market. Alternatively, if he buys atcurrent prices, or already owns them, then he cannot sell for a profit.There is no riskless profit. The problem is that we do not have twosimultaneous, known, prices. The only way that two prices can emerge isover time and since we cannot know which way prices are going to move,trading on these prices cannot be riskless. For example, if a potentialarbitrageur does not own the shares already he cannot buy them in acheap market since there isn’t one. And he is unlikely to buy at the pricesthat exist if he thinks they are already overpriced since he would bedeliberately exposing himself to the prospect that the price will fallimmediately after he buys them. Alternatively, if he already owns theshares, there is no higher priced market in which he can sell at a certainprofit. He can, of course, sell, which is what many investors do if theythink that the market is overpriced. But this is not riskless.

SummaryIn this unit we have looked at the argument that assets are generally correctlypriced and at some of the criticisms of this view. Having completed the unit, youshould be able to:

■ explain the and its foundations

■ explain the implications of the EMH for both investors and for firms

■ show how ‘bubbles’ and ‘crashes’ have posed problems for the EMH

■ show how recent contributions from the field of behavioural financeendeavour to explain why assets may be wrongly priced.

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‘Kashima Oil loses $1.5 billion in forexderivatives trading....’

A reference to Kashima Oil’s problems in 1994

IntroductionThis is the first of two units related to foreign exchange (forex) markets.In this unit, the emphasis is on the use of foreign exchange marketinstruments. In the next unit we look at the factors that influenceexchange rates.

Unit learning objectives

On completing this unit, you should be able to:

6.1 Retrieve and use data relating to foreign exchange markets.

6.2 Explain the distinction between spot and forward markets andselected forex derivatives.

6.3 Describe the use of forex derivatives.

Prior knowledge

The unit assumes that you have studied Units 1–5. Otherwise, it requires no priorknowledge, but some basic mathematical skills and familiarity with basiceconomics and finance is helpful throughout.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008:‘Foreign Exchange Markets’, ‘Derivatives …’ and ‘Options …’). Pilbeam (2005)is also very helpful on futures and options. In Piesse et al (1995) there is a helpfulchapter on derivatives. Howells and Bain (2007) ‘Forex Markets and ‘ExchangeRate Risk …’ also cover much of the material but at a rather lower level. Ritterand Silber (2003) ‘Forex Rates’ is relevant to reading exchange rate data andthere is a chapter on futures and options. You will need a calculator and accessto the internet.

The foreign exchangemarket (I)6Unit

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Foreign exchange marketsA foreign exchange market is a market in which national currencies are boughtand sold. If we ignore tourists buying and selling foreign currency in the formof notes and coin, then trading in foreign currency means transferring fundsinto and out of bank deposits denominated in the relevant currencies. If we usethe term domestic currency to refer to the currency of the country in which themarket is located, then all other currencies are foreign currencies and it followsthat there must be a rate of exchange between the domestic currency and eachof the foreign currencies and, consequently, between each of the foreigncurrencies. Each rate of exchange is a ‘price’. Exchange rates can be found inthe financial press (and the corresponding websites). The Financial Times hasan online ‘currency converter’ which enables you to get an exchange rate for awide range of currencies against any other (see Financial Times, 2009). Centralbanks and national statistics databases will often have a limited selection ofrates, often as long runs of time series data.

When it comes to data on transactions rather than exchange rates or prices,one of the most useful sources of comparative data on forex transactions is theBank for International Settlements (BIS) (<http://www.BIS.org>). The BIScarries out a comprehensive triennial survey of transactions by type, bycurrency, by geographical location and even by counterparty and provides acommentary on the results. Because of the triennial nature of the survey, themost recent data relates to 2007 (BIS, 2007). (The next update will include2010 data.)

Table 6.1 shows the evolution of forex trading, by broad category of trans -action, in recent years. (We explain the various types of transaction in 6.2below.) The rate of growth is striking, especially since 2001.

Instrument 1992 1995 1998 2001 2004 2007

Spot transactions 394 494 568 386 621 1005

Forwards 58 97 128 130 208 362

Forex swaps 324 546 734 656 944 1714

Estimated ‘gaps’ 43 53 61 28 107 129

Total 820 1190 1490 1200 1880 3210

Table 6.1: Global foreign exchange market turnover (Daily averages in April,US$bn)

Source: BIS (2007), table 1

Table 6.2 shows the distribution of these transactions across the five majorcurrencies. The domination of the US dollar is unsurprising. After that, the mostnotable feature is the stable share of the Deutschemark and then the Euro (ataround 37 per cent of the total) and the declining role of the Japanese yen. Thistable shows only the dominant currencies in forex trading (hence the percentagesdo not sum to 100). If we looked at Table 5 in the BIS survey we should see manyother currencies, each of them with very little significance for forex trading.However, some of these show a clear upward trend. An interesting case is the

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Recommended reading: Howells and Bain (2008) ‘Forex

Markets’; Piesse et al ‘ForeignCurrency Markets’; Mishkin

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rupee which was involved in just 0.1 per cent of the whole in 1998 but 0.7 percent in 2007. The Chinese renminbi (or yuan) was undetectable in 1998 but wasinvolved in 0.5 per cent of forex transactions in 2007. The Russian rouble’s shareof forex transactions grew from 0.3 per cent to 0.8 per cent. Hence, if we try toexplain the decline in the share of the Japanese yen in Table 6.2, we shouldprobably look to the growing shares taken by the currencies of emerging markets.

Currency 1992 1995 1998 2001 2004 2007

US dollar 82.0 83.3 87.3 90.3 88.7 86.3

Japanese yen 23.4 24.1 20.2 22.7 20.3 16.5

Deutschemark 39.6 36.1 30.1

Euro 37.6 37.2 37.0

Pound sterling 13.6 9.4 11.0 13.2 16.9 15.0

Swiss franc 8.4 7.3 7.1 6.1 6.1 6.8

Note: Because two currencies are involved in each transaction, the sum of the percentageshares of individual currencies totals 200% instead of 100%.

Table 6.2: Currency distribution of foreign exchange market turnover – majorcurrencies (percentage of average daily turnover in April)Source: BIS (2007), table 3

Table 6.3 shows the geographical distribution of forex trading. This is not quitethe same as Table 6.2, since currencies can be traded in markets outside thecountry of origin. This is immediately apparent in the first line of the tablewhich shows that the UK remains the dominant centre for forex trading, takinga share in total transactions which is twice as large as the role played by thepound sterling.

Country 1995 1998 2001 2004 2007

UK 29.5 32.4 31.2 31.3 34.1

USA 15.5 17.9 15.7 19.2 16.6

Japan 10.3 6.9 9.1 8.3 6.0

Singapore 6.7 7.1 6.2 5.2 5.8

Hong Kong 5.7 4.0 4.1 4.2 4.4

Table 6.3: Geographical distribution of foreign exchange market turnover –major currencies (percentage of average daily turnover in April)Source: BIS (2007), table 5

When it comes to quoting exchange rates or prices (which we do in a moment)we need to be careful, because we are dealing with two currencies. In aconventional exchange, for example of euros for a flight from Paris to NewYork, we talk of the cost of the ticket in euros. It would not occur to us toquote the value of euros in terms of international flights. But where twocurrencies are concerned, there are two ways of doing it and it isn’t obvious thatone is preferable to the other.

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For example, if we are in the UK and are interested in the £/€ exchange rate,we can ask ‘what does it cost (in pounds) to buy €1?’ or alternatively we canask ‘what does it cost in euros to buy pounds?’, the answer to the first mightbe £0.9, in which case the answer to the second would be €1.11. When we askfor the price of one unit of the foreign currency in terms of the domesticcurrency, this is known as a direct quotation. When we ask what will one unitof the domestic currency buy, we are asking for an indirect quotation. In thiscase, £0.9 is the price of a euro, using a direct quotation; €1.11 is the priceusing the indirect quotation method. Sometimes the two currencies aredistinguished as the primary and the secondary currency. The primary currencyis the currency being quoted as a single unit and (perversely) is written secondin expressions like £/€ or €/$. In our £/€ example, the euro is the primarycurrency in the direct quotation and the pound is the primary currency in theindirect quotation.

You must be careful about the method you use when drawing supply anddemand diagrams and when talking about an exchange rate rising or falling.Throughout 2009, most commentators talked about the pound ‘falling’ or‘weakening’ against the euro since it was becoming more expensive to buy euroswith pounds. This is correct only if we understand that we are using the indirectmethod of quotation, since a fall from £0.9 to £0.8, say, would mean that euroswere getting cheaper.

You are given the following information about exchange rates (closing mid-points):£1 = SFr2.1 (indirect quotation of sterling)$1 = €1.1 (indirect quotation of the dollar)€1 = £0.93 (indirect quotation of the euro)Calculate each of these rates in direct terms.

(a) SFr =£ 0.476 (= 1/2.1)

(b) €1 = $0.909

(c) £1 = €1.075

Spot ratesThe exchange rates we have been talking about so far are spot rates. That isthey are current prices – the rates available for deals to be done now. (In factthe exchange of currencies usually takes place two days after the deal is made.)The spot rate is quoted as a spread. Suppose we see 1.4275–1.4385 quoted asthe £/$ spot rate. Sterling is the primary currency and the US dollar is thesecondary one. The spread means that £1 will buy $1.4275. So $1.4275 is thedollar-buyer’s rate. $1.4385 will get £1 and is thus the dollar-seller’s rate. Theeasy way to remember which is which is that the dealer will always give you theworst side. So, if you are starting your holiday to the USA, you know that thelower price is what you will get; but when you get back and want to sell the fewdollars you have left, you will have to pay the higher price to get your poundsback.

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direct quotation

indirect quotation

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secondary currency

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Cross ratesEven the most detailed sources of exchange rate data provide only a selectionof rates. These are usually the exchange rate for the world’s major currenciesand perhaps a longer list of currencies quoted against the domestic currency.This is because there is a very large number of different currencies in the worldand to provide a quotation for each pair would mean an impossibly largenumber of quotations. For example, 100 currencies would require 4950quotations if each were to be quoted against each of the others.

However, if we have an exchange rate for each currency against a commoncurrency, then we can establish what are called cross rates between any pair. Forexample, the Financial Times website quotes eight major currencies againsteach of the US dollar, pound sterling, euro and Japanese yen (Financial Times,2009). It does not, therefore, give us an exchange rate for the Australian dollaragainst the Swiss franc, but since both are quoted against the US dollar, we canuse the US dollar as a means of calculating the Australian – Swiss cross rate.

For example, suppose we know that:

1 Swiss franc buys 0.9 US$1 Australia dollar buys 0.8 US$

then an Australian investor looking for Swiss francs can firstly buy 0.8 of a USdollar and use that to buy 0.8 × 1.11 of a Swiss franc. In other words, oneAustralia dollar will buy 0.89 Swiss francs and so the exchange rate is 1:0.89.

In general, therefore, assuming that the central rate is the US dollar the crossrate can be found as:

Aus$ ×

US$[6.1]

US$ SFr

You are given the following information:

€0.9 buys £1, while £1 buys $CA1.68Calculate the euro price of a Canadian dollar.

1.68 ×

1 = 1.506. €1 buys $CA1.506

1 0.9

Forward rates and other forex derivativesJust as important as spot rates, however, are forward rates. These are pricesnow for currencies to be delivered at some specified future date, for example,in a month’s time (‘one-month forward’) or in three month’s time (‘threemonths forward’). While the forward rate could be exactly the same as the spotrate, more normally it will be higher (at a premium to) or lower (at a discount

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6.2Recommended reading: Howells and Bain (2008)

‘Derivatives’ and ‘Options’; Piesseet al ‘The Derivatives Markets’;

Mishkin (2007) ‘The ForexMarket’; Ritter and Silber (2003)

‘Futures and Options’; Pilbeam(2005) ‘Futures’ and ‘Options’.

cross rate

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to) the spot rate. By higher, we mean that the price paid for delivery in threemonth’s is higher than the price paid for immediate delivery and vice versa.Using our earlier example, if forward rates were at a premium they would bequoted as follows:

Spot: 1.4275 – 1.4385One-month forward: 0.27 – 0.25 pmThree-month forward: 0.53 – 0.51 pm

with ‘dis’ instead of ‘pm’, if they were at a discount. Notice that the premium/discount is shown in cents, so 0.53 is a fraction of a cent, not a fraction of adollar.

Using the data above, calculate the three-month forward rate.

The first step is to remember that a ‘premium’ means that the three-monthprice is higher than the spot price. The second step is to remember that weare looking at the secondary currency. This means that the figures in thespot quote must be reduced. In other words, we must subtract the premiumto get the forward rate:

Spot: 1.4275 – 1.4385Less premium 0.0053 – 0.0051

1.4222 – 1.4334

If we are dealing in US dollars for delivery in three month’s time we get1.4222 for each pound if we are buying; but we must pay 1.4334 if we areselling US dollars and buying pounds.

How do we explain the presence of premia or discounts? Leaving aside anyexpectations about the future trend in spot rates, one factor that must alwaysplay a part is the difference in interest rates available on the two currencies.Suppose that US dollar interest rates are two per cent while sterling interestrates are four per cent (in both cases on three-month time deposits). No onewould hold US dollar deposits (at least not for investment purposes). Indeed,if you were a US citizen, it might even pay you to borrow in order to buysterling now and earn the higher rate of interest. If you could convert thesterling back into US dollars in three month’s time at the original exchangerate, you would make a nice profit because the higher sterling interest ratewould pay the interest on your loan and leave you with the balance. And youwould have earned this interest by using someone else’s money! But how wouldyou guarantee the exchange rate for the reconversion in three month’s time?Easy. Buy US dollars three months forward. If, for example, you could buy USdollars three months forward at the current spot rate, the scheme would befoolproof.

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What name do we give to the kind of transaction in the previousparagraph? (Hint: think back to the discussion of the EMH and ourdiscussion of why noise-traders are supposed to be eliminated from themarket.)

The transaction is known as ‘riskless arbitrage’. Arbitrage means buying at alow price and selling at a higher (that is taking advantage of pricedifferentials – here the difference in interest rates) and ‘riskless’ refers to thefact that the return is guaranteed from the outset. When the deal is done,there are no unknowns. Nothing can go wrong. The prospect of risklessarbitrage should attract a flood of investment and prices should change veryquickly to eliminate this prospect of easy profit.

So why does it not happen that investors in the country with the lower interestrate borrow all that they can in order to buy the foreign currency with the higherrate of return? You have probably worked it out already. What prevents thisfrom happening is the price of the forward contract for US dollars. Suppose thatyou cannot reconvert into US dollars in three months time at the same rate thatyou convert out now? Suppose that the forward dollars are more expensive thanspot dollars. You may have earned more interest in sterling than you would havein dollars, but that is not much benefit if, when you come to turn the sterling intodollars, you find that the dollars are now dearer. And, of course, we can workout exactly what the forward price needs to be in order just to eliminates thispossibility of an easy profit. This is illustrated in Figure 6.1.

Figure 6.1: Riskless arbitrage

Figure 6.1 shows the possibility of two investment strategies in a situation wherethe £/$ spot rate is 1.4275, US interest rates are two per cent pa and UK ratesare four per cent pa. Starting with an investment of £10,000 this can earn UKinterest at one per cent (that is 4% × 3/12). At the end of three months it willbe £10,100. Alternatively, it could buy £10,000-worth of dollars at 1.4275 andearn US interest of 0.5 per cent (that is 2% × 3/12). At the end of three monthsit would be worth $14,346.38 (= 10,000 × 1.4275 × 1.005). If we turn this back

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£10,000 convertedto US$ at current

spot rate

3 month sterlinginterest at 1%

£10,000

1.4275 1.42043m forward

US$14,275 3 month USinterest at 0.5%

US$14,346.38

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into sterling at the original spot rate, then the value is £10,065.41. Clearly, withthese interest differentials and this spot rate, no one will hold US dollar timedeposits, provided that the current spot rate is available in three month’s time.There would be a rush from US dollars to sterling. However, at the time of thedecision, all that is known for certain about the exchange rate in three month’stime is that it can be fixed now by buying a three month forward contract. Giventhe current spot rate and the interest rate differential, we can calculate that thethree month forward rate that just makes riskless arbitrage unprofitable is1.4204 (= 14,346.39/10,100). It is this that makes the other rates sustainable.

The situation that we have just described is known as the interest rate paritycondition and we can summarise it in the interest rate parity formula:

Forward rate =1 + is × spot rate [6.2]1 + ip

where is is the rate of interest on the secondary currency while ip is the interestrate on the primary currency. Using the data from Figure 5.1 for illustration wehave:

Forward rate =1.005

× 1.4275 = 1.4204 [6.3]1.01

In Unit 7 (section 4) we shall look at the various risks that arise from exchangerate fluctuations. One obvious risk arises where an investor buys US dollarassets in the expectation of making a satisfactory return only to find that theexchange rate has changed when it comes to turn the investment back intosterling. Suppose, for example, that you can buy $4 million bonds at the currentexchange rate of £1:$1.4. The sterling cost is £2.857 million. You expect to beable to sell the bonds for $4.2 million. You also expect to receive a couponpayment of six per cent (= $0.24 million). Your expected return is:

4.44 – 4 = 0.11 or 11% [6.4]

4

which is what you will receive if you convert the dollars into sterling at 1:1.4(ignoring foreign exchange dealing costs). But you cannot be sure that theexchange rate will remain at 1:1.4. Learning activity 6e shows what couldhappen if the exchange rate moved against you.

Suppose that in one year’s time the pound to dollar exchange rate is 1:1.46.

1. What would be your profit in sterling from the deal just described?

2. How could you protect yourself against the change in the exchange rate?

1. At the new exchange rate you would receive £3.041 million (4.44/1.46)instead of £.3.171 million (4.44/1.4). The rate of return is

3.041 – 2.857 = 0.0644 or 6.44% (instead of 11%).

2.857

2. You could have bought sterling one year forward. Ignoring dealing costsand spreads, any forward price between 1.4 and 1.46 would havereduced your loss.

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Forward contracts are one way of protecting against this risk. But there aredrawbacks, as follows:

■ You would be locked into the contract at the price you paid and would notbe able to take advantage of any favourable movement in the exchange rate.For example, if the forward price you paid was 1.44 and the spot pricewere, say, 1.42 in a year’s time, you would have been better off acceptingthe spot price. And the spot price might have risen above 1.4.

■ The forward contract is for a fixed amount (here, $4.44 million). Supposethat the bond holder defaulted on part of the coupon so that you actuallyreceived only $4.3 million. You would have to buy the remaining $0.14million at the future spot price in order to complete the contract.

■ If the income stream were uncertain (as from an investment in companyshares rather than bonds), then you would not know how much sterlingyou would need to buy forward.

These are some of the reasons for the development of other instruments thathelp protect against currency risk. Two that we look at here are futures andoptions.

Financial futures belong to a class of what are known as derivatives, since theirvalue depends in part, on some underlying asset, or just ‘underlying’ for short.In the case of futures, the underlying are most commonly stock exchangeindices, interest rates on notional amounts of capital and (as here) currencies(that is exchange rates). Futures are exchange-traded products and to increasetheir tradability they are standardised products.

In a futures contract:

■ The buyer of a future takes on an obligation to buy on a specified date.

■ The seller of a future has an obligation to sell on a future date.

The obligations refer to a standardised quantity of a specified asset on a setfuture date at a price which is agreed today. For example, if we take the caseof euro-sterling futures traded on the Intercontinental Exchange in New Yorkwe find that the standardised quantity is €100,000 per contract. On most ex -changes the set dates for delivery are in December, March, June, and September.If we are looking at currency futures, we expect to see the price for a particularcontract to be quoted as an exchange rate and per single unit of currency. Thus,for example, if we looked at the euro-sterling March 2010 contract we mightsee a price of ‘0.8531’ meaning that the settlement price is €1=£0.8531. Otherinformation shown in a table of prices is likely to include:

■ the opening price at the beginning of the day’s trading

■ the highest price reached

■ the lowest price reached

■ the change from the closing price of the previous day

■ the number of contracts opened the previous day

■ the total number of contracts currently open.

We have already noted that futures contracts have standard features in orderto increase their tradability. For the same reason, futures exchanges use aclearing house in order to reduce the possibility of default risk. This means that

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when a buyer or seller enters into a contract, the contract in each case is withthe clearing house and neither has to be concerned that the other might fail. Theonly risk is the possible default of the clearing house itself and this is reducedby requiring all members of the exchange to keep what are called ‘marginaccounts’ with the exchange. Investors then are required to keep similaraccounts with the members of the exchange. This margin is some fraction of theprice of the contract, so as to cover the maximum daily loss on the contract. Forexample, at the start of the contract, the buyer and seller are required to payan initial margin of say between one and five per cent of the contract value. Asthe value of the contract fluctuates, the exchange moves the correspondinggain/loss between the two accounts. If the price changes sufficiently, the losermay be asked to contribute more into their margin account. The significance ofthis trading on margin (in addition to protecting the market from defaults) isthat it allows investors a high level of gearing. In other words there is the poten -tial to make a very large profit with a very small outlay. Table 6.4 illustrates theprocess. Suppose that you bought the euro-sterling contract mentioned aboveand the initial margin were three per cent. You would need to pay £3,000.Suppose then that the value of the contract rises, falls and then rises again untilat the end €1=£0.95.

Table 6.4: Market price and margin requirements

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Day Futures Daily Cumulative Margin Marginprice gain/(loss) gain/(loss) account call (£) (£) (£) balance (£) (£)

0.8531

June 5 0.8631 1000 1000 3000

June 6 0.8731 1000 2000 3000

June 9 0.8831 1000 3000 3000

June 10 0.8731 (1000) 2000 3000

June 11 0.8631 (1000) 1000 3000

June 12 0.8531 (1000) 0 3000

June 13 0.8431 (1000) (1000) 2000 1000

June 16 0.8531 1000 0 3000

June 17 0.8631 1000 1000 3000

June 18 0.8731 1000 2000 3000

June 19 0.8831 1000 3000 3000

June 20 0.9031 2000 5000 3000

June 23 0.9231 2000 7000 3000

June 24 0.9331 1000 8000 3000

June 25 0.9431 1000 9000 3000

June 26 0.9531 690 9690 3000

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You pay no extra margin to begin with since the price has been rising. But aftera series of losses, on the 13 June, your funds on margin fall to £2000.Commonly, the clearing house sets a lower limit (the ‘maintenance margin’)which is often 75 per cent of the initial margin. In this case that lower limit isbreached and the clearing house asks for additional funds to be placed in themargin account. After 13 June the market price rises again and at the end of thecontract you are able to buy euros at the contract price (£0.8531) and sell themin the spot market for £0.95 each. Your profit is £9,690–£3,000 or £6,690 foran outlay of £3,000.

We turn now to the pricing of futures contracts. The good news is that this isreally an exercise in covered interest parity which we have already met inconnection with forward contracts [6.2]. Assume that a UK firm requires eurosto settle an account in three month’s time and would be happy to buy theseeuros at the current pound/euro exchange rate. It can either:

■ buy a futures contract for delivery in three months’ time

■ buy euros three months forward

■ borrow for three months in sterling, buy euros now and invest the euros ateuro interest rates for three months.

Ignoring differences in transaction costs and some other details that we comeback to in a moment, each strategy must produce the same result, otherwisethere would be opportunities for profitable arbitrage. Since we know from [6.2]that the fair price of the forward contract depends upon the spot exchange rateand the interest differentials between the two currencies, then the same must betrue for futures contracts. Hence:

Futures price =1 + is × spot rate [6.5]1 + ip

Futures contracts involve obligations. However, this does not mean that buyersgenerally take delivery or sellers generally make delivery of the underlying.Once the futures contract has served its purpose it can be closed by entering intoa reversing contract. Someone with an obligation to sell an underlying asset ona given date can buy a futures contract requiring him or her to take delivery ofthe same instrument on the same date.

Options contracts, as their name implies, avoid the obligations in future. Aswith futures they can be bought or sold (written). There are two fundamentallydifferent kinds of options:

■ a call option gives the right (but not the obligation) to buy an asset at apredetermined price (the strike price) on a specified date

■ a put option gives the right (but not the obligation) to sell an asset at apredetermined price on a specified date.

We have referred to a ‘specified date’ for the transaction. But this is strictly trueonly for a European-style option. An American-style option can be exercised atany time up to the specified date at the discretion of the holder (the buyer). Aswith futures, options can be written on a variety of underlying assets includingequities, interest rates, foreign exchange rates, bonds, stock indices and more.

call option

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The buyer of a call option stands to profit if the spot price rises above the strikeprice. In this case, the holder acquires the asset at the strike (or exercise) priceand then sells it at a profit in the spot market. By contrast, the buyer of a putoption stands to gain from a fall in the price of the underlying asset. Once thespot price falls below the strike price the holder can buy the asset in the spotmarket and sell at the higher strike price. Notice that in both cases the holdersexercise the options at their discretion. If the price of the underlying does notmove in a favourable direction, or to a sufficient extent, the option expiresunexercised. The sellers (or writers) of options benefit from what is called theoption premium. This is the price per unit of the underlying asset that buyerspay for the option.

Table 6.5 shows the information that is typically displayed regarding currencyoptions. Notice that prices are given for both call and put options and that theyare given for a range of expiry dates and strike (or exercise) prices.

US$/€ options10 February Calls Puts

Strike price Mar Apr May Mar Apr May

12200 2.00 2.50 2.91 0.90 1.81 2.11

12300 1.85 2.00 2.31 1.21 2.01 2.53

12400 0.96 1.50 1.83 2.10 2.43 3.01

Table 6.5: Currency option prices

Currency options are options on the futures contracts we discussed above.These are usually for the US dollar against non-dollar currencies and buying acall option gives the buyer of the call the right to buy the non-dollar currencyat the strike price specified. Prices are shown in US cents, Hence, the strikeprice of 12300 should be read as an exchange rate of $1.23 = €1. The holderof a call option benefits if the value of the non-dollar currency rises in value.

What determines the size of option premium (or price)? Notice that there is apattern to the distribution of premia and this pattern gives us substantial clues.It reflects two crucial factors that play a role in the options price. The first iscalled intrinsic value while the second is called time value. Intrinsic value is theabsolute difference between the value of the underlying asset and the strike priceof the option. For example, if we look at the 12300 calls in Table 6.1, the optionwill have intrinsic value if the spot value of the euro rises above $1.23 = €1 sincethe holder of the option can exercise it in order to buy euros at less than theirspot price and then sell in the spot market. In this situation, the option is saidto be in the money. If the spot value of the euro is below $1.23 = €1 then theintrinsic value is zero and the option is said to be out of the money. Where thespot price equals the strike price, the option is said to be at the money.

One might imagine that an option that was out of the money was worthless.But think again about what an option entitles the holder to. If it is a call option,it gives the right to buy at some time in the future up to a specified date. So, onemight be holding an option which is out of the money at the moment – in otherwords the spot price is below the strike price and so it is not worth exercising

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now. But the option may have some time to run, and circumstances can change.And the longer the option has to run, the longer the period during which pricescould change so that the intrinsic value becomes positive. This gives the optionits time value and the time value increases with the remaining life of the option.

Now we should be able to make sense of the pattern of prices. If we take calloptions first we see that the price of the option rises with both the strike priceand the life of the option. The first is explained by intrinsic value. Suppose thatthe current spot price is $1.235 = €1. The 12300 option is ‘in the money’ andthe 12200 option is even more deeply in the money. They both have positiveintrinsic value, unlike the 12400 option which is out of the money with zerointrinsic value. This explains the negative relation between the value of a calloption and its strike price. Nonetheless, even when out of the money, a calloption may have time value. It is perfectly possible for the 12400 option toacquire intrinsic value in future. Hence, on 10 February, even the March optionhas some value. But the April and May options have even more time value,since the chance of moving into the money are even greater.

1. What is meant by an ‘in the money’ option?

2. Why might an option still have a positive market value even when it is‘out of the money’?

1. An option that is ‘in the money’ is an option that would yield a profit ifexercised now. For example, a call option whose strike price is below thespot price means that the holder can buy the underlying at the strikeprice and sell it in the spot market for a profit. An ‘in the money’ optionis said to have ‘intrinsic value’.

2. Suppose that the spot price in our call option were below the strikeprice. There would be no point in exercising the option since this wouldmean buying the underlying at a price which exceeded the price forwhich it could be bought in the open market. Such an option is ‘out ofthe money’ and has no intrinsic value. However, if there remains sometime to expiry, the option may still have ‘time value’. It may be worthbuying, especially if there is a long time to expiry and the underlying hasa very volatile price.

The pattern of prices on put options can be explained by parallel reasoning.Remember that a put option gives the right to sell. In this case the option willhave intrinsic value (and be in the money) when the strike price is above thespot price. So, the higher the strike price, the greater the intrinsic value. Whenit comes to intrinsic value, therefore, the relationship between option premiumand strike price will be positive. The time value relationship is explained in thesame way as for call options.

In summary, therefore, we can write a simple rule which applies to both call andput options:

Premium = intrinsic value + time value [6.6]

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We can even go further than this in our search for factors determining optionpremia. First of all we know that intrinsic value depends on the strike-spotrelationship and so a change in the market value of the underlying will affectall the premia. Furthermore, since time value derives from the chance that pricesmight change further and bring an option into the money before expiry, thenthe volatility of the price of the underlying must also play a part. For a givenlength of time, the probability of an option moving into the money must begreater for an asset with large price volatility than one which is comparativelystable. Finally, we need to consider the rate of interest. Buying a call optiongives the buyer the right to buy in future. The alternative, of course is to buynow in the spot market. Buying the option, however, costs a good deal less thanbuying the underlying asset. Strictly speaking therefore the purchase of a calloption releases the difference in value between the underlying and the price ofthe option to be reinvested elsewhere. The higher the rate of interest, the morevaluable is this alternative investment and consequently the more valuable is thecall option. The premium will rise with the rate of interest. Given the price ofa call option we can use what is called the put-call parity theorem to determinethe price of a put. Since the put-call prices are inversely-related, it follows thatthe rate of interest affects put prices in the opposite way.

Increase in Impact on Impact oncall option put option

Asset spot price Up Down

Exercise (strike) price Down Up

Volatility Up Up

Time to expiry Up Up

Interest rates Up Down

Table 6.6: Factors in option pricing

Using foreign exchange derivativesForeign exchange markets as a whole (including their derivatives) are used by avariety of agents. Most obviously, they are used by people wishing to buy or sellgoods services in foreign countries. Notice also that foreign currency will berequired also if an investor wishes to buy an overseas asset and foreign currencywill be exchanged for the domestic currency when the foreign asset is sold. Henceit is important to realise that while some forex dealing will be related to ‘trade’,a great deal of it will be related to ‘portfolio’ transactions – transactions relatedto the organisation and reorganisation of wealth. (Dixon, 2001, p250, suggeststhat only five per cent of forex transactions are related to trade. The rest are‘speculative’.) This dramatically widens the number of potential participants inthese markets. We can identify the following groups of ‘players’ in forex markets:

■ the end users of foreign exchange: firms, individuals and governments whoneed foreign currency in order to acquire goods and services from abroador to undertake portfolio investment

■ the market makers: usually large international banks which hold stocks ofcurrencies to allow the market to operate and which make their profitsthrough the spread between buying (bid) and selling (offer) rates of exchange

6.3Recommended reading: Howells and Bain (2008)

‘Derivatives’ and ‘Options’; Piesseet al ‘Derivative Markets’; Mishkin

(2007) ‘The Forex Market’; Ritterand Silber (2003) ‘Futures and

Options’; Pilbeam (2005),‘Futures’ and ‘Options’.

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■ speculators: banks, firms and individuals who attempt to profit fromoutguessing the market

■ arbitrageurs: (usually) banks that make profits from buying in one market atthe same time as selling in another, taking advantage of small inconsistenciesthat develop between prices or rates of return in different markets

■ central banks, which enter the market to attempt to influence the inter -national value of their currency – perhaps to protect a fixed rate of exchangeor to influence an allegedly market-determined rate.

We have already met the role of arbitrageurs when we talked about coveredinterest parity. Arbitrageurs ensure that prices are driven to equilibrium levels(allowing for transaction and other costs) by eliminating the possibility of profitfrom price differences. The presence of speculators – buyers or sellers who thinkthey know better than the market – are essential to provide sellers whenarbitrageurs wish to buy and buyers when they wish to sell. We know about therole of market makers from Units 2–4 and we shall look at exchange rateregimes in Unit 8. For the rest of this section we look at the use of forexderivatives by end users who need foreign currency for trading or investmentpurposes and are trying to protect themselves against the risk of exchange ratefluctuations. By contrast, learning activity 6g looks at one of the ways in whicha speculator might exploit forex derivatives.

The risks that the users of forex markets face can be grouped under threeheadings:

■ Transaction risk is the risk that the domestic value of any foreign currencyreceipts or payments may differ from what was expected as a result ofexchange rate fluctuations. Typical examples are provided by US firms, say,expecting to be paid in Japanese yen in the three month’s time. If the yenweakens against the dollar in the meantime, then the US firms will receivefewer dollars than they expected.

■ Translation risk arises where firms have foreign-denominated assets and/orliabilities on their balance sheets. When reported in the home currency, thevalue of these assets and liabilities will appear to change with fluctuationsin exchange rates.

■ Economic risk is the risk that exchange rate fluctuations cause a change inthe economic environment in which a firm operates, even though the firmitself may have no forex payment/receipts or assets/liabilities. An exampleis provided by a domestic producer (for example, of cars) selling in a marketto which overseas producers also have access. A weakening of the exchangerate makes the domestic firm more competitive.

Faced with the risks that arise from foreign exchange rate movements, investorsmay try to ‘hedge’ these risks. By hedging we refer to actions that can be takento protect against financial loss, usually by investing simultaneously in twoassets whose prices move in opposite directions in response to a common event.We shall compare the use of a currency option contract and a futures contractfor the purpose of hedging against future exchange rate movements, which giverise to potential transaction risk. (Bear in mind that the same issues would ariseif we were comparing the use of the option against a forward contract.) Whileoptions and futures contracts can both be used for this purpose, there aresignificant differences between the two. In a futures contract, both parties areobliged to go through with the transaction when the time comes; in an options

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contract, the holder can walk away, leaving the option unexercised if theconditions suit. With a futures contract there is a symmetry in the payoff tothe buyer and seller. For example, for every dollar the spot price is above thefutures rate at expiry, the buyer gains and the seller loses a dollar. But this is nottrue for an option where the maximum loss that the buyer can make is the lossof the premium paid. For the writer of the option, however, the downside couldbe unlimited. If we are comparing the two strategies, therefore, the first thingwe can say is that: ‘futures may be useful for hedging against symmetric risksbut options can be better at hedging against asymmetric risks’.

Our example follows. Suppose that in June a Japanese company orders £2million of goods from a UK company with an understanding that delivery (andpayment) will occur in a year’s time. The payment must be made in sterling atthat point. At the moment, the exchange rate is ¥68/£1. However, the Japanesefirm takes the view that sterling might appreciate in future, which will meanthat it will have to pay more (in yen) to settle the deal. In short, the Japanesefirm wishes to protect itself against this appreciation of the pound. However,the opposite is obviously a possibility and the firm would like to take advantageof any appreciation of the yen against the pound. The spot rate is ¥68/£1 whilethe one year’s future/forward rate is ¥63/£1. A one year call option to buypounds for ¥63/£1 can be bought for ¥3.

A forward contract would require the Japanese firm to pay ¥126 millionregardless of the exchange rate in one year’s time. However, the call optionwould be exercised only if the pound is above ¥63/£1. The following tableshows the costs of the two strategies for different future spot rates. It also showsthe costs of doing nothing at all and leaving the position unhedged.

Table 6.7: Hedging with options and futures

Spot exchange Cost using Cost using Cost of spot rate at time of option forward/futures contract expiry ¥:£ contract contract (unhedged)

71 132,000,000 126,000,000 142,000,000

70 132,000,000 126,000,000 140,000,000

69 132,000,000 126,000,000 138,000,000

68 132,000,000 126,000,000 136,000,000

67 132,000,000 126,000,000 134,000,000

65 132,000,000 126,000,000 132,000,000

64 132,000,000 126,000,000 128,000,000

63 132,000,000 126,000,000 126,000,000

62 130,000,000 126,000,000 124,000,000

61 128,000,000 126,000,000 122,000,000

60 126,000,000 126,000,000 120,000,000

59 124,000,000 126,000,000 118,000,000

58 122,000,000 126,000,000 116,000,000

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Case Study

The cost of the options contract is ¥6 million (2 million × ¥3). This gives thefuture option to purchase £2 million at ¥63/£1 or ¥126 million, a total of ¥132million. However, since this is an option that does not have to be exercised ithas the advantage that if the ¥ strengthens sufficiently, the option can beallowed to lapse and the yen to be bought in the spot market. The premium willstill have been paid of course and so, when the option lapses, the total cost ofacquiring sterling will be the spot market price of yen plus the premium alreadypaid. Hence if the yen strengthens to ¥62/£1, the option strategy will still bemore expensive than the futures at ¥130 million (= ¥124 million + ¥6 million).However, when the rate has strengthened sufficiently, the option strategy willbe the cheapest, notwithstanding the premium. This will occur when ¥59 = £1.Hence we see the advantage of the option over a futures contract: it allows theholder to take advantage of a strengthening of the currency as well as protectingas a hedge against weakening.

‘A speculator who felt that interest rates were likely to rise or a currency’svalue decline would go short in the relevant asset by selling a futurescontract’.

1. Why would a speculator go short rather than long in these two cases?

2. What does going short in interest rates mean?

1. Interest rates likely to rise: this means that securities prices are likely tofall and thus there would be a loss associated with holding securities.Similarly there is a loss from holding a currency whose value falls. Otherthings being equal, people do not wish to hold net amounts of assetswhose values are thought likely to fall but to be in a position where theywould need to buy the assets in question after the price fall has occurred(that is, to be currently short in the asset).

2. As indicated above, someone who is short in interest rates is short insecurities whose prices change as interest rates change. Thus, to holdbonds (be a net lender) is to be long in bonds and in interest rates (therate of return on bonds). Investors become short in interest rates byselling interest-rate-sensitive securities now in the expectation thatinterest rates will rise and securities prices will

When hedging goes wrongRead the following and answer the questions below:

Ravenscroft plc’s losses of approximately £200 million, which it puts down to‘abnormal foreign exchange exposures’, arose because the company took astrong but incorrect view on the direction of the yen. It is standard practicefor companies with a large portion of yen-based income from bothoperations and exports, as Ravenscroft has, to hedge against adversecurrency movements. But the firm appears to have gone further, takingheavy positions on the expectation of yen weakness. It seems that the

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Case Study continued

company took positions in both derivative and cash markets, writing calloptions on the yen, and selling the yen short in the foreign exchange market.Although it is quite common for large companies to write call options, it is apractice approached with caution. In buying a call option, the option holdercan only lose the nominal cost of the option. Writing – that is, selling – a calloption, on the other hand, leaves the writer with unlimited exposure…

1. What is meant by ‘hedging against adverse currency movements’? Howmight Ravenscroft have hedged?

2. What must they have done in order to go short in yen?

3. What is a call option in yen?

4. Under what circumstances will the writer of a call option in yen lose?

5. Explain why such losses may be unlimited?

1. Hedging is the act of removing the risk associated with a change in theprice of an asset by taking out an offsetting transaction in anothermarket, usually the derivatives market. Ravenscroft had net income indollars. They were thus long in dollars and the risk they faced, as aBritish company, was that the value of the dollar would fall. They couldhave hedged this risk, therefore, by selling dollars forward, by buying afutures contract in sterling/dollars so that the contract would becomeprofitable if the dollar weakened, or by buying a call option insterling/dollars (establishing the price at which it would have been ableto sell dollars for pounds).

2. Since they started long in dollars, to go short, they must have taken outmore contracts that would produce a profit in the case of the dollarweakening than they needed to hedge their initial long position. In otherwords, they deliberately moved from one open position where the riskwas that the dollar would fall in value to an open position in which therisk was that the dollar would rise in value.

3. An option giving the right to buy dollars at a given price.

4. The writer of a call option in dollars has to sell dollars at the agreed(strike price). If the writer is short in dollars, he will have to buy thosedollars in the cash (forex market) to meet his obligation and will thuslose if the cash price of the dollar is above the strike price in the optionscontract. In other words, the writer loses if the dollar increases in value.

4. The losses may be ‘unlimited’ because the writer has to meet theobligation in the contract no matter how much the dollar has increasedin value: the greater the increase in the value of the dollar, the greaterthe loss will be. This contrasts with the buyer of the option, whosepotential loss is limited to the premium paid for the option, no matterhow much the value of the dollar falls.

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Self-assessment questions6.1. Look at the following set of exchange rates:

£1 = €1.458; $1 = €0.753; £1 = $1.886

What is wrong with these rates. Show how, if they did exist, a profit couldbe made by trading the currencies.

6.2. Consider the relative advantages and disadvantages of using forwardscontracts, futures contracts and options as means of speculation.

6.3. Why is it more risky to write (sell) options contracts than to buy them?

6.4. Why might the increased protection provided to individual traders by thederivatives markets increase the risk of the whole financial system runninginto difficulties?

Feedback on self-assessment questions

6.1. This is an exercise in arbitrage. The first step is to take any two of thethree exchange rates and to use these to calculate the cross rate. Since thedollar is the vehicle for calculating cross rates in practice, it makes senseto take the two rates involving the dollar – the sterling/dollar rate and thedollar/euro rate and to use these to calculate the cross rate for the euroagainst the dollar.

Thus, we have:

$1 = €0.753£1 = $1.886

It is then convenient to express both exchange rates against the dollar(that is as indirect quotations of the dollar – the number of units of theforeign currency that exchange for one dollar). To do this, we need totake the reciprocal of the pound/US dollar rate, which gives us:

$1 = £0.53$1 = €0.753

We can now calculate the cross rate between the euro and sterling. Toproduce an exchange rate in the same form as the third rate quoted in theexercise, we need to treat the sterling rate as the denominator, so that wehave:

£1 = €0.753/0.53 = €1.421

We could, of course, have calculated the cross rate as €1 = £0.53/0.753 =£0.704.

We now have two exchange rates for the euro against the pound, the crossrate of €1.421 and the rate given in the exercise as the market rate,€1.458. It is clear that there is an inconsistency in the three rates given inthe exercise – in relation to the two rates involving the dollar, the marketis over valuing sterling against the euro. For the set of rates to beconsistent, one should get only €1.421 for each pound, but the market isgiving €1.458. This means that there is a profit opportunity forarbitrageurs and that their actions in pursuit of the profit will remove theinconsistency.

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The next step is to work out the direction in which one has to trade toobtain the profit. In any market, in order to make a profit one has to buysomething cheap and sell it dear. Therefore, one would not wish to buypounds at the market rate of €1.458. Rather, one has to sell sterling foreuro at that rate. No matter which currency you commence in, one of thesteps of the transaction must be to sell sterling for euro.

6.2. There are technical differences among the different forms of contractalthough the relative costs associated with the different contracts shouldequalise the net benefits of each. Nonetheless, different types of contractwill appeal to various market agents depending on their needs and ontheir views as to what is likely to happen in the underlying cash markets.The three types of contracts can be grouped in different ways to make anumber of points:(a) The derivatives contracts (futures and options) give speculators the

possibility of making very high rates of profit because of the highgearing associated with them (see section 9.3).

(b) In theory, forwards contracts have an advantage over derivatives tothe extent that no payment needs to be made until the currency inthe contract has to be delivered. With options, the premium needsto be paid when the contract is taken out, while, with futures,margins must be paid to keep the contract marked to market. Inpractice, this is not so important since a bank entering into aforwards contract with a client will want to assure itself that thedefault risk is very low and might well require the client to maintainfunds on deposit with the bank during the life of the contract.

(c) Forward and futures contracts lock in an investor to a givenexchange rate, providing a hedge against an unfavourable exchangerate move but reducing the potential profit from a favourable ex -change rate change. Thus, options have an advantage in that theyallow firms to combine hedging with speculation.

(d) Options contracts are capable of almost infinite variety (see, forexample, section 9.3) and are thus very flexible.

(e) Futures and options may be bought on exchanges and these providea number of advantages in terms of the liquidity, riskiness and thecost of the contracts. Of course, forwards contracts for commoncurrency pairs and for commonly-demanded periods of time arelikely to be relatively cheap. Both futures and options can be boughtover the counter as well as on exchanges.

6.3. The potential loss from buying an option is limited to the premium paidfor the options, since a loss-making option can be abandoned rather thanexercised. A writer of an option that is profit-making for the buyer has tofulfil the contract and thus has to pay the full profit to the buyer. Thewriter of an option cannot abandon the option if things go against him.The risk is greatest with uncovered or naked calls. Here the writerpromises to deliver an asset which he does not have. Since its price mayrise (in theory to infinity) before the option is exercised, the potential riskis enormous. In the case of a covered call, the writer already owns theasset and the loss is limited to the gain in the asset’s value that is enjoyedby the buyer of the option.

6.4. This is the notion of moral hazard, which implies that when people feelprotected they will take greater risks than otherwise. We are simply

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applying to financial markets here the idea that drivers wearing seatbeltsand in stronger and more protected cars are likely to drive faster, leadingto an increase in the number of accidents. A common argument in relationto financial markets is that government insurance of bank deposits leadspeople to pay no attention to the way in which banks are run and allowbanks that follow high-risk strategies to flourish. There is some evidencethat the confidence generated by derivatives played some part inencouraging banks and other financial institutions to take on high levelsof risk leading up to the financial crisis in 2007.

SummaryIn this unit, you have seen how exchange rates are quoted and how currenciescan be bought and sold directly in spot markets or through forwards, futuresand option contracts.

Having studied the unit, you should now be able to:

■ retrieve and understand foreign exchange rate data, bearing in mind thedistinction between direct and indirect quotation

■ understand the distinction between spot and forward markets and marketsfor currency futures and options

■ understand the use of a selection of forex derivatives as a means of hedgingcurrency risk

■ appreciate the comparative merits of futures and options contracts as ameans of hedging.

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‘Canada bullish on loonies outlook.’Financial Times (24 December 2009)

IntroductionIn Unit 6 we looked at a selection of instruments traded in foreignexchange markets, including currency itself and forward, futures andoptions contracts. In this unit we look at what causes fluctuations inexchange rates and at the potential risks to which these fluctuationsgive rise.

Unit learning objectives

On completing this unit, you should be able to:

7.1 Explain the main theories of exchange rate determination.

7.2 Interpret evidence on the behaviour of forex rates.

7.3 Explain the role of arbitrage and speculation in the determination ofexchange rates.

7.4 Describe the risks associated with forex fluctuations and theimplications for trade.

Prior knowledge

The unit assumes that you have studied Units 1–6. Of these, Unit 6 is essential.Otherwise, it requires no prior knowledge, but some basic mathematical skillsand familiarity with basic economics and finance is helpful throughout.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008:‘Forex Markets’). Pilbeam (2005) ‘Theories of Exchange Rate Determination’ isalso very helpful on exchange rate determination. Howells and Bain (2007) ‘ForexMarkets’ and ‘Exchange Rate Risk’ also cover much of the material but at arather lower level. Lawler and Seddighi (2001) part three deals with exchangerate determination and the effects of variability on trade. Ritter et al (2003) ‘ForexRates’ has a rather limited discussion of exchange rate theories. You will need acalculator and access to the internet.

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Exchange rate determinationIn Unit 6 we referred many times to exchange rate risk – the probability thatoutcomes would be different from what we expected because of a change inexchange rates. Table 7.1 shows that these fluctuations can be considerable,even over fairly short periods.

year-end € US$

1999 1.6081 1.6121

2000 1.5938 1.495

2001 1.6348 1.4556

2002 1.5342 1.6095

2003 1.4197 1.7905

2004 1.4127 1.9199

2005 1.4552 1.7166

2006 1.4841 1.957

2007 1.3619 1.9909

2008 1.0342 1.4376

2009 1.1255 1.6148

Table 7.1: Exchange rates, euro and US dollar against sterling 1999–2009Source: Bank of England (2009)

The table shows that over the period 1999 to 2009 the value of the eurofluctuated between 61p and 90p, while the US dollar was worth between 51pand 70p. How do we explain these variations?

The economists’ first step inevitably is to think in terms of supply and demandand the second step is to think about the fundamentals that might lie behind thesupply and demand shifts. We met this approach in Units 3–5 where weidentified the ‘fundamentals’ underlying bond and share pricing and thendiscussed the extent to which these really played a part when we looked at theefficient market hypothesis. Many of the same issues arise here.

What might the fundamentals be in the case of foreign exchange transactions?A traditional approach has been to focus upon the balance of payments. Whenproducers in Malaysia sell goods to consumers in the USA, they expect to bepaid, ultimately, in their own currency (the ringgit). Thus, the movements ofgoods from Malaysia to the USA creates an opposite flow of currencies.Importers in the USA must firstly buy ringgits with dollars. In the foreignexchange market, therefore, the flow of goods has generated a supply of dollarsand a demand for ringgits. Indeed, early exchange rate theories focused on justthis part of the balance of payments – the balance of trade – when looking foran explanation of exchange rate movements. They paid little, if any, attentionto the capital account. Hence, an ‘equilibrium’ exchange rate came to bethought of as the rate of exchange that would produce a balance of paymentsor more specifically a balance of trade equilibrium.

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7.1Recommended reading:

Howells and Bain (2008) ‘ForexMarkets’; Howells and Bain (2007)

‘Forex Markets’; Pilbeam (2005)‘Theories of Exchange Rate

Determination’; Ritter et al (2003)‘Forex Rates’.

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There are two immediate problems with this approach. Firstly, since exchangerates are continually changing, it is rather difficult to identify ‘equilibrium’situations. And even when two currencies enjoy a brief stable relationship, thisdoes not necessarily coincide with an ‘equilibrium’ in the balance of payments(however defined). The other is that a balance of payments equilibrium is anaggregate concept. For example, if we just focus on trade, then ‘equilibrium’requires exports to match imports in total. There is no requirement that bi-lateral flows also sum to zero, even though an exchange rate is a bi-lateralrelationship. Nonetheless, the idea that exchange rates must be linked tointernational payment flows remains a useful starting point.

Purchasing power parityWhat would be the fundamentals if the balance of payments provides theanswer? The essential issue is one of international competitiveness, so thefundamentals are those factors that determine the ability of one country’sproducts (and services) to compete with those of others. These will be a mixtureof ‘real’ factors like labour and other factor productivity, technological progressand economic growth. But it must also include ‘nominal’ factors like the generallevel of prices in one country compared with another. The role of differentialprice levels has drawn attention to the principle of purchasing power parity (orPPP). This is the principle that goods of the same quality should trade at thesame price in any country, once its price had been converted into some commoncurrency.

The idea is simple enough. If UK goods are dearer than comparable goods in,say, China, then UK citizens will switch from UK to Chinese-produced goods.As we know from our US-Malaysia example, this will result in an increase inthe supply of pounds in the forex market and an increase in the demand for theyuan. The value of the pound would fall relative to that of the yuan and thiswould continue until the currency flows stabilised and that would happen onlywhen Chinese goods ceased to have a competitive advantage, that is whenprices in the two countries, expressed in a common currency, were equal. Thisillustrates the absolute form of PPP:

■ spot exchange rates in equilibrium are a reflection of differences in pricelevels in different countries.

However, since we are more usually concerned with changes in exchange ratesthan in absolute levels, it is more usual to express this idea in the form ofrelative PPP (RPPP). This says that:

■ changes in equilibrium spot exchange rates reflect differential rates ofinflation in different countries.

In general then:πe

D – πeF =

Eet+1 – ES [7.1]

1 + πeF ES

where π is the rate of inflation, D and F indicate domestic and foreign, eindicates an expected value and ES is the spot exchange rate expressed in directquotation. As a rough approximation, we can read [7.1] as saying that:

■ the difference between the domestic and foreign inflation rates is equal tothe percentage change in the exchange rate, defined as domestic units ofcurrency per unit of foreign currency.

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absolute PPP

relative PPP

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PPP (and RPPP) are powerful ideas. It is a variation on the ‘law of one price’and it draws on the forces of arbitrage that we have met before (see also section7.3). In other words, if PPP does not hold then there is a profitable opportunityfor someone to buy in the cheap market and sell in the dear. At the theoreticallevel, therefore, PPP is attractive. But how useful is it in practice?

The Australian dollar is worth €6.15. In the course of the next year, inflationin Australia is expected to be seven per cent, while in the Eurozone it isexpected to be three per cent. According to PPP theory, what Aus$:euroexchange rate should we expect in a year’s time.

Rearranging [7.1] we have

Eet +1 =

πeD – πe

F ES + ES =0.07 – 0.03

6.15 + 6.151 + πe

F 1 + 0.03

= [0.0388] 6.15 + 6.15 = 6.389

In one year’s time we should expect the exchange rate to be Aus$6.389:€1,a depreciation of 3.88 per cent.

Let us assume for a moment, that PPP is a major influence on exchange rates,at least in some long-term sense. It then follows that if we had a satisfactorytheory of inflation, we could explain movements in exchange rates by referenceto differential inflation rates and then by reference to differences in whateverit is that causes inflation. For many years, long-run macromodels posited aconnection between the rate of monetary growth and the rate of inflation,derived from a quantity theory of money. Given this, then it is possible totheorise about exchange rate movements starting from differences in rates ofmonetary expansion. If country A has a more rapid rate of monetary growththan country B, then the combination of PPP and this monetary analysis ofinflation tells us that the currency of country A will depreciate against thecurrency of country B. Although models of inflation which rely on monetarygrowth have long since been abandoned by monetary policymakers, monetarytheories of the exchange rate still have their supporters.

We shall look at the testing of forex theories in 7.2. But note at this point thatPPP extracts from a number of real world complications. Firstly, it overlookstransport and other costs of moving goods between countries. These might playa small role if we are looking at trade between the UK and Germany, evensmaller between Germany and France, but could be considerable between UKand China. Other costs could include tariffs, quotas and a variety of regulationsdesigned to deter foreign competition. Secondly, it assumes that consumers arefully-informed about the quality and prices of goods produced in othercountries. Again, proximity may play a part, or at least similarity of culture.Thirdly, goods may be less directly comparable than appears at first sight.Electrical goods work at different voltages and/or frequencies. Video standardsdiffer across countries. Drug approval procedures differ. British cars are drivenfrom the right-hand seat and so on.

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Interest rates, expectations and the capital accountFocusing on international trade may seem an obvious way of trying to explainexchange rate fluctuations. But it is worth remembering, from Unit 6, that onlya very small fraction of forex transactions are trade-related. The rest are insome sense portfolio, or more bluntly, ‘speculative’ transactions and are part ofthe capital account of the balance of payments. Switching attention to thecapital account has brought two other factors into the discussion. The first isrelative interest rates and the second is expectations.

The interest rate argument is that funds will flow towards the currency thatoffers the best rate of return. Hence if the interest rate in country A is higherthan in country B, funds will flow from B to A, pushing up the value of A’scurrency against that of B. Naturally, if there is any merit in this line ofargument, then we are forced to ask what causes differences in nominal interestrates across countries? One answer is the international Fisher hyphothesis. TheFisher hypothesis says that:

■ in equilibrium, the real rate of interest is the same in all countries andtherefore the difference in nominal rates is explained by differences ininflation.

Hence, if i is the nominal rate of interest in the home currency (D) and theforeign currency (F), then

iD – iF =πe

D – πeF [7.2]

1 + iF 1 + πeF

Since the right-hand side of this expression is the same as the left-hand side in[7.1], we could write:

iD – iF = Ee

t+1 – ES [7.3]1 + iF ES

which gives us an explanation of appreciation/depreciation in terms of relativeinterest rates.

However, there are problems with this explanation that have some parallelswith PPP. The Fisher explanation also relies on perfect markets, full informationand completely free capital movements. In practice, however, investors have totake account of different levels of sovereign and default risk, which also causeinterest rate differentials. This helps explain why capital flows between therichest and poorest countries are very small indeed, notwithstanding very highinterest rates in poor countries.

The second consequence of switching attention to capital flows is that itintroduces expectations as an important issue. Since investors are looking fora rate of return over a period of time (instead of buying currency to financeimmediate transactions) it makes sense for them to be concerned with future aswell as present values – of inflation, interest rates and the exchange rate itself.But once we introduce expectations, we also introduce a psychological elementinto decision-making. Forecasting what is likely too happen in future requiresthat we form some judgement of what others may be going to do in future andthis will include forming judgements of central bank reactions to economic

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news since central banks (generally) set short-term interest rates as a policyinstrument. Furthermore, governments themselves may have a view about thedesired exchange rate, and may encourage official intervention, even thoughthey may say in public that they endorse the principle of floating exchangerates. This introduces a number of factors that it are hard to describe asfundamentals, especially if it is expectations of these variables, or expectationsof other people’s expectations of these variables that really matters. None -theless, it helps to explain some of the volatility that one sees in exchange rates,perhaps better than notions of equilibrium based on fundamentals.

OvershootingA notable attempt to preserve the idea of a long-run equilibrium exchange ratewhile accommodating fluctuations that moved the actual rate a long way fromequilibrium was that of Dornbusch (1976) who initiated a series of what becameknown as overshooting models.

If prices are perfectly flexible, agents fully informed and so on, then differentialsin rates of inflation and interest rates will cause the exchange rate to appreciate/depreciate. Behind this, as we saw above, is the view that it is differential ratesof monetary expansion that cause these differences in inflation and interest rates.Thus we have an explanation of exchange rate determination that is based uponPPP and monetary conditions.

However, it is much more realistic to assume that prices are sticky. It takes timefor goods prices and wages in particular to adjust. There are many reasons forthis stickiness. It takes time, and is costly, to adjust prices at frequent intervals.It creates uncertainty. Hence contracts are conventionally made for a fixed period,typically a year but sometimes longer, and breaches of contract and even attemptsto renegotiate are often met with hostility. Furthermore, where industries areoligopolistic, firms will be reluctant to make upward price adjustments for fearof losing business to competitors and reluctant to make downward adjustmentsthat might spark a ‘follow my leader’ stream of competitive price reductions thatreduce profits across the sector. The fact of price stickiness, and the reasons forit have been extensively explored in connection with monetary policy where it iswidely-accepted that price stickiness causes monetary policy to have real effects(on output and employment). However, while product and labour markets showevidence of price stickiness, it is a characteristic of financial markets that pricesadjust very quickly, if not instantaneously (recall the efficient market hypothesisthat we discussed in Unit 5). Dorbusch’s insight was to bring the two together andrecognise the implications.

The Dornbusch overshooting hypothesis is easiest to follow (and to showdiagrammatically) if we think of change in the price level rather than in rates ofinflation, though of course a change in the price level where previously it wasstatic is an increase in the rate of inflation from zero. So, we begin typically, byassuming an equilibrium position in which the exchange rate is given.Furthermore price levels are given and monetary conditions (strictly the moneysupply) are the same across the countries concerned.

Now we introduce a five per cent increase (say) in the money supply. In the longrun, this country will experience a five per cent increase in the price level and,under PPP, its exchange rate will depreciate by five per cent. However, money

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markets and foreign exchange markets are not constrained by price stickiness. Inthe money market, the increase in money supply produces an instantaneous fallin the rate of interest and in the forex market there is an instantaneousdepreciation of the exchange rate. The critical point is that while there has beenno adjustment in prices, there has been no effect on the demand for money in themoney market and so the increase in money supply has pushed the interest ratebelow what will be its ultimate equilibrium position when prices and the demandfor money have had time to adjust. This ‘overshooting’ of the interest rate causesa corresponding overshoot of the exchange rate which depreciates by more thanis necessary for equilibrium. As prices adjust over time, both the interest andexchange rates climb back from their low levels to an equilibrium which liesbetween the initial position and the immediate post-shock level.

Figures 7.1 and 7.2 show this in slightly different ways. Figure 7.1 stresses theoriginal and final equilibrium positions while Figure 7.2 illustrates theadjustment dynamics more clearly.

Figure 7.1: Exchange rate overshooting

In Figure 7.1, the PPP curve shows the long-run condition, namely that there is anequiproportionate relationship between the nominal exchange rate and the pricelevel. Provided, for example, that a five per cent increase in the price level is metby a five per cent depreciation in the nominal exchange rate, then the real exchangerate is unaffected and we are on the PPP schedule. However, this is a long-runcondition. In the short-run we can be off the PPP schedule.

The curve labelled M, illustrates money market equilibrium. Since the moneysupply is assumed to be fixed, then equilibrium requires an adjustment of moneydemand. Why is it drawn upward-sloping? Imagine an increase in the price level.This causes an increase in the nominal demand for money but the supply is fixed.(There is a reduction in the real money supply.) Equilibrium between MS and MD

can only hold if the nominal demand for money is reduced and this requires a risein the domestic interest rate. Assume that foreign interest rates are fixed, then thisrise in the domestic rate must cause an inflow of foreign currency and the exchangerate will appreciate. Hence if we start at point A in the figure (where the moneymarket is in equilibrium and PPP holds) an increase in the price level moves us upthe M schedule, say to B. This is possible in the short run. However, at point Beither domestic goods are too expensive or the exchange rate is overvalued. In thelong run prices must fall and we move back to A.

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Price level

Nom

inal

exc

hang

e ra

te

C

D

A

B

MM’

PPP

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Now, starting from A again, imagine an increase in the money supply. This isshown by the shift of M to M’. To begin with, the price level is unchanged. Butsince the money market must always be in equilibrium, the nominal exchange ratemust fall to C, which is below its new long-run equilibrium. In the short-run, itdoes not matter that we are off the PPP schedule. But in the long run the price leveland the exchange rate will adjust until we are on PPP at D.

Figure 7.2 tells the same story but stresses the adjustment process with respect totime.

Figure 7.2: Overshooting adjustment

At time t0 there is an increase in the money supply, M. With a lag, the pricelevel begins to rise but in the meantime there has been an instantaneous fall inthe interest rate, i and exchange rate, E. Eventually, the exchange rate settles atits new equilibrium level E1 but it does this by appreciating from the artificiallylow level to which it fell initially.

The overshooting hypothesis shows how real exchange rates can showpersistent deviations from equilibrium, even when people are well-informed.

1. Why do prices in goods and labour markets adjust more slowly thanprices in financial markets?

2. Why does this matter?

1. In goods and labour markets prices are set in contracts that last for aperiod of time. Buyers and sellers prefer the certainty that this gives evenif it limits the instant adjustment to supply/demand changes.Furthermore, changing prices in goods and labour markets is more costlythan in financial markets. Price changes, especially in labour markets,may involve lengthy negotiation.

2. These ‘price rigidities’ matter in foreign exchange markets because theythrow the entire adjustment to a monetary shock immediately onto therate of interest and thus onto the exchange rate.

Time

M

P

i

E0

E1

t0

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Random walksThe Dornbusch overshooting model had its origin in the frequent empiricalobservation that, in floating exchange rate regimes the degree of volatilityappeared to be greater than changes in ‘fundamentals’ would suggest orexplain. A more extreme attempt to explain exchange rate volatility is to saythat exchange rate changes follow a random walk, though this is not so muchan explanation as an admission that rational explanations are impossible. Weshall say a bit more about this in the next section because it is an idea thatcomes out of the empirical data (Dixon, 2001). There is no theory that explainswhy rates should follow a random walk, though such evidence is less surprisingin a market where transactions in foreign exchange are largely speculativerather than related to trade. We should recall that there is quite a lot of evidencethat company share prices follow a random walk (see Unit 5).

By saying that movements in exchange rates follow a random walk, we aresaying that there is no better way of predicting the future rate than by lookingat the current rate. Where ES is the spot rate, then:

ESt = ESt−1 + εt [7.4]

Adding fundamentals makes no improvement to the forecasting ability. At thetime that Meese and Rogoff (1983) announced this discovery, it causedconsiderable surprise, but the idea that exchange rates are very difficult toexplain and forecast over short time horizons in particular has become widelyaccepted, though fundamentals may play some role over longer periods. Weturn to the evidence in the next section.

Table 7.1 shows that the euro has appreciated substantially against thepound sterling in recent years. What factors might cause such anappreciation?

If we think about fundamentals and the trade balance then it could be thatthe UK trade balance has been more negative than that in the Eurozone; orthat inflation has been higher than inflation in the Eurozone. As regards thecapital account it may be that interest rates in the UK have been lower thanin the Eurozone.

Moving away from fundamentals, any news that undermines confidence inUK financial markets will have an adverse effect or anything that causes anincrease in uncertainty. This could involve political factors since financialmarkets traditionally favour Conservative over Labour governments.

We need to bear in mind two other things:

1. that markets are forward-looking and therefore anything that changesexpectations about these events is likely to have an effect

2. that we have looked for ‘adverse’ news about the pound. The answermay lie in news about the euro.

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Interpreting the evidenceWhen it comes to assessing the evidence on exchange rate determination, thefirst point to make is that there are a number of practical difficulties. Forexample, the intuition of PPP is that the exchange rate will adjust so that theprice of goods and services is the same in two or more countries, because ifthat were not so, then arbitrage profits would be available to traders whobought in the cheap market and sold in the dearer one. Clearly, this abstractsfrom transport and related costs and PPP recognises this. But the fact remainsthat only some goods (and relatively few services) are internationally traded.This then raises the question of how we are to compare the relevant price levelsbetween two countries in order to test for PPP. Price indices, by their verynature, tend to be very broad. Their function is to chart movements in the pricelevel as a whole. It is very difficult to find an index of prices for tradable goodsalone. Furthermore, PPP is meant to apply to similar baskets of goods whereasnational price indices are based upon a basket of goods which reflects, so faras possible, the consumption patterns of the population. Suppose that we werefortunate and could find a price index for traded goods produced in the UK andtraded goods produced in, say, Zambia. The UK basket would have a smallweighting for food and a large weighting for consumer durables. In Zambia, theopposite would be true. Does it make sense to compare the relative prices oftraded goods using two such different baskets?

That said, we do wish to make such comparisons and we can only use the datathat is to hand. Given the data, there are numerous ways of examining it,ranging from simple graphical analysis to more sophisticated, econometrictechniques. Figure 7.3 shows the behaviour of the pound:US dollar exchangerate from 2000 to 2009 (the broken line) and compares it with what theexchange rate should have been had it been determined by absolute purchasingpaper parity (the solid line). On a PPP basis, there should have been little changeover the period, since the dollar was worth between 64p and 68p. In practice,it swung between a high of 70p in 2001 and a low of 50p in 2007.

Figure 7.3: The sterling–dollar exchange rate, 2000–2009Source: OECD (2009), table 4

7.2Recommended reading:

Howells and Bain (2008) ‘ForexMarkets’.

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Figure 7.4 compares the actual and PPP exchange rates for the euro and USdollar. Once again, on a PPP basis the exchange rate shows little variation (thesolid line), with the dollar strengthening very slightly over the period. Theactual rate (the broken line), however, shows that the euro strengthened quitesignificantly from about €1.1 to the dollar in 2000 to about €0.67 to the dollarin 2009.

Figure 7.4: The euro–dollar exchange rate, 2000–2009

In both cases, the figures show that the actual exchange rate exhibits morevolatility than is warranted by the ‘fundamentals’ (in this case PPP) and weshall see in a moment that ‘excess volatility’ is one of the most general findingsof empirical investigations of exchange rate behaviour.

In fact, we can link this with the Meese and Rogoff (1983) findings that wementioned at the end of the last section. You will recall that they found thatforecasts of exchange rates, based upon fundamentals, could not improve on asimple random walk model. In fact, their model included a drift term, κ:

ES = ESt−1 + κ + εt [7.4]

By adding a number of additional terms to reflect the ‘fundamentals’ that appearin conventional theories of exchange rate determination, it was possible to showthat none of these made any significant improvement. The testing focused on USdata. The fundamentals whose role was tested were:

1. the ratio of US/foreign money supply

2. the ratio of US/foreign real income

3. the ratio of US/foreign real interest rates

4. the ratio of US/foreign expected inflation

5. US and foreign trade balances.

For the most part, the testing involves placing restrictions on the coefficients onthese terms and looking to see whether the restrictions are accepted by the data.For example, the Dornbusch overshooting model makes no reference tocumulated trade balances and so one would expect to find the coefficient of 0on (5) if the overshooting model holds. The finding that adding these macro -

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economic variables made little improvement was initially surprising. Themeasure ment of expected inflation is always a matter of debate but by and largethe results appeared robust. Recent attempts to overturn them have not beennotably successful (Rogoff, 1999). But there may be a long-run/short-run issuehere. Mark (1995) found that fundamentals did improve the random walkmodel at long horizons.

Against this, Ehrmann and Fratzscher (2004), in a paper for the ECB, showedthat certain types of news had significant (instantaneous) effects on the USexchange rate using data over the 1993–2003 period. They interpret thesignificant news items as amounting to news about the ‘strength of theeconomy’ and therefore as some sort of evidence that fundamentals matter.Disturbingly, however, the news items that appear to be insignificant in theirstudy are equally suggestive of the state of the economy. The surveys ofpurchasing managers appear to be the most significant factor in short-runexchange rate movements while news about retail sales, housing starts and thetrade balance are irrelevant.

In spite of much theorising and testing, we do not seem to have advanced muchbeyond the ‘stylized facts’ that Mussa (1979) extracted from the evidence.Briefly, his conclusions were:

1. On a very short-term (for example, daily) basis exchange rates are unpre -dictable.

2. On a month-to-month basis less than ten per cent are predictable.

3. Countries with high inflation rates have depreciating currencies and over thelong run the rate of change or the exchange rate between two currencies isroughly equal to the difference in their inflation rates.

4. Countries with rapidly expanding money supplies tend to have depreciatingcurrencies.

5. In the long run, the excess of domestic over foreign interest rates is roughlyequal to the expected appreciation of the foreign currency.

6. Changes in the spot rate tend to overshoot any smoothly adjusting measureof the equilibrium exchange rate.

7. In the long run, countries with persistent trade deficits tend to have de -preciating currencies; those with trade surpluses tend to have appreciatingcurrencies.

To what extent are fundamentals crucial for exchange rate determination inthe long run?

It is clear that exchange rates frequently differ from any notion of anequilibrium rate determined by fundamentals and in the Dornbuschovershooting model we are given good reasons why this is so. However, itdoes appear to be the case that the exchange rates of economies that havelarge balance of trade deficits or high rates of inflation for prolongedperiods of time show some of the signs of responding to thesefundamentals as theory predict. Furthermore, some of the reasons for

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deviations from equilibrium (in particular sticky prices) may have less effectas time passes. The problem with the short-run/long-run distinction,however, is that shocks may occur too frequently for the long run to beachieved. This seems especially possible with financial variables likeexchange rates. If this happens, then we may never be in the long run andfundamentals, though they may be relevant, will never provide a completeexplanation.

Arbitrage and speculation in forex marketsIn Unit 6 we said that we can identify the following groups of ‘players’ in forexmarkets:

■ the end users of foreign exchange: firms, individuals and governments whoneed foreign currency in order to acquire goods and services from abroador to undertake portfolio investment

■ the market makers: usually large international banks which hold stocks ofcurrencies to allow the market to operate and which make their profitsthrough the spread between buying (bid) and selling (offer) rates of exchange

■ speculators: banks, firms and individuals who attempt to profit fromoutguessing the market

■ arbitrageurs: (usually) banks that make profits from buying in one market atthe same time as selling in another, taking advantage of small inconsistenciesthat develop between prices or rates of return in different markets

■ central banks, which enter the market to attempt to influence the inter -national value of their currency – perhaps to protect a fixed rate of exchangeor to influence an allegedly market-determined rate.

In this section we look in more detail at the role of arbitrageurs and speculators.

Arbitrage in forex marketsEconomists are strongly attached to the ‘law of one price’. The law means thatcomparable goods or service must trade at the same price and the extent towhich it applies depends upon the process of arbitrage. Arbitrage refers to theact of being cheaply in one market (or in one part of a market) and selling at aprofit in another. The reason that the law of one price is held to havewidespread application is because its absence implies that opportunities forprofit are being missed and the forgoing of profitable opportunities isinconsistent with the most fundamental characteristics of economic agents: thedesire to maximise wealth and the use of rational calculation in so doing.

In foreign exchange markets, it is the behaviour of arbitrageurs that isresponsible for the interest parity condition (interest rate arbitrage) and forequilibrium exchange rates (exchange rate arbitrage).

Exchange rate arbitrage involves taking advantage of differentials in the priceof a currency in different markets. Such arbitrage transactions may be classified

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in terms of the number of markets involved. Thus we may have transactions intwo markets (two-point arbitrage), three markets (three-point arbitrage) ormore. Two-point arbitrage operations are very simple, taking advantage ofsmall variations in the one exchange rate in two markets. For example, if thespot exchange rate of the US dollar were $1.40 = £1 in London and $1.45 = £1in New York, it would be possible for arbitrageurs to make a profit by buyingpounds in London and selling them immediately in New York. Indeed, this isan example of riskless arbitrage since, provided the different rates persist longenough for the trade to take place, the value of all variables is known. This actof buying and selling should push up the price of pounds in London and pushdown the value of pounds in New York until the two were equal.The arbitrage operation would close the gap between the two rates. In practice,the rates would not come exactly into line because of the existence oftransactions costs, but the rates should move to being transactions-costs close– sufficiently close to remove any possible arbitrage profits.

The profits from two-point arbitrage are sufficiently easy to spot (and exploit)that they are extremely rare. However three-point arbitrage, which occurswhere exchange rates among different currencies are mutually inconsistent, isa more likely possibility. Arbitrageurs then attempt to profit from theseinconsistencies and in the process eliminate discrepancies and establish mutuallyconsistent exchange cross rates. Assume that the following three market ratesapplied in Hong Kong:

■ €1 = HK$11.1647

■ HK$1 = ¥ 12.000

■ €1 = ¥131.260

We wish to consider the possibility that these rates are mutually inconsistent.Our first step is to take any pair of these market rates and use them to calculatethe exchange cross rates consistent with them:

HK$11.1647 × Y12.000€1 HK$1

Thus, it is clear that the market price (€1 = ¥131.260), relative to the otherpair of exchange rates, is undervaluing the euro in terms of the yen (the yen isovervalued against the euro). In other words, the three market rates aremutually inconsistent and a profitable arbitrage opportunity exists.

To realise an arbitrage profit, it is necessary to follow two rules:

1. buy cheap and sell dear2. finish in the currency in which you started.

Assume we hold yen. Our aim must be to organise our transaction to makesure that at some point we sell yen for euros, in order to take advantage of theinconsistency we discovered by calculating the cross rate. In order to be able todo this, we must take the following steps:

■ Step A: Sell yen for euros

■ Step B: sell euros for HK dollars

■ Step C: sell HK dollars for yen.

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Using the data above, and assuming that you begin with ¥1000, show howyou can make an arbitrage profit (ignore transaction costs).

1. Selling ¥1000 for euros at €(1/131.260) gives €7.618.

2. Selling €7.618 buys HK$85.05

3. Selling HK$85.05 for yen at HK$1:¥12.00 gives you ¥1020.6, a profit of¥20.6

In practice, the calculation would be a little more difficult than is suggestedhere because you would be faced with bid and offer rates for eachexchange rate and you would need to choose the correct rate of the pair,depending on whether you were buying or selling.

In Unit 6, we discussed riskless arbitrage in connection with the interest rateparity condition. If you have difficulty recalling this, look again at thediscussion surrounding Figure 6.1 where we was that different interest rates inthe US than in the UK meant that no one would hold US dollars unless theforward exchange rate compensated them for this. It was the action ofarbitrageurs that imposed this condition.

Foreign exchange markets and speculationSpeculation is generally regarded with suspicion, being regarded frequently asthe source of market disruption and mispricing. However, there is another sideto this activity. Speculators provide liquidity to a market. By this we mean thatthey are ready buyers and sellers and by taking positions in which they betagainst the market, they provide buyers when other wish to sell and sellerswhen others wish to buy. Thus, it is argued, their presence provides a benefitfor agents who wish to use the market for normal business or insuranceservices. For example, in the absence of the activities of speculators, the numberof people wishing to buy or sell a relatively minor currency forward may be sosmall that no market maker is prepared to offer forward contracts involvingthat currency.

There may also be price implications. For example, if only small volumes of aparticular asset (say a forward contract involving, say, Australian dollars andThai bahts) were sold, the risks to the market maker would be high and thebid/offer spread on the contract would have to be large in order to compensate.Thus, firms wishing to hedge against risks associated with holding Australiandollars would find it expensive to do so. The presence of speculators deepensthe market, reduces the volatility of the exchange rates and leads to a loweringof the cost of using the market. During 2009, it became fashionable to arguefor a tax on financial transactions in order to discourage short-term risk-taking.It was rarely mentioned that any intervention that reduced the volume oftrading was likely to reduce liquidity, increase price volatility and increase costslike spreads.

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In addition, as we have already seen, it is claimed that speculators act to ensurethe efficient operation of markets, linking present and future prices of assets.This favourable view holds speculation to be stabilising, always moving themarket towards its equilibrium. Destabilising speculators – those trying to betagainst the natural direction of the market – would, it is argued, lose sincemarket forces are so strong that it is not possible to act against them. Forexample, suppose market forces determine that the value of a currency mustfall. Speculators make their profit by seeing this in advance of other people andselling the currency with the aim of buying it back later at a lower price. Thustheir action forces the value down towards its new equilibrium value. Again,speculators who realise that a rise/fall from an equilibrium is likely to be onlytemporary act on the correct assumption that the exchange rate returns to itsprevious level after the effects of the temporary shock wear off. They sell/buythe currency when it has deviated sufficiently from its equilibrium value for thereturn to equilibrium to compensate them for the trouble and risk of engagingin the transaction. In doing this, they help to push the currency back to theoriginal equilibrium position. Successful speculators thus are said to ensure thatmovements to new equilibrium positions occur more smoothly than otherwisewould be the case and that equilibrium positions are stable. Since the aim ofspeculation is to make a profit, it follows that unsuccessful speculators quicklyleave the market. Only successful speculators remain in the market. Thissupport for speculation is an important part of the argument that markets leftto themselves produce stable equilibrium exchange rates and thus is a majorelement in the case for floating rates of exchange.

Arguments against speculation claim that some speculators do lose – they arenot the core of professionals in the market but a part of the large fringe oftraders, tourists and central banks that take open positions in foreign exchangebut to whom the activity is peripheral. If this is so, it does not follow that theoutcome of speculation is always to move the market in the direction in whichit would otherwise have gone.

Of greater weight is the proposition that markets do not always work well andthat this allows the possibility of profitable destabilising speculation. Marketsmight, for example, fail because of time lags, different speeds of adjustment ofdifferent prices, lack of information or asymmetric information. In suchcircumstances, speculators might attempt to amplify price movements. This ismore likely where trading volumes are low (thin markets) and market agentsform expectations extrapolatively. For instance, speculators might be able to sella currency sufficiently heavily to force its value down; others within the marketobserve the fall and assume it will continue. Thus, they also sell, pushing theprice down further still. Speculators are then able to buy back in at the lowerprice, taking their profit.

We have also seen the suggestion that even speculators may be risk averse,limiting the amount they bet on any economic outcome that is less than a surething. In such a case, their actions would not succeed, for example, in bringinginto line forward and future spot rates of exchange.

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Foreign exchange risk and its implicationsIn Unit 6 we saw that the risks from exchange rate fluctuations could begrouped under the headings of transaction risk, translation risk and economicrisk and we looked at some examples of these as they arose for individual firms.But there is more to foreign exchange risk than its effects on individual firms.If those firms are risk-averse (a common assumption) then it seems reasonableto suppose that they will prefer the relative certainty of earning their profits intheir home country – leading to a reduction in the level of international tradefrom what it would otherwise have been – or they will adopt the hedgingtechniques that we discussed in Unit 6 which involves them in additional costs.Since the collapse of the Bretton Woods system and the move to floatingexchange rates in 1973, the negative effects of exchange rate variability havebeen a major concern to economists.

Why should exchange rate variability influence international trade? The startingpoint is that many contracts are not denominated in the home currency. Tavlas(1997) shows that there are quite wide variations across countries. In Japan, forexample, only 25–35 per cent of contracts were denominated in yen in the mid-90s while in the USA over 90 per cent were denominated in US dollars (whichreflects the fact that some contracts are denominated in US dollars) across theworld. This creates a potential problem since most contracts involve a time lagbetween the agreement to deliver goods or to discharge a service at a givenprice and the receipt or making of payment. In the intervening period theexchange rate may change.

The effect on trade of exchange rate variability will depend on:

■ the degree of risk-aversion amongst producers and traders

■ the degree of market power (affecting the extent to which variations in costcan be passed on)

■ the size and predictability of exchange rate fluctuations

■ the price elasticity of demand for imports and exports

■ the presence of markets with more stable exchange rates.

In Unit 6 we noted a number of devices that firms could use in order to protectthemselves against forex fluctuations. However, there are limits and costsassociated with hedging activity. Firstly, the expected receipts may not beknown with certainty. This makes it difficult to hedge the exact amount ofexposure; forward contracts generally have a maximum maturity of one yearwhile exchange traded contracts have standardised dates and amounts whichagain makes it difficult to hedge the exact amount for exactly the desiredperiod. And, as we have seen, these hedges carry a price, or premium. All ofthese may deter firms from pursuing international business.

There is also the possibility that variability has differential effects across firms.Small firms, for example, may find it harder to pass on any costs (of the hedgingor of the variability). They may have smaller financial reserves with which towithstand risk if they do not hedge. Large firms are likely to trade with a largerrange of countries than small firms and this will offer some degree of protectionby diversifying their exposure.

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Case Study

A third consideration involves the reaction of governments. They may resort toprotectionist policies or drag their feet when it comes to signing up to tradeliberalisation measures. They may undertake competitive devaluations to helptheir exporters or provide them with hidden subsidies under ‘infant-industry’type arrangements. All of this will slow down and/or distort the growth ofinternational trade.

What is the evidence? There has been a lot of empirical work in this area,summarised by Abbott (2001) and grouped according to type:

■ aggregate trade studies, which look at the aggregate trade flows of a countryor group of countries

■ bilateral trade studies, which analyse trade flows between two countries

■ industry-specific studies, which examine the effects of volatility

■ cointegration analysis, a rather different type of category which distin -guishes the method rather than the subject of the investigation.

Another useful survey is provided by McKenzie (1999). What both show is thatin spite of a large amount of work covering a wide range of countries and usinga number of different approaches, there remains some uncertainty about theextent to which exchange rate variability affects international trade. Part of theproblem almost certainly lies in the way in which exchange rate variability ismeasured, baring in mind that this has to represent the way in which firmsactually perceive the uncertainty of their profits.

The ‘loonie’Read the following report about the Canadian dollar (the ‘loonie’) andanswer the questions that follow.

‘Canada bullish on loonie outlook’Peter Garnham

Financial Times December 24 2009 02:00

The Canadian dollar advanced yesterday after Jim Flaherty, Canadianfinance minister, extolled the virtues of the loonie as a reserve currency.

Mr Flaherty said it would not surprise him if China and Russia, two of theworld’s largest holders of foreign exchange reserves, were to raise theshare of the Canadian dollar in their stockpiles, adding that manyinvestors were ‘looking around the world to invest in market currenciesthat are reliable’.

Analysts said it was notable that the Canadian dollar had outperformedthe resurgent US dollar since the US unit hit a 16-month low on a trade-weighted basis late last month.

Camilla Sutton, of Scotia Capital, said many of the factors that had led tothe recent US dollar rally were also supportive of the Canadian dollar.

She said the upward pressure on the US dollar had been caused by therealisation that there were many hurdles ahead for the Eurozone,

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including sovereign risk, and that fundamentals in the US were improvingfaster than many had previously thought.

‘Canada has limited sovereign risk and what is fundamentally good forthe US is also good for Canada and therefore the Canadian dollar,’ saidMs Sutton. ‘Accordingly, we think the recent outperformance of Canadiandollar is justified and expect it to be an ongoing trend.’

In late trade in New York, the Canadian dollar was up 0.8 per cent toC$1.0487, its strongest level in almost two weeks.

Meanwhile, the Swiss franc made ground as traders continued to test theSwiss National Bank’s tolerance towards a stronger currency.

After breaking through SFr1.50 against the euro at the end of last week, alevel that the Swiss National Bank had been defending since March in itsfight against inflation, investors have been pushing the Swiss franc steadilyhigher in an attempt to provoke a reaction from the central bank. JaneFoley, of Forex.com, said traders were ‘playing chicken’ with the SNB …

1. What is meant by the phrase ‘...market currencies that are reliable?’

2. What is meant by ‘sovereign risk’ when applied to the Eurozone?

3. What evidence would you look for if you wished to confirm that‘...fundamentals in the US were improving...’

4. The report says the Canadian dollar was ‘...up 0.8 per cent toC$1.0487’. How do you interpret the value 1.0847?

5. The report refers to the Swiss National Bank’s tolerance towards astronger currency. What does this suggest about the SNB’s exchangerate policy and what could the SNB do if it was not willing to tolerate astronger currency?

1. Note that it is investors who are looking for ‘reliability’. We can be suretherefore that ‘reliable’ means unlikely to depreciate since a depreciationwould mean a loss to investors when they changed back into their owncurrency.

2. ‘Sovereign risk’ refers to the possibility that a government may defaulton its obligations in some way. Given the reference to the Eurozone, wecan assume that the article has the problems of Greece, Ireland andPortugal in mind. At the end of 2009, there was widespread concernthat credit rating agencies were downgrading their ratings of thesegovernments’ bonds because of the size of their debt.

3. The fundamentals would include rate of growth of output, labourproductivity, inflation. The evidence could be data referring directly tothis or data which implied satisfactory values – so it might be the growthof retail sales, average hours worked, producer prices and so on.

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4. Where only one value is expressed in an exchange rate quotation, wecan usually assume that it is the value of the quoted currency against theUS dollar. In this case, we can be certain, since the report is discussingthe Canadian dollar’s strength against the US dollar. So the exchangerate here is C$1.0487:US$1.

5. The report is saying that the Swiss National Bank is prepared to see theSwiss franc appreciate against other currencies (specifically the euro). If itwere unhappy about this appreciation, the simplest response would beto lower interest rates in Switzerland to make the Swiss franc lessattractive to investors.

Self-assessment questions7.1. List as many items as you can of ‘news’ that would be likely to cause the

value of your domestic currency to fall. Explain why in each case.

7.2. Explain the following terms in the context of the foreign exchange market:(a) covered interest arbitrage(b) long positions in a foreign currency(c) hedging(d) three-point foreign exchange arbitrage.

7.3. Explain and defend the argument that speculation in markets is desirable.

7.4. How might one use the spot markets to obtain protection against foreignexchange risk? What advantages do the forward markets have for thispurpose?

Feedback on self-assessment questions7.1. This could be a very long list. Some likely items would be:

(a) poor balance of trade figures: domestic goods uncompetitive,currency needs to weaken to re-establish competitiveness (PPP)

(b) a reduction in domestic interest rates (or an increase in interest rateson other currencies) (interest rate parity)

(c) market expectation of a cut in interest rates(d) an increase in domestic inflation relative to inflation elsewhere (PPP)

or statistics suggesting that inflationary pressures are increasing(high money supply growth figures, for example) (But note: if theinflation figures were particularly bad, it might persuade the marketthat the monetary authorities were likely to push up interest rates inresponse – this might cause the value of the currency to rise.)

(e) increasing unemployment or low rates of economic growth thatmight lead the market to expect cuts in interest rates

(f) indicators suggesting a low level of confidence about the futureamong firms and consumers, which might lead the market to expecta weakening of the economy and hence cuts in interest rates

(g) anything that causes political uncertainty – elections, especially ifthey look as if they might be won by candidates hostile to financialmarkets; political scandals that might undermine the Government orweaken the leadership likely to come from the Government.

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(a) Covered interest rate arbitrage occurs when there is a profit to bemade from moving funds into another currency for a short periodof time to take advantage of higher interest rates on that currencywhile, at the same time, protecting against the associated risk thatthe value of the foreign currency will fall by selling the currencyforward. Covered interest rate arbitrage leads to covered interestrate parity, which occurs when the gains from investing in thecountry with the higher interest rate are equal to the forwarddiscount on that country’s currency.

(b) Taking a position in a market just means undertaking transactionsin that market. However, the term is normally used to imply an openposition – that is, one where the market agent is subject to risk ofloss. There are two types of open position depending on whetherthe risk is that the price of the asset concerned might rise or fall. Ifthe market agent faces a loss when the price of the asset rises, itmust be the case that he or she does not currently hold the asset (or,at least, does not hold enough of it to meet his or her commitments).This would be a short position (the agent is short of the asset). If theagent faces a loss if the price of the asset falls, it must be that he orshe currently holds more of the asset than needed to meet futurecommitments. This is a long position. Thus, examples of long posi -tions in the foreign currency market would be:(i) a UK citizen who needs funds eventually in sterling but

currently holds US dollars and will lose if the dollar falls invalue (long in US dollars)

(ii) a French exporter who has shipped goods to the USA for saleand will be paid for those goods in US dollars, which will thenhave to be converted into euro (long in US dollars)

(iii) a US speculator who has bought euro in the hope that the eurowill rise in value (long in euro).

(c) ‘Hedging’ is commonly used just to mean acting to protect againstrisk of loss in a market that is to move from an open to a closedposition. However, the idea of constructing a hedge is often thoughtof more precisely than that. The idea is that hedging involves theprocess of taking an open position in a market such that the risk isequal to and in the opposite direction from a risk faced in anothermarket. Thus, loss from one transaction will be matched by profitfrom the other. For example, the French exporter above who wouldlose if the dollar fell in value before she is paid for her goods, mighthedge against this risk by taking a short position in US dollars to theexpected amount in either the forward forex market or in a deriva -tives market. She might, for example, take out an option to selldollars at some time in the next three months at the existing spotmarket rate. Then, if the value of the dollar does fall in the spotmarket, she will lose on her exports but will stand to profit from heroptions transaction.

(d) Three-point exchange rate arbitrage is the process of taking advan -tage of small differences in exchange rates among three currenciesin the same market, for example, the pound/dollar, pound/euro, andeuro/dollar rates of exchange.

7.3. There are two points to be made here. The uncontroversial point is thatspeculators add liquidity to the market, allowing end users to deal in the

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market more effectively and more quickly. The second is that speculatorsstabilise the market because successful speculators guess the direction inwhich the market is heading and hence cause it to reach its newequilibrium position more quickly. For example, say we start with anequilibrium exchange rate, say pound/euro, but a change occurs in thefundamentals of the exchange rate that will push the value of the pounddown. Successful speculators see this before other market participantsand sell sterling with the aim of buying it back later at a lower price. Thisaction forces the value of sterling down in the direction that it will headin any case, but because of the action of the speculators it movesdownwards more quickly than it would otherwise have done and reachesits new equilibrium more quickly.

However, there are two big assumptions here. One is that speculators aresmall in relation to the market and are unable to influence the‘equilibrium’ price. All they can do is to anticipate it by making betteruse of available information. This seems unlikely especially in relation toless frequently traded currencies. We could easily imagine an alternativeset of actions. Big speculators sell an apparently settled currency, pushingdown its value sharply. Other market users respond to the fall by alsoselling, pushing the value down further still. Speculators buy back in andmake a profit. The market has been destabilised since there had not beena clear reason for the exchange rate to change in the first place. Thesecond assumption required to support the stabilising speculationargument is that only successful speculators survive in the market. Thus,the great bulk of speculation is towards equilibrium rather than awayfrom it. This proposition can also be attacked. Many participants engagein occasional acts of speculation and many, on average, lose.

7.4. The first step is to decide upon the sort of risk being discussed. Twoexamples follow:

Case A: an importer short in US dollarsAssume firstly that we are dealing with a British importer who is short inUS dollars. He has entered into a contract to buy goods in US dollars inone month’s time but currently does not have dollars. Therefore, he hasto buy US dollars over the next month. The risk he faces is that the valueof the dollar will rise and, thus, that the goods will cost him more insterling than he had anticipated. In order to make a profit on the goodsin the United Kingdom he will then have to sell them at a higher priceand this might cause him to lose sales.

If only the spot market were available, the only form of protection againstthis risk would be to buy US dollars immediately and invest them short-term until the dollars were needed to meet the import contract. Thiswould establish the rate of exchange and remove the risk associated witha strengthening dollar. The importer would receive US interest ratesduring the period in which he was holding dollars. There would be a costin buying dollars in advance if US dollar interest rates were lower thansterling interest rates and a lost profit opportunity if the dollar happenedto weaken rather than strengthen. The existence of a forward marketwould allow the importer to buy dollars forward at an agreed rate andwould thus establish the rate of exchange in the same way as the spotexchange transaction.

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There would be no potential cost from investing at a lower interest ratebut, if US dollar interest rates were lower than sterling rates, the US dollarwould be trading at a forward premium. Thus, there would be anequivalent cost arising from the fact that the forward exchange rate wouldbe worse from the importer’s point of view than the spot rate. That is,buying forward, the importer would need to pay more in sterling for therequired US dollar amount than he would need to do spot. Having takenout a forward contract, the importer could not benefit from a subsequentweakening of the dollar and so in this way also the spot and forwardtransactions would be equivalent. That leaves one potential advantagefrom using the forward market. In theory, the importer does not need topay until the delivery date on the forward contract and this would havecash flow advantages. However, whether this advantage would actuallyexist would depend on the relationship between the importer and hisbank. The bank would generally require some guarantee that the importerwould be able to meet his obligations under the forward contract and, asa condition of entering into the contract, might require the importer tohold a sterling deposit with the bank. In this case, protecting against riskthrough the spot and forward markets would be equivalent, except thatthere would almost certainly be greater flexibility in the forwardtransaction to cover uncertainties regarding the quantity of dollarsrequired and the date on which the payment had to be made. The limitedadvantages associated with the forward market help to explain the growthof derivatives markets, as we shall see in the next unit.

Case B: an exporter long in US dollarsConsider next a British exporter who knows that she will receive apayment in US dollars at a future date. She is long in US dollars and facesthe risk that the value of the dollar will fall before the dollars are receivedand thus she will receive less in sterling for her goods than she hadanticipated. This would reduce (and perhaps remove altogether) the profitmargin on her export deal. In the absence of a forward market, she wouldneed to take out a loan in US dollars and convert the dollars into sterlingat the existing spot exchange rate. She would then be able to deposit theproceeds in the United Kingdom at British interest rates. Then, when shereceived the dollars from the sale of her goods, she would use these torepay the dollar loan. Thus she would have established the amount ofsterling she would receive from the sale but would, of course, have tomake interest payments on her US dollar loan. Her net position wouldagain depend on the relative interest rates in the United States of Americaand the United Kingdom. If, as we assumed in Case A, interest rates werehigher in the United Kingdom than in the United States of America, theinterest she received on her UK deposit would be greater than that paidon her US dollar loan.

In practice, much would depend on her credit rating since this woulddetermine the interest rate she would need to pay to obtain the dollarloan and whether any collateral would be required. If a forward marketwere available, she would be able to sell the dollars forward at the existingforward rate of exchange. This would establish the exchange rate shewould obtain when she received her dollars. With UK interest rates higherthan USA rates, sterling would be at a forward discount and the forwardrate would be more favourable to her than the spot rate. Again the

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question would arise as to whether the bank with whom she was makingthe forward contract would require any guarantee that she would indeedhave dollars available to meet her obligations on the delivery date. Inneither the spot nor the forward case would the exporter benefit fromany unexpected strengthening of the US dollar.

SummaryIn this unit we look at what causes fluctuations in exchange rates and at thepotential risks to which these fluctuations give rise.

On completing this unit, you should now be able to:

■ explain the main theories of exchange rate determination including absoluteand relative purchasing power parity

■ appreciate that exchange rates show greater volatility, especially in the shortrun, than can be explained by fundamentals.

■ understand the role of arbitrage and speculation in the determination ofexchange rates

■ appreciate the risks associated with forex fluctuations both for firms andalso for the growth and development of international trade.

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‘Black Wednesday.’Reference to Wednesday 16th September 1992, when the

pound sterling was forced out of the ERM

IntroductionIn the final part of Unit 7 we looked at the risks to firms and to inter -national trade that are caused by fluctuating exchange rates. In this unitwe look at arguments for and against fixed exchange rate systems.

Unit learning objectives

On completing this unit, you should be able to:

8.1 Explain the benefits and disadvantages of fixed and floatingexchange rate regimes.

8.2 Explain the theory of currency union.

8.3 Interpret the development of the European Monetary Union (EMU)in the light of this theory.

8.4 Identify alternative currency arrangements in a selection of develop -ing countries/regions.

Prior knowledge

The unit assumes that you have studied Units 1–7. Of these, Unit 7 is essential.Otherwise, it requires no prior knowledge, but some basic mathematical skillsand familiarity with economic principles will be helpful throughout.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008: ‘TheEMS’ and ‘The ECB’). Lawler and Seddighi (2001) (especially part three) dealswith convergence in the EMU. Ritter et al (2003) discusses fixed and floatingexchange rate regimes. Mishkin (2007) ‘The International Financial System’covers much the same ground as well as currency boards and dollarisation. Youwill need a calculator and access to the internet.

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The advantages and disadvantages offixed and floating exchange ratesFrom Unit 7 we know that floating exchange rate regimes give rise to consider -able exchange rate volatility – certainly more than can be explained by anorderly transition from one equilibrium rate to another. Throughout Units 6and 7 we were concerned that these fluctuations expose firms to a higher levelof risk than would otherwise be the case and we explored some possiblehedging techniques. In 7.4 we looked at the argument that exchange ratevolatility might even reduce the amount and growth of international trade,though the evidence on this was not entirely clear. However, there is a generalpresumption in economics that free (international) trade increases economicwelfare and that fluctuating exchange rates must in some way discourage thistrade. Remember that we identified three ways in which these fluctuations poseproblems:

■ exchange rate fluctuations increase the risk faced by firms and it is alwayscostly and sometimes impossible to hedge these risks

■ small firms and new firms may find these risks especially difficult to copewith

■ governments may respond to fluctuations by competitive devaluations,tariffs and other devices.

In this section, we are going to look at the merits of fixed and floating exchangerates, firstly from a theoretical point of view. We shall then look at our experi -ence of fixed exchange rate regimes with different design features. Interestingly,we shall see that one of the prime motivations behind these regimes has beenthe third bullet point in our list – the desire to prevent governments frompursuing the ‘beggar-my-neighbour’ opportunities presented by floating rates.

The theoretical considerationsWhen it comes to the merits of fixed and floating exchange rate regimes, thereare essentially two theoretical issues.

The first is the one that we have been concerned with since Unit 6, namely thatfluctuating exchange rates introduce additional uncertainty and risk for firmswhich engage in international trade (and also for international investors). Thismust have some negative effect on investment and trade even if it is difficult topin down the evidence unambiguously. And since we regard the free movementof goods, services, labour and capital as a good thing, this uncertainty reducesworld income and welfare. Since this has been a major theme already in ourdiscussions we shall not say much more about it here.

The other issue that arises in these debates is the autonomy of monetary policy.For reasons that we shall look at in a moment, a country which opts for a fixedexchange rate regime, surrenders the ability to conduct an independentmonetary policy. (You may recognise this as a frequent issue in the debate overthe UK joining the European Monetary Union (EMU)). On the face of it, thisis a high price to pay for exchange rate stability, but in 8.4 we shall see thatthere may be circumstances in which the sacrifice brings additional benefits.

To understand this second issue we need some diagrams. Figure 8.1 shows theforeign exchange market under a fixed exchange rate regime.

8.1

Recommended reading: Mishkin (2007) ‘The International

Financial System’; Ritter and Silber(2003) Part Three.

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Figure 8.1: Official intervention when the currency is overvalued

In Figure 8.1, the exchange rate is expressed as the amount of the domesticcurrency required to purchase a unit of foreign currency. This means that a risein the value of E in the figure indicates a depreciation in the value of thedomestic currency. Since we are looking at a fixed exchange rate regime, thevalue of the domestic currency is going to be tied or fixed to that of the foreigncurrency. For this reason, we shall describe the foreign currency as the anchorcurrency. (When we discuss regimes in practice, we shall see that the anchorcurrency has often been the US dollar.) The supply curve, S, shows the supplyof the foreign or anchor currency while the demand is shown by the demandcurve D. The supply of foreign currency will depend upon the demand for thecountry’s exports together with the demand for the country’s financial assets.The demand for foreign currency will come from importers wishing to buygoods from overseas together with domestic investors wishing to purchaseforeign currency for investment in overseas assets. The initial equilibrium isshown at E and this corresponds to the ‘par’ or target value of the domesticcurrency in this system.

We now introduce some disturbances. Imagine, for example, that there is a fallin the country’s net exports, other things unchanged. This means an increase inimports relative to exports and this will result in an increase in the demand forforeign currency by domestic importers and a fall in the supply of foreigncurrency coming from overseas buyers of domestic goods. In the diagram, thedemand curve shifts to the right, to D’, and the supply curve to the left, to S’.In a free market, the exchange rate would rise from E to E’. (Remember thatthis means a depreciation in the value of the domestic currency.) At its par ratethe currency is overvalued.

But since this is a fixed exchange rate regime, the depreciation is not allowed.The Government (usually in the form of the central bank) is obliged to interveneto preserve the par value. This means that the central bank has to sell foreigncurrency reserves in order to buy the domestic currency. In effect, the centralbank has to return the supply and demand curves to their original positions.

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How does this relate to monetary policy? Note firstly that selling foreignexchange reserves and buying the domestic currency amounts to reducing thedomestic money supply. So, if we think of monetary policy in terms of policychanges in the stock of money, then the money supply and monetary policy arebeing determined by the need to maintain the fixed exchange rate. Alternatively,the central bank might use the domestic interest rate in order to persuadeprivate sector agents to change their behaviour. A rise in the domestic rate,relative to rates overseas. makes domestic assets more attractive to investorswho will then buy the domestic currency in order to invest in those assets. Thisincreases the supply of foreign currency. At the same time, domestic investorswill be less enthusiastic about investing overseas and so their requirements forforeign currency will fall. Once again, the central bank is trying to push thesupply and demand curves back to their original position. But if it does this,then the rate of interest is being determined by the need to maintain the fixedexchange rate and so once again monetary policy is no longer available formacroeconomic stabilisation. We shall see later that this was an issue for the UKeconomy when it was a member of the European exchange rate mechanism in1992.

Figure 8.2 shows the opposite case. We begin as before with the exchange rateat its target value, E. But this time we introduce a different disturbance. Supposethat the foreign country (the source of the anchor currency) reduces its interestrate. This makes domestic financial assets more attractive (other thingsunchanged) than assets in the anchor country. There will be an increase in thedemand for domestic and a reduction in demand for foreign assets. Conse -quently, the demand for the anchor currency will fall while its supply willincrease as a result of foreign investors offering it in exchange for the domesticcurrency. This time, the supply curve shifts to the right (from S to S’) and thedemand curve shifts to the left (D to D’). In Figure 8.2, the exchange rate triesto move down from E to E’, indicating an appreciation of the domesticcurrency. At its par rate the currency is undervalued.

Figure 8.2: Official intervention when the currency is undervalued

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But once again, this is not allowed under the rules. The central bank must nowbuy foreign currency, which increases the domestic money supply, or cut interestrates in order to make its domestic assets less attractive. Once again, monetarypolicy is being determined by the exchange rate, rather than being free torespond to the other needs of the economy.

Notice that there is a critical sense in which these operations are asymmetric.Maintaining the value of a weak currency is not exactly the opposite of tryingto weaken a strong one. This is because, for a central bank, the supply ofreserves is finite, while the supply of domestic currency is not. A central bankthat is conducting a ‘support’ operation by selling foreign currency knows thatit can only do this for so long, before it runs out of foreign exchange reserves.By contrast, a central bank that is buying foreign currency can always createdomestic currency with which to make the purchase. This can be a majorproblem for a central bank supporting a weak currency, if central banks withstrong currencies decline to see them weaken. Furthermore, speculators areaware of this asymmetry and can therefore ‘bet’ on the likelihood that acurrency will have to be devalued or leave the fixed exchange rate regimealtogether. We shall see examples of this also in the following sections.

Why does a fixed exchange rate regime mean that a country must give upan independent monetary policy?

This arises because monetary policy must be focused on maintaining thefixed exchange rate. For example, if the currency begins to depreciate(suggesting that it is overvalued at its par rate) then the central bank musteither use its holdings of foreign currency reserves to buy the domesticcurrency to maintain the par rate or it must raise interest rates in order toencourage foreign investors to buy the domestic currency. Both of theseactions constitute a ‘tightening’ of monetary policy and will reduce the levelof demand in the domestic economy. Notice this means that if a fixedexchange rate regime includes a ‘dominant’ currency then events in thatdominant economy will spillover into the smaller economies. For example,for minor currencies pegged to the US dollar, a rise in US interest ratesmeans that the minor economies will also have to put up interest rates.

Fixed exchange rates in practiceThe gold standardThe earliest fixed exchange rate regimes were those where the unit of accountwas a fixed weight of gold. The earliest versions of these ‘gold standards’ areknown as ‘gold specie standards’ and involved the use of gold itself as the meansof payment in the form of gold coins. Variations on the gold specie standardwere the later ‘gold exchange standard’ and the even more recent ‘gold bullionstandard’. The central feature of all these from our point of view is that thevalue of the domestic currency was fixed in terms of a quantity of gold and,clearly, if the value of several currencies was fixed in relation to a commonstandard, then their values must were fixed in relation to each other.

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By 1900, most of the world’s significant trading nations had adopted someform of gold standard and so their currencies were fixed to each other by virtueof being convertible into gold which could then be exchanged for any othercurrency. The emergency conditions of the First World War saw a number ofcountries suspend convertibility but reinstate it during the 1920s. The end camein 1931 when a major international financial crisis led to a collapse ofconfidence in several major currencies (including the pound sterling). Sincecentral banks could not meet the demand for gold at the established exchangerates, convertibility was widely suspended but this time never reinstated.

Nonetheless, the gold standard was widely credited with having encouraged amassive increase in world trade between 1870 and 1930, which had facilitatedthe economic development of most of Europe, and North America. (The use ofthe term ‘suspension’ in 1931 indicates that many countries hoped it could berevived.) And the arguments in its favour were exactly those that we associatewith fixed exchange rate regimes today – it eliminates the uncertainty thatoccurs when exchange rates fluctuate. But it also carried with it the disadvan -tage that we have just explored, namely, that a country on the gold standardloses control over its domestic monetary policy. This was because a tradeimbalance between two countries would result in a corresponding imbalance inthe demands for the respective currencies and since the currencies wereconvertible into gold, the deficit country would have to make net transfers ofgold to the surplus country. This would then force corresponding reductions/increases in their respective money supplies. Central banks could try to reducegold inflow/outflows through the use of interest rates, but this simply producedthe monetary policy problem in another form.

In fact, there was an additional problem with the gold standard, namely thatworld monetary policy was greatly influenced by the discovery and productionof gold and its use for non-monetary purposes. If the world gold supply didnot expand as rapidly as world trade, then the result was bound to bedeflationary.

1. In 1925 the gold price of a US dollar was 0.0513 ounces while the goldprice of the pound sterling was 0.25 ounces. What was the US dollar:pound exchange rate?

2. What are the drawbacks of linking the value of a currency to gold?

1. $4.87:£1 (= 0.25 ÷ 0.0513)

2. Firstly, gold has other uses: in medicine, industry and fashion. Hencethere is a resource cost involved in having large quantities of gold instorage as a monetary reserve. Secondly, the supply of gold for monetarypurposes will depend on the rate of discovery and extraction of gold andalso on the alternative demands for it. If the stock of gold expands moreslowly than the growth in world trade, for example, there can be ashortage of international liquidity which has a deflationary effect.

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Following the collapse of the gold standard in 1931, and in the midst of thegreat depression, governments embarked on a series of ‘beggar thy neighbour’policies by, for example, using currency devaluations to increase the com -petitive ness of their country’s export products to reduce balance of paymentsdeficits. This merely passed the problem of falling economic activity tocompetitor countries, worsening national deflationary spirals, which resulted inplummeting national incomes, shrinking demand, mass unemployment, and anoverall decline in world trade. Trade in the 1930s became largely restricted tocurrency blocs (groups of nations that use an equivalent currency, such as the‘Sterling Area’ of the British Empire). It was against this background and adetermination not to repeat these mistakes, that delegates from all 44 alliedcountries met at Bretton Woods, New Hampshire, in 1944, to establish aninternational system of monetary management.

Bretton WoodsAlthough there were differences of emphasis, there was widespread agreementamongst the planners at Bretton Woods that the post-war economic ordershould be based upon free markets, albeit with some degree of regulation. Theacceptance of some need for government intervention had been strengthened bythe experience of the great depression in the 1930s. Public management of theeconomy had emerged as a primary activity of governments in the developedstates. Employment, stability, and growth were now important subjects ofpublic policy. In turn, the role of government in the national economy hadbecome associated with the assumption by the state of the responsibility forassuring of its citizens a degree of economic well-being. In addition the USrepresentatives were inclined to the view that both world wars had their originsin economic grievances and so the design of a satisfactory internationalfinancial system had security as well as economic implications.

The Bretton Woods system comprised four elements. The first was a com -mitment to fixed exchange rates in order to get most of the advantages of thegold standard but also, it was hoped, without some of the drawbacks. Whatemerged was an ‘adjustable peg’ system. Exchange rates would normally befixed in relation to the US dollar (subject to a margin of fluctuation of +/– oneper cent), but there was provision for upward (revaluation) and downward(devaluation) adjustments when it became clear that a country’s exchange ratewas fundamentally incorrect. Member central banks were to be responsible formaintaining parity by the kind of interventions that we discussed in 8.1 usingholdings of US dollars as the reserve (or anchor) currency. In turn, the USagreed separately to link the dollar to gold at the rate of $35 per ounce of gold.At this rate, foreign governments and central banks were able to exchangedollars for gold. In effect, therefore, Bretton Woods established a system ofpayments based on the dollar, in which all currencies were defined in relationto the dollar, itself convertible into gold, and above all, ‘as good as gold’. TheUS currency was now effectively the world currency, the standard to whichevery other currency was pegged. As the world’s key currency, most inter -national transactions were denominated in US dollars.

In addition to the adjustable peg exchange rate mechanism, the Bretton Woodssystem introduced three important institutions. The first of these was theInternational Monetary Fund (IMF) whose role was twofold. The first was tooversee adjustments to the par value of exchange rates in the event of

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fundamental disequilibrium. In effect, it was the IMF’s job to decide when anexchange rate was unsustainable and to negotiate a new par value.

Its other role was to provide assistance to countries experiencing short-termbalance of payments difficulties by providing loans of foreign currency todebtor countries. The source of these loans lay in ‘quotas’ of gold and theirown currencies that member countries were required to paid into the IMF as acondition of membership of the system. On this and a related issue, there wasa disagreement between the UK and the USA. For the UK, Keynes had originallyargued for the creation of an international reserve currency (‘bancor’) to be putat the IMF’s disposal (rather than the mix of gold and individual currencies).He also argued for a mechanism that would ensure that balance of paymentsadjustment would involve both deficit and surplus countries. (This was thepoint we encountered in section 8.1.) In both cases Keynes lost the argumentand the detailed arrangements were those favoured by the US negotiators,though there was much agreement on other issues. The fact that adjustmentwas to fall entirely on the deficit country did quite a lot to tarnish the IMF’sreputation in future years. This arose because it was accepted that, as theprovider of loans to deficit countries, the IMF should impose terms andconditions on the future economic conduct of the borrower. Given that theborrower had to make all the adjustments, these terms could sometimes bequite onerous and the IMF acquired a reputation for imposing harsh anduncaring conditions on what were often rather poor countries.

Another problem that the IMF inherited was the failure to identify clearly whatwas meant by ‘fundamental’ balance of payments disequilibrium. Given thatrevaluation/devaluation could only take place in such cases, and also that somegovernments came to see the maintenance of their currency’s par value as sometest of economic virility, the result was that many countries laboured underrepressive economic policies designed to prop up their exchange rate, when itwould have been in everyone’s interest to devalue.

The two other creations of the Bretton Woods system were the World Bank(intended to grant loans for economic development projects) and the GeneralAgreement on Tariffs and Trade (GATT), later to become the World TradeOrganisation whose purpose was to promote the liberalisation of world trade.

The fixed (more strictly adjustable peg) element of the Bretton Woods systemcame to an end in 1971 after more than 25 years which had seen the rapideconomic recovery of nations devastated by World War II, as well as the rapidgrowth of world trade. This was also a period in which the USA moved fromrunning balance of payments surpluses to running large and persistent deficits.By 1960, it was commonplace to talk about a ‘dollar glut’. The origin of thesedeficits lay partly with US consumers’ desire to enjoy a high standard of leavingeven it meant borrowing to do it and also with the Cold War and the USGovernment’s need for high military spending overseas. To begin with, thesupply of dollars was helpful to international stability. Recall that BrettonWoods effectively made the US dollar a reserve currency. A ready supply ofdollars was, therefore, essential to ensure adequate growth of world liquidity.But the dollar could also be exchanged for gold (at least by central banks andgovernments) and the rate of exchange had been fixed at $35 per ounce. Asthe stock of dollars grew much more rapidly than the US stock of gold, doubts

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began to surface about the value of the dollar. This gave rise to what becameknown as the Triffin dilemma (or ‘paradox’) after the economist Robert Triffinwho first drew attention to it in 1960. The paradox was that world liquidityrequired a steadily expanding stock of US dollars, but increasing the stock ofdollars increased the likelihood that countries would not wish to hold liquidityin this form. By the end of the 1960s, it was apparent that the dollar wassubstantially overvalued at $35 to an ounce of gold. In fact, some governmentshad begun exchanging dollars for gold at $35 and then selling the gold on theopen market for considerably more.

The formal end of the exchange rate element of the Bretton Woods system isnormally dated at 15 August 1971, the day on which the USA ended itspromise to sell gold at the fixed price of $35. But there had been numerousdevaluation of other currencies in the years leading up to 1971 (including theUK in 1967). Furthermore, some features continued for a short periodafterwards. In December 1971 ten major trading countries met at theSmithsonian Institute in Washington. A general realignment of currencies wasagreed, a wider 4½ per cent band was introduced and the gold price rising to$38. But these arrange ments lasted little more than a year. The pound floatedin 1972, in February 1973 the dollar was devalued again, by the middle of theyear most major currencies were floating and the US abandoned a fixed goldprice in November.

A Bretton Woods II?The immediate effect of the ending of the Bretton Woods was the emergence ofa more free market, less-managed, international financial system. This includedfloating exchange rates (as we have seen) and also the dismantling of capitalcontrols. Later, in the 1980s and 1990s this was accompanied by marketliberalisation in a number of major developing countries, notably China startingin 1978 and India in 1991. The result in the last twenty years has been rapidgrowth, particularly in SE Asian economies, and rather slower growth in theWest.

Along with this has emerged an informal currency arrangement whereby anumber of SE Asian economies, with large current account surpluses and highsaving rates, have been exporting and lending to western states (especially theUS) with low savings rates and large current account deficits. Lending to the USmeans, of course, buying dollar-denominated assets. Because the SE Asianeconomies have simultaneously, and of their own volition, pegged theircurrencies informally to the US dollar, there are obvious similarities to thesituation that existed under the original Bretton Woods system during the1960s. In 2003, three economists, Dooley, Folkerts-Landau and Garber,referred to this as a ‘Revived Bretton Woods’ system and followed it up withseveral more published and conference papers. More contentiously, the originalpaper went on to argue that this was a natural and sustainable state of affairs:

‘We argue that the normal evolution of the international monetary systeminvolves the emergence of a periphery for which the development strategyis export-led growth supported by undervalued exchange rates, capitalcontrols and official capital outflows in the form of accumulation ofreserve asset claims on the center country. The success of this strategy infostering economic growth allows the periphery to graduate to the center.

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Financial liberalization, in turn, requires floating exchange rates amongthe center countries. But there is a line of countries waiting to follow theEurope of the 1950s/60s and Asia today sufficient to keep the systemintact for the foreseeable future.’

(Dooley et al, 2003)

Their argument is clear enough. The international financial system is dividedinto two parts: the centre (roughly the USA) and a periphery (China and otherless developed economies in SE Asia). The periphery is anxious to grow rapidlyand seeks to do this by keeping its exchange rates artificially low against thecurrencies of the centre, principally the US dollar. In doing this the peripheryaccumulates claims against (that is lends to) the centre. This is the role that wasfulfilled by Europe and Japan under the original Bretton Woods system. Rapidgrowth will eventually allow the periphery to graduate to the centre (just asEurope did). And there is a line of countries waiting to follow in the footstepsof Europe (in the 1960s) and Asia today. The parallels with the original BrettonWoods system are close enough to encourage some commentators to describethis arrangement as Bretton Woods II. But we need to be careful here. Thecurrent structure of the international financial system even now is a matter forgreat concern and some controversy. There are many proposals for change andeven requests for proposals (see for example Chowla and Griffiths, 2009).These are sometimes expressed as ‘the need for a Bretton Woods II’ (which wehope to build in the future). See for example the calls by Sarkozy and Brown(2009).

But the argument that the existing informal arrangements themselves constitutea Bretton Woods II has caused considerable controversy, mainly because of theassumptions that underlie the final sentence in the quotation. The weakness ofthe argument is that other countries may not want to take up this role in futureand, worse than that, there is no guarantee that Asian countries will want to doso for much longer. In fact, the danger goes wider than simply a change ofattitude on the part of the periphery countries in this arrangement. The centralissue is the stability of the US dollar. This would be threatened by futurereluctance of any major investors to hold US dollars. Suppose, for a moment,that the enthusiasm for financing the US deficit dries up, whether it is becauseof a change of heart of Asian countries or countries in Europe. What would bethe consequences?

The easiest to predict would be a steep rise in US interest rates as Asia dumpsUS bonds and their price collapses. (Recall the inverse price-yield relationshipwe explored in Unit 3.) The fall in prices might well bankrupt Asian banks andcause a major financial crisis. Remember too that a sale of (or unwillingnesstold) US assets will mean a fall in the value of the US dollar against othercurrencies. Anyone holding assets denominated in US dollars will find the valueof their investments falling. This will include not just Asian banks but westernbanks too, who bought US bonds and other assets in the past. This exposesthose banks to the translation risk that we discussed in Unit 7. In the extremecase, these banks will find their liabilities (not denominated in US dollars)exceed their assets and will be insolvent. The fall in US bond prices is almostcertain to cause a sell-off of other US assets – houses and equities are theobvious examples and we would have financial crisis in the West which wouldnot be so very different from the one we experienced in 2008, with similar

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consequences for the US real economy. Once the US economy slows down, thiswill destroy the growth on which the Asian countries have been depending. Amajor world recession then looks quite likely.

The question then is how likely are investors to change their minds? It isdifficult to tell – and if we knew (or had strong reason to believe) that the USdollar was becoming unattractive, then the efficient market hypothesis tells usthat everyone would then try to sell dollars simultaneously and its value wouldcollapse. There is no reason to suppose it would be gradual or orderly. Arethere any pointers? There is certainly a lot of anxiety, though most of this hasfocused upon the Asian countries that make up the periphery in ‘Bretton WoodsII’. For example, Roubine and Setser (2005) were too pessimistic in their timingbut their paper highlights the dangers. Collectively, they amount to saying thatthe system is unsustainable and must change sometime:

■ There is a tension between the US need to borrow to finance its deficits andthe loss that lenders are bound to suffer if or when the US takes steps toeliminate those deficits:

■ The present arrangement threatens internal political stability. The cheapfinancing of the US deficit enables US consumers with jobs to enjoy cheapgoods but puts US workers of internationally traded goods out of work.

■ In order to buy the US debt and to stop the yuan from rising, the Chinesecentral bank is creating large amounts of. yuan. (Recall the discussionaround Figure 8.2 above.) This rapid increase in the Chinese money supplywill be inflationary at some point in the future.

■ The yuan will have to be revalued at some point. When this happens, therewill be corresponding losses on China’s holdings of dollars. The losses onexisting dollars will be very large (estimated at ten per cent of GDP in 2005and getting larger with everyday that passes).

Given our earlier discussion of the Bretton Woods (I) institutions, we mightalso note Eichengreen’s (2004) argument that this whole structure is voluntary.There are no bodies like the IMF available to discourage an Asian central bankfrom simply walking away.

Notice that all of these problems are potential threats to the world economybecause the current value of the US dollar rests on foundations that critics likeRoubine and Setser argue are very weak. There is one other feature of thecurrent arrangements that one might argue has already been a problem andplayed some part in the build-up to the financial crisis of 2008. This is the effectof the Asian demand for dollar assets on the shape of the yield curve. In Unit3 (3.4) we explained that the yield curve normally slopes upward meaning thatit is more expensive to borrow by issuing long-dated bonds than it is to borrowusing short-dated instruments. Ultimately, we said, the shape of this curvedepends upon the demand for bonds with different periods to maturity and,therefore, depending on this demand, the shape of the curve could change. Thestrong demand for US bonds and other long-dated assets had the effect in2006–7 of flattening the yield curve – meaning that the premium required onlong-term borrowing was reduced. Bear in mind that the 2008 crisis was causedby excessive and unwise lending by banks (and borrowing by households andfirms). The circumstances that encouraged this are quite complex but acontributory factor was the willingness of China and other Asian countries to

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fund the US deficit. Without that, long-term interest rates would most likelyhave been much higher.

1. In what sense could the US dollar be described as ‘weak’ under the so-called Bretton Woods II arrangements?

2. List five ways in which a fall in value of the US dollar could causedifficulties for the international financial system.

1. The ‘weakness’ of the US dollar that has troubled commentators since2000, is not a reference to its actual exchange rate. It is more the beliefthat the value of the US dollar was unsustainable – in a sense that it wasovervalued by the willingness of China and other Asian currencies to holdUS dollars in large quantities, partly to keep their own exchange rates low.

2. If China and other Asian countries changed their policy and the USdollar fell sharply in value the consequences would very likely include:(a) a fall in the value of US bonds(b) a fall in the value of US dollar-denominated assets on bank balance

sheets(c) a rise in US interest rates which is likely to cause other rates to rise in

line(d) a slow down in the US economy(e) a fall in demand for exports from less developed economies.

The theory of currency unionA currency union is a situation in which a number of countries share a commoncurrency. In the context of our present discussion, therefore, it is one particularway of operating a fixed exchange rate regime. Hence the arguments for andagainst a currency union are much the same as those underlying the debatesabout fixed and floating exchange rates. The term ‘currency union’ is oftenused interchangeably with ‘monetary union’ though this is not strictly accurate.A monetary union usually involves rather more. In particular it involves botha common currency but also a single market. The obvious example (which weturn to in the next section) is the European Monetary Union which is normallyregarded as having been established in January 1999.

As we have just said the merits (and drawbacks) of currency union are veryclose to those of any other form of fixed exchange rate regime. Since we havealready visited these, we list them only briefly here. The main advantage is:

■ lower exchange rate volatility, uncertainty and risk (and therefore higherlevels of international trade.

However, a currency union will have the additional advantages of:

■ lower transaction costs for firms trading across national boundaries sinceall transactions occur in a single currency

■ greater price transparency, and more competition, since prices are expressedin the common currency.

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If we then add the condition for monetary union of no trade barriers, then thereshould also be an advantage from:

■ a better functioning internal market (including economies of scale).

Against these benefits, we know that the main cost of any system of fixedexchange rates is:

■ the loss of an economic policy instrument (that is monetary policy).

In a situation where an economy experiences some form of economic shock, notexperienced by other participants in the system, it will not be able to adjust tothis shock by a change in the exchange rate.

Just how important this loss is, depends upon the nature of the shock and theflexibility within an economy to adjust without a change in the exchange rate.During the planning for European Monetary Union (EMU) this became a majorissue as part of a debate over whether the proposed members of EMUconstituted an optimum currency area (OCA).

There is a substantial literature on the criteria that need to be met by an OCA.The starting point of the debate was a paper by Robert Mundell (1961) inwhich he set out the criteria for an OCA that were quite demanding and in theabsence of which flexible exchange rates would be preferable. Since the EUcountries certainly did not meet the OCA criteria, even by the 1990s, Mundell’searly work was hardly supportive of EMU. The problem is this:

‘Consider a simple model of two entities (regions or countries), initiallyin full employment and balance of payments equilibrium, and see whathappens when the equilibrium is disturbed by a shift in demand from thegoods in entity B to the goods in entity A. Assume that money wages andprices cannot be reduced in the short run without causing unemployment,and that monetary authorities act to prevent inflation…

The existence of more than one (optimum) currency area in the worldimplies variable exchange rates… If demand shifts from the products ofcountry B to the products of Country A, a depreciation by country B oran appreciation by country A would correct the external imbalance andalso relieve unemployment in country B and restrain inflation in countryA. This is the most favorable case for flexible exchange rates based onnational currencies.’

(Mundell, 1961)

From this, we draw the conclusion that one requirement of an OCA is thatthere should be a high degree of wage and price flexibility amongst its members.But typically, as we know, this is not the case. Of course, if the unemployedworkers in country B migrated to the expanding industries of country A thiswould be another solution to the problem. So another desirable characteristicis a high degree of factor mobility. This might be available in some cases. Forexample, in the USA workers and their families do migrate across stateboundaries in pursuit of better wages and living standards. But the USA doesnot only have a single currency it also has (largely) a single language andculture. This is not a situation that applied to the EU in the build up to EMU.Ideally, OCAs also need some means of making internal transfers of income toareas/regions adversely affected by shocks. For the single nation state this can

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be achieved by a combination of taxation and regional policy (though richregions are generally reluctant to help the poor). But the European Union hadno such mechanism, and one of the features of EMU was a ‘Growth andStability Pact’ and a ‘no bail out’ clause which made it virtually impossible totransfer income from one country to another.

The consequence of Mundell’s early work (and that of others that followed)was a general consensus that nation states alone were natural candidates forOCAs. Since single currencies already prevailed within nation states, Mundellwas sometimes accused of stating the obvious. Hence, attempts to create OCAsacross natural boundaries would always involve some cost in the surrender ofthe exchange rate policy instrument.

Subsequently, Mundell (1973) changed his view of the possible merits of EMUon the grounds that a large currency area made it easier for individualcountries/regions to withstand supply shocks. The argument was essentiallyabout risk. Starting from the view that investors overwhelmingly hold assetsdenominated in the domestic currency (in other words, there was little inter -national portfolio diversification) then a supply shock to the domestic economy,in which numerous firms failed, could result in significant default on domesticfinancial assets. In a currency union, however investors would hold claims onfirms in a number of countries/regions with the result that defaults in one regionwould have much smaller effects. Essentially, the fact that investors hold claimsacross national borders means that ‘prosperous’ regions help to absorb the shockto poor regions. Not everyone was convinced by this argument but it doesexplain why Mundell eventually found himself supporting the EMU experiment.

How does a currency union differ from a monetary union?

Both involve fixing the rate of exchange between nation states by adoptinga single, common, currency. However, a monetary union is usuallyunderstood to include additional features like a single market. This involvesthe removal of any trade and capital restrictions between the memberstates, while a currency union can exist even with these restrictions. Amonetary union may also include some degree of political integrationbetween the member states.

European Monetary Union (EMU)Given this rather gloomy consensus, one might ask how EMU ever got off theground. But before we consider this, we need a little history since this providespart of the answer.

As we have already seen, the EMU is much more than an OCA. It is linked tothe development of a single market (if slightly incomplete) and, in the opinionof some critics, to the development of more centralised European politicalinstitutions.

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The idea of a monetary union was first floated in 1970 by the WernerCommittee which optimistically called for completion of the project by 1980.However, little progress was made in the 1970s which were dominated by thebreak up of Bretton Woods and then by various schemes, including the ‘snakein the tunnel’ aimed at restraining the degree of exchange rate fluctuationsbetween members of the European Union and between the EU and the USdollar (Gros and Thygesen, 1998). The Single European Act (1986) and thecommitment to complete the single internal market by 1992, gave the issue newimpetus and in June 1988 the European Council established a committee tomake concrete proposals. The Delors Report (1989) proposed a three stageprogress towards EMU. The proposals, with minor modifications, wereincorporated in the Maastricht Treaty (1992) which set out a timetable as wellas a description of the key institutions. The Treaty identified three stages:

■ Stage 1, beginning 1 January 1993. This established a Monetary Committeeto monitor the conduct of monetary policy in member states that had joinedthe exchange rate mechanism (ERM, of which more in a moment) and tooversee the dismantling of capital controls in member states.

■ Stage 2, beginning 1 January 1994. This established the European MonetaryInstitute to work out the details of the introduction of the single currencyand the role of national central banks within the monetary union.

■ Stage 3, beginning 1 January 1999. This established the European MonetaryInstitute as the European Central Bank which would fix the exchange ratebetween national currencies and the euro, introduce the euro for thedenomination of bank deposits and take over the official reserves of membercentral banks.

Stage 3 itself was later divided into three phases which finally saw eurobanknotes and coin introduced in January 2002.

In the meantime, in March 1979, the ‘snake’ was replaced by the EuropeanMonetary System (EMS) and a system for linking the exchange rates ofcountries that wished to participate, known as the Exchange Rate Mechanism(ERM). After a difficult start, this functioned reasonably well until 1990 whenthe Bundesbank began to raise interest rates in response to inflationarypressures caused by the unification of Germany. Consequently, other ERMmembers, some in very different situations, had to raise rates too and thisprovoked speculation that some governments would be forced to devalue ratherthan impose high interest rates on economies facing recession. After raisinginterest rates from 10 to 15 per cent in a single day the UK governmentwithdrew sterling from the ERM in September 1992. This incident providesthe perfect example of the problem we discussed at the end of the ‘Thetheoretical considerations’ in section 8.1. Two year membership of the ERMlater became one of the eligibility criteria for countries wishing to join EMU.We return now to the question of why, if the EU met so few of the requirementsof an OCA, it managed to introduce a monetary union.

Part of the explanation is that the merits of EMU were never judges on solelyeconomic criteria. As we noted above, EMU was essential for the developmentof the single market and the single market for many of its supporters was partof the political integration of Europe and was linked in turn to questions ofpeace and security.

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On the economic front, however, there were two arguments in favour of union.The first doubted just how serious a loss of policy instrument was involvedwhen exchange rates could not be adjusted. Let us return to the Mundellexample and assume that the shift in demand is a reduction in demand forFrench goods and an increase in the demand for German ones. With little priceflexibility and no exchange rate to devalue, France will face risingunemployment and falling output. A devaluation, making French goodscheaper and German ones more expensive, might help. But the effect of this isto make German goods dearer in France – it involves a fall in French real wages.Suppose that labour is not prepared to accept this. Trade unions demand highermoney wages to compensate and the advantage of devaluation if quickly lost.Clearly the benefits of this policy instrument depend upon how open economiesare and on their institutional arrangements for price and wage setting –including indexation, explicit or covert. How much stabilisation capacity theeurozone countries have sacrificed is uncertain (Eichengreen, 1994).

Why might exchange rate flexibility be of limited value as an instrument ofeconomic policy?

The main issue is that the initial effects may be small and/or will be short-lived. Take the case of a country that devalues in order to lower the foreignprice of its exports. This simultaneously involves a reduction in real incomefor its inhabitants. They are likely to resist this by demanding higher moneywages. How successful they will be depends upon political and institutionalconsiderations in the devaluing country. If money incomes are automatically‘indexed’ to the price level, there will be no effect. In less extreme caseswhere there is no indexation but trades unions are strong and there is awidespread consensus in society that real incomes should not fall, then theeffects will be temporary.

The second argument concerned the probability of asymmetric shocks. Ageneral shock, such as an oil price rise/fall affects all countries to some degreeand is a lesser problem. Furthermore, what matters for EMU is the likelyfrequency and scale of asymmetric shocks after the creation of the union andthis could easily be affected by the union itself. This would be the case if theunion had some effect upon the similarities (or ‘convergence’) between themember countries since countries with similar economic structures, policies andstructures are less likely to be affected differentially by any shock than countriesthat are radically different. This explains the emphasis on ‘convergence’ as acondition of EMU membership. We have already noted the requirement forsome degree of exchange rate convergence (membership of the ERM for twoyears with no devaluations.

Other convergence requirements include:

■ Price stability. An applicant’s rate of inflation must not exceed the averageof the three best member countries by more than 1.5 per cent.

■ Public sector finances. An applicant’s budget deficit must be no more thanthree per cent of its GDP and the ratio of its debt to GDP should not exceed60 per cent of GDP.

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■ Interest rates. An applicant’s long-term interest rate must not exceed theaverage long-term rate of the three lowest-inflation member countries bymore than two per cent.

Notice that these are requirements for ‘nominal’ convergence. Reducing therisks of symmetric shocks requires what is called ‘real’ convergence, that is tosay a degree of similarity in labour productivity, living standards, unemploy -ment rates and economic structure. It is only with real convergence that shocksare likely to affect a group of countries or regions in a similar way. Althoughthere no real convergence for membership of EMU, there are numerous featuresand rules of EM membership that are intended to encourage such convergence.The free movement of labour, and uniformity of employment regulation is oneof these, as are rules about access to training and higher education. It is alsopossible that the nominal convergence encourages real convergence to somedegree. Katsoulie (2001) shows how the price stability criterion may affect theconvergence of unemployment rates.

Other currency arrangementsSo far, we have presented the loss of the variable exchange rate as a policyinstrument as a ‘cost’, a price that has to be paid for exchange rate stability,though we have also suggested that the cost might sometimes be small. How -ever, there are circumstances where removing the freedom to adjust exchangerates might have positive benefits. This is most likely to arise where a countryhas rather weak policy and monetary institutions and where its commitment toprice stability is in doubt. Situations like this are more common amongdeveloping and emerging market economies. In these cases, it may be better tolimit the amount of discretion that can be exercised over monetary policy. Thepaper by Gudmunsson (2008) explains some of the principles that lie behind thechoice of an appropriate exchange rate regime and provides a detailed surveyof the choice of regimes by countries in Africa. Here we look briefly at threeregimes that have been adopted by governments trying to strengthen their anti-inflation credentials.

The first of these is exchange rate targeting. This involves fixing the value of adomestic currency in relation to some other (anchor) currency. This is usuallychosen because it has a history of low inflation. Once again, it is the US dollarthat is usually chosen, though the UK adopted a policy of exchange ratetargeting using the Deutschemark, informally from 1986 to 1989 and thenexplicitly as part of the ERM from 1989 to 1992 and France did the same from1989.

The advantage of exchange rate targeting is that it forces the targetingpolicymaker to follow the monetary policy adopted in the anchor country. If itdoes not, the exchange rate will appreciate or (more likely) depreciate which isnot allowed. Furthermore, if the exchange rate target is credible, then this mayencourage price setters in the targeting country to expect low inflation. Thelower are agents’ inflation expectations, the easier it is for a central bank toachieve low inflation, especially if it is trying to lower the rate first.

Another advantage of exchange rate targeting is that it makes the objectives ofpolicy easy to understand. Everyone knows what is meant by a ‘sound currency’

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(and most would regard it as desirable). This also helps to make low inflationmore credible, especially in a country where inflation has been the norm.

A disadvantage of exchange rate targeting, however, is that it causes shocks tothe anchor country to be automatically transmitted to the targeting country.We have already mentioned the strains caused to ERM by German unificationin 1990. This gave rise to inflationary pressure in Germany, which respondedby raising interest rates. Interest rates in the targeting countries had to rise instep, with the result that France was forced into recession while the UKabandoned the target in 1992. In the UK case, speculators were facing a virtualone-way bet. Once doubts emerged about the government’s willingness to raiseinterest rates, speculators sold sterling requiring yet a further rise in interestrates. With enough selling, sterling was bound to be devalued.

An alternative to exchange rate targeting is the currency board. This requiresthe domestic currency to be backed 100 per cent by a strong foreign currency.The domestic note issuing authority then establishes a fixed exchange ratebetween the domestic and foreign currency and guarantees to exchangedomestic for foreign currency. As fixed exchange rate regimes go, this is ratherstronger than the exchange rate target since there is no scope at all for thedomestic authority to exercise any discretion. (In an exchange rate targetingregime, the authorities can increase the money supply or change interest rates,even if it threatens the target.) In a currency board the monetary authority canonly increase the domestic money supply by taking in foreign currency inexchange.

This reveals one of the disadvantages of the currency board. This is that if thereis a speculative attack against the domestic currency, the domestic currency isexchanged for foreign currency and the money supply contracts. A currencyboard also means that the central bank cannot act as lender of last resort sinceit cannot create liquidity in excess of its holdings of foreign currency. Someother way of preserving banking stability has to be found.

Argentina, Bosnia, Hong Kong and Estonia are amongst the countries that haveoperated currency boards, during the 1990s.

Finally, a currency regime that provides an even stronger commitment to a fixedexchange rate and a monetary policy operated by some external authority iswhat has come to be known as dollarisation. This involves the replacement ofthe domestic currency by some other currency altogether, usually the US dollar.The strength of this commitment over the currency board lies in the possibilitythat the monetary authority in a currency board regime could change the linkbetween the foreign and domestic currency. With dollarisation, that isimpossible. A dollar is a dollar. It also has the advantage that the currencycannot be subject to speculative attack – unless the attack takes place across alldollar countries. The main disadvantage of dollarisation, not experienced withthe other regimes, is the loss of seignorage. Seignorage is the profit that accruesto the note issuing authority (usually the Government) from the differencebetween the face value of the notes and coin and their cost of production. Forsome governments in poor countries, this might be significant.

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Case Study

1. Why might it sometimes be advantageous for governments to give upcontrol over their monetary policy by adopting a fixed exchange rate?

2. What kind of exchange rate regime might be suitable for this purpose?

1. Imagine a country with rapid inflation, weak government and a centralbank with a history of political interference and corruption. Several timesin the past the Government has promised to bring down the rate ofinflation but it has never happened for long and no one any longerbelieves these promises. If the country really does now want lowinflation then the outcome of monetary policy will almost certainly beimproved by handing it over to someone else, especially if the alternativeauthority has a reputation for maintaining price stability.

2. Tying the country’s exchange rate to a ‘strong’ currency would be oneway of removing the discretion of the home authorities to conductinflationary policy. This is because a rate of inflation that exceeds that ofthe anchor currency will cause investors to sell the domestic currencyand hold assets in the anchor currency instead. This will cause thedomestic currency to depreciate unless the central bank buys thedomestic currency and/or raises interest rates.

There are various ways of creating this tie including exchange ratetargeting, a currency board and or even replacing the domestic currencywith the anchor currency.

The costs of monetary unionRead the following and answer the questions below.

‘Was the euro a mistake?’Barry EichengreenVoxEU.org, 20 January 2009

2008 was the year of asymmetric financial shocks for the Eurozone, but2009 will be the year of the symmetric economic shock. All of Europe isslipping simultaneously towards recession and the threat of deflation.Here one of the world’s leading international economists explains that acommon monetary policy response is optimal. Euro interest rates shouldbe cut to zero and quantitative easing undertaken, all complemented byfiscal expansion by Eurozone nations that can afford it. What started asthe euro’s greatest challenge could be its salvation, but only if policymakers act swiftly.

What started as the Subprime Crisis in 2007 and morphed into the GlobalCredit Crisis in 2008 has become the Euro Crisis in 2009. Sober peopleare now contemplating whether a euro area member such as Greecemight default on its debt. In addition to directly damaging bank balancesheets, this would destroy confidence in its banking and financial system.

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Case Study continued

Unable to borrow and facing horrific bank recapitalisation costs, thecountry would have to print money. To do so it would have to abandonthe euro and reinstate its old national currency. As not a few critics – fromWillem Buiter to Wolfgang Munchau to yours truly – have observed, theprevious paragraph is rife with dubious premises and logical non-sequiturs. To start with, that Greece will be allowed to default isquestionable. There is an alternative, namely fiscal retrenchment, wagereductions, and assistance from the EU and the IMF for the cash-strappedgovernment.

To be sure, this alternative will be excruciatingly painful. No one will like itexcept possibly the IMF, which will relish the opportunity of reasserting itsrole as lender to developed countries. There will be demonstrationsagainst the fiscal cuts and wage reductions. Politicians will lose supportand governments will fall. The EU will resist providing financial assistancefor its more troublesome members.

But, ultimately, everyone will swallow hard and proceed, much as the USCongress, having played rejectionist once, swallowed hard and passed the$700 billion bank bailout bill when disaster loomed.

Admittedly, if the current crisis has taught us one thing, it is that weshould not underestimate the ability of politicians to get it wrong. Buteven the most blinkered politicians will see what is at stake here. Investorswould flee en masse from the banks and markets of a country thatcontemplated abandoning the euro (Eichengreen, 2007). No matter howserious the crisis, politicians will realise that attempting to jettison theeuro will only make it worse.

Another lesson of the crisis is that financial shocks can spreadunpredictably. No one knows whether or not a Greek default would causeIrish and Italian bond prices to collapse, precipitating full-fledged debt andbanking crises there. But no one wants to find out. In the end, the EU willovercome its bailout aversion.

Euro adoption is irreversible: Was it a mistake?

The euro area will hang together, in other words, because the decision toenter is essentially irreversible. Getting out is impossible withoutprecipitating the most serious imaginable financial crisis – something thatno government is prepared to risk.

But then was the mistake getting in the first place? Opponents ofmonetary union founded their arguments on asymmetric shocks. Theyargued that adverse shocks affecting some members but not others wereso prevalent that locking them into a single monetary policy was reckless.If those asymmetric shocks hit heavily-indebted countries, then the latterwould also have no capacity to deploy fiscal policy in stabilising ways.Absent coping mechanisms like a system of inter-state transfers, the onlyoption would be a grinding deflation and years of double-digitunemployment. More prudent would have been to allow such countriesto retain the option of pushing down the exchange rate instead ofpushing down wages. Desperately needed improvements in

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Case Study continued

competitiveness would then be more easily engineered. This is the‘daylight-savings-time argument’ for exchange rate flexibility.

Part of what we have seen is clearly an asymmetric financial shock.Countries like Greece with debt and deficit problems have been singledout by investors who are now fleeing everything that emits the slightestwhiff of risk. Similarly, the countries with the biggest housing bubbles,such as Ireland and Spain, are now suffering the most serious slumps astheir bubbles deflate and problems ramify through their financial systems.It is their bond spreads that have shot up. It is there where output hasslumped most sharply and where the need for wage reductions is mostdramatic. The only mystery is why it took investors so long to focus ontheir problems – why were they not singled out six months or a year ago?

Asymmetric financial shock, symmetric economic shock

But the more days pass, the more it becomes evident that the truly bigevent is the negative economic shock affecting the entire euro area.Different euro area members may have felt financial disturbances to adifferent extent, but they are all now experiencing the economicdisturbance in the same way – they are all seeing growth collapse.Germany, which thought itself immune from the economic crisis, is nowseeing its exports slump and unemployment rise. The rise inunemployment may be small so far, but it is the tip of the iceberg. Andthere is no longer any doubt about how much ice lies just below thesurface.

This shock is symmetric – it is affecting all euro area members. In turn thismeans that a common monetary policy response is appropriate. There willnow be mounting pressure for the ECB to cut interest rates to zero, moveto quantitative easing, and allow the euro exchange rate to weaken. (Thislast part of the adjustment is already beginning to happen without theECB having to do anything about it.) Now that recession and deflationloom across the euro area, this is a response on which all members shouldbe able to agree. It can be complemented by fiscal stimulus. If countries ina relatively strong budgetary position, like Germany, are in the bestposition to apply it, all the better; the result will be help from outside fortheir more heavily indebted, cash-strapped neighbours who need it most.

What the ECB should do

Of course, this assumes – to return to an earlier theme – that policymakers do the right thing. The ECB will have to abandon its fixation withinflation, cut rates to zero, and proceed with quantitative easing.Germany will have to abandon its deficit phobia and apply the fiscalstimulus that it and the larger euro area so desperately need. Afterwallowing in denial, both are now moving in the requisite direction. Butthere is no time to waste.

If 2008 was the year of the asymmetric financial shock, then 2009 is theyear of the symmetric economic shock. In the same way that the formershould have been the year of the euro’s greatest jeopardy, the latter canbe the year of its salvation. But for this to be true, policy makers must act.

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1. Why does the author argue that the alternative solution to Greece’sproblems will be ‘excruciatingly painful’?

2. Why should the IMF not mind this painful alternative?

3. Why would investors flee en masse from any country contemplatingleaving the euro?

4. What were the arguments used by opponents against monetary union?

5. What is meant by ‘Absent coping mechanisms like a system of inter-state transfers...’

6. Why have bond spreads shot up in Spain and Ireland?

7. The author says that the euro exchange rate is beginning to weaken‘without the ECB doing anything about it.’ How does that happen?What could the ECB do to encourage a weakening?

1. The issue is that Greece might default on its debt since this has increaseddramatically in relation to its GDP. If this is to be prevented the firstrequirement is to stop and reverse the increase in indebtedness. This willrequire a dramatic cut in government spending and an increase intaxation (’fiscal retrenchment’). Public services (and employment in thepublic sector) will be reduced and this will be very unpopular. Wage cutswill make Greek exports more competitive, improving its net exports andoutput in general. This will also help to improve public finances byincreasing tax revenue and reducing spending on unemploymentbenefits. Loans from other EU countries and/or the IMF will reassureholders of Greek bonds that default is unlikely.

2. This is a reference to the IMF’s reputation for ‘bullying’ countries that arein financial difficulties. This usually takes the form of imposing strictconditions on economic policy before making funds available. Almostinvariably, these involve cuts in public spending and the pain falls onlower income groups. It is difficult to know whether the author reallymeans that the IMF gets pleasure from this or whether the remark ismeant to be a satirical comment.

3. Fear of the unknown is probably enough in itself. We have stressedmany times in earlier units that uncertainty means risk and markets donot like either. A more concrete reason is that once a country leaves theeuro, it is not clear where it can turn for support. The Governmentwould almost certainly default on its debt which would bankrupt Greekbanks as well as causing huge losses to international holders of Greekbanks. The flight from Greece that would follow from even acontemplation of leaving the Eurozone is explained by each investorneeding to get out before the other investors (‘get out while the going isgood’).

4. We are told that ‘Opponents of monetary union founded theirarguments on asymmetric shocks’. These are the standard argumentsagainst fixed exchange rates and currency unions that we have discussedthroughout this unit. As we said in answer to 8.1 Greece faces years ofpainful deflation. The critics argue that without the monetary union,Greece would have been able to devalue and this would have helped

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increase competitiveness without so much downward pressure onwages.

5. ‘Absent’ here means ‘without’ and this is making the point that EMU isa currency union which has no facility for using fiscal policy toredistribute income between countries. In fact, there is a ‘no bail out’clause that prevents member governments from helping those that arein deficit. The author’s argument is that the consequences of forcingGreece out of EMU would spread crisis to other countries very quicklyand are so severe that the EU will be forced to change its mind on bailouts. ‘...a Greek default would cause Irish and Italian bond prices tocollapse, precipitating full-fledged debt and banking crises there. But noone wants to find out. In the end, the EU will overcome its bailoutaversion’.

6. The ‘spreads’ referred to here are the differences between the rate ofinterest on long-term Irish and Spanish bonds and the ECB’s officialinterest rate. Since the spreads in other countries have not jumped, thenit follows that the ‘spread’ between Irish/Spanish bonds and French,German, Austrian and other bonds have also increased. The ‘jump’ isquite simply explained as a reflection of increased risk. The Irish andSpanish debt situations were not much better than the Greek positionand bond rating agencies had downgraded Irish and Spanishgovernment bonds (see Unit 3).

7. This means that the value of the euro has fallen against other currencies,primarily of course, the US dollar. This has occurred because investorsoutside the EMU have become concerned about the security of theirinvestments and have sold EMU assets and withdrawn their funds (in USdollars, sterling, or whatever). The author’s argument is that the ECBshould further encourage this weakening which it could do by reducingits official interest rate. But the tone of the article suggests that hedoubts the ECB will do this quickly enough – before this is a major EMU-wide crisis.

Self-assessment questions1. What is meant by an ‘adjustable peg’ system of exchange rates? What are

its advantages and disadvantages?

2. What is Triffin’s dilemma (or ‘paradox’)?

3. What are the requirements of an optimal currency area?

4. Outline the main features of the original Bretton Woods arrangements.

5. What were the economic reasons for wanting monetary integration inEurope?

6. Why might interest rates differ in different countries, even within amonetary union?

7. What is meant by Bretton Woods II?

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Feedback on self-assessment questions1. An adjustable peg system of exchange rates is one in which exchange rates

are fixed, but can be changed in certain circumstances. Since the main -tenance of fixed exchange rates depends heavily on confidence that theywill stay fixed, while provision has to be made for changes when rates arepermanently out of line, considerable care is required in design ing thecriteria for permitting realignments. If speculators think that rates might bechanged as soon as one country has a problem, then speculators willbuy/sell the currencies and force a realignment. The criteria usually refer to‘fundamental balance of payment disequilibrium’, but this may leave‘fundamental’ undefined. The Bretton Woods regime of ‘fixed’ exchangerates was strictly an adjustable peg regime.

2. This is the problem that, in order to function as a world reserve currency,a currency has to increase with the growth in world trade. But being areserve currency requires that holders have confidence in it and the greaterthe quantity in circulation the less secure that confidence will be.

3. Free movement of labour, goods, services and capital; wage and priceflexibility; a system for fiscal redistribution between regions.

4. The key feature was the adoption of an adjustable peg system in order to‘fix’ the exchange rates of participating countries. Another featureincluded the creation of the IMF to oversee the operation, to provideassistance to countries with temporary balance of payments problems,and to decide on exchange rate realignments. Bretton Woods also estab -lished the World Bank, to provide development loans and the GeneralAgreement to Tariffs and Trade (later the World Trade Organisa tion) topromote free trade.

5. The most obvious argument is that a single currency is required to createa genuine single market.

There are two reasons for this:(a) as long as devaluation remains a possibility, countries are able to

protect inefficient industries by devaluing; indeed, if all other formsof protection were ruled out by the Single Market Act, there mightbe an incentive for members to engage in competitive devaluationsin an attempt to export unemployment to their partners

(b) price transparency – consumers are much more easily able tocompare prices across the single market and, thus, to choose theproducts of the most efficient firms, if there is a single currencyacross the whole market.

There are a number of other possible subsidiary arguments. These include:(a) removal of the costs required to convert from one currency to

another(b) removal of an important element of uncertainty facing firms, pos -

sibly encouraging firms to increase investment in the EU(c) a reduction of the costs of protection against exchange rate risk.

6. The interest rate decisions of the ECB strongly influence short-term interestrates across Europe but interest rates on the various types of loans made byfinancial institutions include risk premiums. The movement to a singlecurrency removes foreign exchange risk among euro area countries andthus removes a major reason for the interest rates being different in

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different member countries. However, there are still potential differences indefault risk.

7. ‘Bretton Woods II’ has a number of meanings. For some economists, itrefers to a set of informal arrangements that had developed by 2003whereby by deficits in the USA were being financed by a group of south-east Asian countries that had informally pegged their currencies to eachother and to the US dollar, at an artificially low rate. There is an obviousparallel between the role of the south-east Asian states and Europe andJapan during the original Bretton Woods arrangements. There has beenmuch controversy as to whether this arrangement is stable. But since thefinancial crisis of 2008, ‘Bretton Woods II’ is often used in connectionwith the need to develop a new set of formal arrangements to governinternational financial transaction.

SummaryIn this unit we have looked at arguments for and against fixed exchange ratesystems.

Having completed this unit, you should be able to:

■ explain the theoretical benefits and disadvantages of fixed and floatingexchange rate regimes

■ describe the details of a selection of fixed exchange rate regimes

■ explain the theory of currency union

■ relate the requirements for a currency union to the development of the EMU

■ identify a selection of alternative monetary arrangements that have beenadopted in merging/transition economies.

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‘Guilty! Guilty! – verdict will meanprison for ex-Enron chiefs.’

Newspaper headline following conviction of Enron executives on charges of conspiracy and fraud

IntroductionIn this unit we look at the case for regulating financial markets and atdifferent approaches adopted in different jurisdictions..

Unit learning objectives

On completing this unit, you should be able to:

9.1 Explain the economic theory of regulation.

9.2 Describe the key features of financial market regulation in the USA,UK and EU.

9.3 Assess the problems caused by globalisation and the internationalis -ation of financial markets.

Prior knowledge

The unit assumes that you have studied Units 1–8. Of these, Unit 5 is essential.Otherwise, it requires no prior knowledge, but some basic mathematical skillsand familiarity with economic principles will be helpful throughout.

Resources

The whole of the unit is supported by the core text (Howells and Bain, 2008,mainly ‘The Regulation of Financial Markets’ but also ‘The US Financial System’and ‘The Internal European Market’). Mishkin (2007) ‘Economic Analysis ofBanking Regulation’ is also useful, though it focuses more on the regulation ofbanking rather than market activity. You may find a calculator and access to theinternet useful. Many economics textbooks deal with the general issue of marketfailure.

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The need for regulationBroadly speaking, there are two schools of thought on the existence of regulationin a mixed market economy. The first explanation is that regulation arises as aresponse to some market failure, and that it is carried out in ‘the public interest.’The second explanation is that regulation is an economic good of value tocertain groups in society, and that the suppliers of this good are various levelsof Government. The first of these is the traditional approach that can be foundin most textbooks and you should read the rest of this section and the first twoparts of section 9.1 as reflecting that approach. We shall then consider thealternative briefly, and then, in the final part of section 9.1, we shall remindourselves that, from a theoretical point of view, all forms of regulation act likea tax on the activity concerned and that this ‘cost’ should always be set againstany benefits that might follow from the regulation.

In a world of perfectly competitive markets, resources (including financialresources) are devoted to the use that produces the maximum social welfare. Inthe language of textbooks, we shall have the ‘optimum allocation of resources’.Since we are talking about financial markets, let us refer to these resourcesloosely as ‘capital’. The users of capital will pay a price which is just equal tothe benefit that they expect to get from its deployment, while suppliers will geta reward which just induces them to supply that capital, without any excessprofit (or ‘economic rent’).

However, it is well-known that the conditions required for this perfectlycompetitive and ideal outcome are very demanding. They include:

■ Many suppliers with an insignificant share of the market. The decisions ofeach supplier are too small to affect the overall market.

■ The trading of identical products. One product is a perfect substitute foranother.

■ Consumers have full information – about prices and about the quality of theproducts.

■ No barriers to suppliers entering or leaving the market, at least in ‘the longrun’.

■ All suppliers have equal access to resources (including the current state oftechnology).

■ No ‘externalities’ and therefore no divergence between private and socialcosts and benefits.

It is unlikely that these conditions, in their entirety, can be found in any market.Sometimes, the absence of one or more condition has consequences that are soserious that we talk of market failure, and it is the consequences of marketfailure that give rise to the economic arguments for regulation.

Interestingly, financial markets are often quoted in textbooks as providing someof the nearest examples to perfectly competitive markets but we can show thatthey fail to meet several tests. The two major failures involve information andexternalities and we look at each of these in moment. But notice that there isalso a problem with the very first condition on the list. Participants in financialmarkets are not all of equally small size. Indeed, some are very large. They mayenjoy economies of scale, in which case they will also enjoy a degree of

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9.1Recommended reading: Howellsand Bain (2008) ‘The Regulation

of Financial Markets; Mishkin(2007) ‘Economic Analysis of

Banking Regulation’.

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monopoly power. And if the economies of scale are substantial, this may makeit difficult for competitors to enter the market (condition four). Notice thatthere may be substantial economies of scale in the use of information.

Asymmetric informationPerfect markets require that the participants are fully informed. And there is agreat deal of information available to financial markets and we think that, asa rule, it is quite quickly incorporated into prices and rate of return. However,not everyone is equally well-informed. Suppliers of capital generally have lessinformation about how their funds are going to be used – what sort of risks theywill be exposed to, what level of profit the borrower expects to earn from theiruse – than the borrower has. More generally, savers have a problem in fully-understanding the financial instruments and products that they buy. This isbecause the products themselves are quite complex and are bought veryinfrequently so that there is little opportunity to learn from experience. This isthe situation known as ‘asymmetric information’.

The connection between asymmetric information and market failure lies withrisk. As a rule of thumb we think that borrowers have superior information tolenders. This means that lenders may fail to appreciate fully the risk to whichthey are exposed and therefore misprice it. Or in the worst case they may simplyfail to recognise risk at all. Either of these increases the possibility of insolvency.This in turn could threaten the stability of the financial system, as we saw in the2008 crisis, and may also lead to some products and services no longer beingprovided.

Why is asymmetric information associated with risk?

It depends upon the situation in which the asymmetry occurs. Someexamples:

1. For a saver taking out a personal pension, failure to understand thedetails of the plan completely may mean that the accumulated sum atretirement is inadequate when it is too late to do anything.

2. For a company offering motor insurance, the inability to assess the riskof its clients accurately could make the firm insolvent.

3. The failure to understand that Enron executives were disguising the truefinancial state of the company meant that many workers lost their lifesavings.

The threats from asymmetric information are usually grouped under twoheadings which we have also met in earlier units. These are ‘adverse selection’and ‘moral hazard’. One useful way of distinguishing these is to think of thefirst as having its effects prior to a contract being entered into while the secondoperates after the contract has been signed.

Adverse selection describes the situation whereby the buyer of some marketinstrument (the lender) does not have sufficiently detailed information about the

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issuer (the borrower) and the project being funded in order to be confident ofthe price that should be paid. This may be because the relevant information isnot available or could not be obtained by any normal means, or, morefrequently, it arises because the level of detail required simply makes it toocostly. The consequence is that the lender can only make a rough appraisal ofthe level of risk. Consider the case of bonds, for example. We know that newly-issued bonds normally carry a ‘rating’ from a risk-rating agency. But the agencycannot afford the time and effort required to rate each bond individually. Itputs bonds into risk ‘bands’ or categories. The bonds in that category are thentreated as if they all carried the same degree of risk and so they all carry thesame risk premium. The problem is that the single price offered across the bandwill be offered to borrowers who still have differing levels of risk and the levelof risk will be known only to themselves, if at all. For the riskiest borrowers inthe band, the rate they have to pay on the bond will look attractive, while forlower risk borrowers it will look too high. The consequence is that only theriskiest borrowers in each band go ahead with their bond issues with the resultthat the risk rating exposes buyers to a higher risk than they expected. Thebuyers then face a rate of default which is higher than was originally calculatedfor that band. The risk has been underpriced. And the problem will not besolved by raising the price, since the same process will occur again, so long asa uniform price is being offered to borrowers of differing risk. Ultimately,adverse election could discredit the ratings process, bondholders would loseconfidence in the system and the market would contract or even fail completely.

Moral hazard refers to the situation whereby a borrower has obtained fundsand then uses them in some way that is riskier than the lender had expected(and priced for). The incentive to the borrower to behave like this arises becausethe funds have been obtained on the lender’s best guess at the level of riskinvolved. Imagine the issue of new shares. The new issue will have been accom -panied by substantial documentation about the firm and its activities and thiswill focus on the risk and return on its activities to date. If this is a firm beingpublicly listed for the first time, then the investment bank sponsoring the offerwill have set a price which it thinks makes the shares attractive to investors, byvirtue of the likely risk and return. If it is a right’s issue, the price will be fixedby the market for existing shares. In both cases, the firm’s cost of capital isbeing determined at the time of issue. But once the funds have been obtained,the firm may be tempted to earn higher profits by using the funds for someproject that is riskier than it has hitherto been used to.

Moral hazard is a very troublesome issue for regulators. This is partly becauseof the threat that it poses to market participants. But there is a more intriguingproblem. This is that regulation itself may promote moral hazard. This isespecially a danger where the regulation is intended to reduce risk. The mostobvious example from the area of finance is deposit insurance. Almost allregimes offer some degree of deposit insurance in order to avoid the danger ofcontagion and systemic collapse that would follow from a ‘run on a bank’.However, once the deposits are insured, neither the bank’s management northe depositors themselves, have any strong incentive to monitor what the bankis doing with those deposits. They could be lent for the riskiest enterprises inorder to increase the rate of return. This is why systems of deposit insurancealways carry a set of conditions which banks must meet in order to qualify forthe protection. So the process becomes circular and cumulative: the regulatorintervenes to limit risk but this creates moral hazard and so further regulation

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is required to limit the moral hazard. There is also the point that complyingwith regulations imposes a variety of costs on the regulated firm which may, inconsequence, try to evade the regulation and this may lead it into riskier(because hidden) activity.

The issue of moral hazard has played a large part in the aftermath of the 2008financial crisis. Firstly, it features in many of the explanations. The argument goesthat banks were encouraged to pursue extremely risky strategies because they hadbecome used to the idea that the state would always protect them from outrightfailure. Hence, the saying goes, that ‘profits were privatised [went to the banks andtheir shareholders] while losses were socialised [were met by the taxpayer]’. Thisplays a fundamental role in the analysis of Alessandri and Haldane (2009), whoalso show that the one-sided nature of the bank-state contract had shifted in banks’favour in the years leading up to the crisis. Secondly, it played a part in thedevelopment of the crisis itself, with the US and UK regulators being slow to act inthe early stages of the crisis, knowing that if they did bail out failing banks, the billcould be enormous and provide confirmation to banks that they would be perfectlysafe in future. When Lehman Brothers was allowed to fail (in September 2008), theshock that followed provided clear evidence of just how confident financial marketshad been that a major bank failure was impossible. And moral hazard worries playa major part in the arguments for reform of financial systems to prevent a similarcrisis in future. Although the proposals differ in detail, they all contain the commonthread that banks (and their traders) have become insensitive to risk because theyare ‘too big to fail’. Hence we see proposals for a ‘Tobin tax’ (on financialtransactions) to raise the cost and reduce the volume of trading; for the prohibitionon banks engaging in trading in securities on their own account (on the grounds thatthis will force the splitting of banking firms into more, smaller units); and the ideaof ‘living wills’ which maintain a complete record of a bank’s interbank obligationsso that it can more easily be closed down in the event of failure.

Needless to say, participants in financial markets do all that they can to protectthemselves from the dangers of both adverse selection and moral hazard and theydo this by making the best use of the information that is available. And regulatorstry to help by laying down rules for the disclosure of key information. But thecritical question is obviously ‘what information do they have?’ In section 9.2 weshall see how financial regulations in selected countries try to ensure a minimumlevel of reliable information to help prevent some of these problems and why allregulatory schemes have strict rules and tough penalties against insider trading.

Why is insider trading always treated as a serious offence?

First of all, insider trading is unfair. It means that people who are closelyinvolved with a firm can buy and sell shares in advance of the generalpublic. This gives them an advantage in making capital gains and avoidingcapital losses. More serious for most regulators, however, is that once theability for insiders to take advantage becomes known (or even stronglysuspected) investors lose confidence in the whole market and withdrawfrom it. This makes it harder for borrowers to raise funds (there are fewerlenders) and raises the price.

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ExternalitiesWhile asymmetric information may be commonplace in financial transactions,it is not restricted to financial activity. In many transactions, there will be caseswhere one party has more information than another. And so to make the casefor regulation we have to move on to a second stage of the argument whichamounts to saying that the consequences of asymmetric information and themispricing of risk can be much more serious in a financial context. This linksasymmetric information to another category of market failure. This is the caseof ‘externalities’.

An externality is any cost (or benefit) which is not paid by either party to thetransaction; it is paid (or received) by those who are external to the deal. Theconventional economic wisdom is that if there are positive externalities(benefits) then the goods or services responsible for those benefits will beunderproduced if the decision is left to the market; if there are negativeexternalities (costs) which no one pays for, the goods or services will beoverproduced. At first sight, it may be difficult to see how the concept ofexternalities applied to financial transactions but consider for the moment thecase of financial intermediaries (rather than markets) who are lending to eachother. In doing so, they are aware of a level of risk and they price their deals toreflect that risk, meaning that the price is adequate compensation for thepossibility of say one in one thousand deals defaulting. So far as the two partiesto the deal are concerned, this is a fair price. But suppose now that the default,when it happens, means that the lending bank cannot repay its own debts toanother intermediary, which cannot then settle its debts. We can see a pictureof ‘contagion’ beginning to emerge very quickly. Suppose now that in thisatmosphere of crisis banks simply refuse to make payments to each other. Thepayments system grinds to a halt and firms (and households) who have nothingto do with the banks, except that they were relying on the payment systemoperated by the banks, find that they cannot make payment. Trade stops. The‘costs’ of the original default are many thousand times greater than the cost tothe lending bank (which we know was compensated by an adequate rate ofinterest). In terms of economic theory, there is potential market failure becausebanks are not faced with the full cost of their risky behaviour. Risky lending isbeing ‘overproduced’. We mention this case of externalities and intermediariesbecause it was so obviously in the minds of regulators during the 2008 crisis.

We turn now to externalities and markets. Many investors have access tofinancial markets only through intermediaries like unit and investment trusts orpension funds and life assurance companies. These are managers of very largecollective investment funds. They can trade in markets at very low unit costs.This raises the question of whether they may ‘overtrade’. That is to say thatinvestors get little benefit from the continuous turnover (or ‘churning’) of theirportfolios (because the efficient market hypothesis in Unit 5 tells us that fundmanagers cannot beat the market) and yet are forced to pay fees to fundmanagers which substantially exceed the cost of trading. So far, this is just anexample of monopoly power. But if the frequent trading of stocks and bondscauses other problems like price instability or costs for firms and their registrarsof keeping track of ownership, then the question of externalities arises. Theprivate costs incurred by fund managers in frequent buying and sellingunderstate the full (social) cost and the trading is excessive. Externalities areoften said to arise from faulty property rights since those who are adversely

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affected cannot charge their loss to the perpetrators. But it also requires that thevictims appreciate (that is can identify) the cause of their losses. The idea thata significant amount of financial activity might be ‘socially useless’ attractedwidespread attention following the remarks of the Chairman of the UK’sFinancial Services Authority in the summer of 2009 (Turner, 2009).

Why is it difficult to know whether frequent trading is socially useless ornot?

Firstly, as we know from Units 3 and 4, the trading of existing securities ismany times greater (by value and volume) than the funds raised by newissues. From Unit 5, we know that the advantages of professional fundmanagement are slight for the investor, but that fund managers have anincentive to trade actively. Therefore, we can be sure that there is a vastamount of trading taking place that has no direct link with new lending andborrowing and some of it is likely to be of very little benefit to anyoneexcept those carrying out the trading. However, the fact that a largeamount of trading takes place continuously, gives the assets a liquidity thatthey would not otherwise have. This liquidity makes the new issues muchmore attractive to buyers than they would otherwise be and thereforecontributes to minimising the cost of new capital. The difficulty in making ajudgement lies in knowing how much trading is required for liquidity andhow much is genuinely unnecessary.

The question of externalities arises again in a more diffuse way when we askwhether the development of certain types of instrument or certain types ofactivity, make the financial system less stable than it might otherwise be. Thefinancial crisis of 2008 provides a powerful demonstration of the colossalexternalities that can be associated with a major financial crisis, extending wellbeyond the participants in the financial system and threatening the livelihoodsand security of people with no direct interest in financial activity. Ever sincethe Dutch Tulip Mania (see Unit 5) it has been legitimate to criticise ‘specula -tors’ as somehow seeking to benefit themselves while causing disruption toothers. But in more recent times, hedge funds have come under suspicion,together with ‘programme trading’ and, in the 2008 crisis, the development of‘exotic’ instruments like credit default swaps. The argument could be made thatthese products and practices have been developed at a private cost which hasbeen covered by their earnings, but with very substantial external costs thatwere not appreciated at the time.

Finally, we can combine information problems and externalities just once moreto make another case for regulation, very broadly defined. This arises becausewe think that individuals tend to suffer from ‘financial myopia’, meaning thatthey are short-sighted. They do not appreciate the level of lifetime saving thatis required to provide financial security in old age and even if they do, they aredeterred from taking action until it is too late because they feel that they do notunderstand or trust the products they are offered. Most people would agreethat a mark of a civilised society is some minimum level of security in old age

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and therefore if people do not provide it for themselves, the cost will fall on therest of society (via taxation). Hence, an adequate level of long-term privatesaving has not only private benefits but external benefits also which accrue tofuture taxpayers. But since private savers do not receive these public benefits,they will ‘underconsume’ long-term savings unless there is some incentive orpressure provided by the state. This argument featured in the ‘Sandler Report’into the UK retail savings market (Sandler, 2002).

What kind of market intervention might be used to tackle the problem ofunderconsumption of long-term savings products?

Government could subsidise long-term savings. This could be done by givingtax relief on contributions or the Government making a fractionalcontribution alongside each private payment. The difficulty lies in ensuringthat the subsidy goes only to the behaviour that we wish to encourage.Hence the practice of Government contributing support only to recognisedpension schemes.

Economic theories of regulationThese theories of regulation are based on the premise that, rather thanregulation being imposed in the public interest, there is a demand for regulationfrom groups who see some benefit for themselves. Such views enjoyedincreasing popularity among economists and government decision makers inthe 1970s and 1980s as a trend toward deregulation of previously regulatedindustries and markets began to gain momentum (see, for example, Stigler,1971; Posner, 1974). Economic theories of regulation often offer explanationsfor observed outcomes in situations where public interest explanations areinadequate. Some examples of regulation, relating to financial markets, thatmight be argued to yield benefits to participants, include:

■ Membership of exchanges. In order to trade in organised markets it is fre -quently necessary to be a member of an appropriate exchange (Euronext-NYSE, Chicago Board Options Exchange and so on). Members have tosatisfy certain conditions and one can argue that there is a public interestargument here in that the rules help to exclude unscrupulous and/or incom -petent traders. But they also act as barriers to entry and confer a degree ofmonopoly power on those firms that are members. The require ment forprofessional qualifications in order to undertake certain types of financialactivity is a more general example of the same principle.

■ Capital requirements. Under international banking regulations, banks arerequired to hold a minimum level of capital (or ‘equity’) against risk-adjustedassets. This is often presented as a tax on banking (which it is) imposed forthe public good. But it also acts as a barrier to entry and helps to supportmonopolistic banking structures, of which the UK is a very good example.

■ Cross-subsidisation. Regulation can sometimes influence the price that firmscan charge. For example, banks are often under pressure to provide ‘simple’bank accounts at very low cost to customers on low incomes; insurance

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companies are pressed to provide low cost, ‘basic’ pension facilities. Again,one can see a public good argument – everyone benefits if the low paid haveaccess to bank deposits as means of payment; everyone benefits if the poorhave adequate pensions. But these provisions are often cross-subsidised byhigher charges on other banking products and facilities. Low incomehouseholds benefit at the expense of the better off.

In section 9.2, we shall refer to the problem of ‘regulatory capture’. This refersto the situation where the regulator starts to identify with the interests of thefirms that it is regulating. In consequence, the regulation becomes more laxthan it should be. Theories of regulation which see it as a good which is beingbid for by interest groups, see regulatory capture as more or less inevitable.

Regulation as a taxOne of several consequences of the recent interest in regulation as somethingwhich yields advantage to competing interest groups, rather than being aregrettable necessity for the public good, is the recognition that regulationinevitably acts as a tax. We look at why this is the case now, and we take theexample of capital requirements imposed on banks. This may seem strange,when our focus is on financial markets, but there are two good reasons:

■ Most trading in financial markets is carried out by banks or divisions orsubsidiaries of banks. Hence when regulators talk about improving thefunctioning of financial markets they mean finding ways to change thebehaviour of banks (and other financial firms).

■ In the next section, we shall look at selected features of the market regula -tory process in the USA, EU and UK. Some of the differences expressthemselves as different attitudes towards bank regulation and thereforetowards capital requirements.

When we say that regulation acts like a tax, we need to be clear what thismeans. The effect of a tax on any product is to increase its price. The result isa reduction in the equilibrium quantity bought and sold, and an increase in itsprice. In a supply and demand diagram, the supply curve shifts to the left.

We shall illustrate this now by looking at the Basle capital adequacy rules. Theserequire banks must hold a minimum level of capital equal to eight per cent ofrisk-adjusted assets. We ignore any distinction between types of capital. Thebank in Table 9.1 just meets this requirement.

Assets Liabilities and capital

£bn Risk Risk £bnweight adjusted

Loans 80 1 80 Time deposits 100

Bonds 30 0.4 12 Sight deposits 36

Bills 32 0.25 8

Cash 2 0 0 Capital 8

Total 144 100 144

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To see this ratio working like a tax we shall compare the difference between thesituation where the requirement does not apply with the situation where it does. In order to do this, we need some interest rates. Assume:

■ The rate paid on deposits is four per cent pa.

■ The rate charged on loans is six per cent pa.

■ The cost of capital (the return to shareholders) is 15 per cent pa.

Now suppose that the bank is faced with the demand for additional lending of£1 billion. The bank decides to lend an extra £1 billion. Remember that thereis no capital adequacy requirement at the moment. This means that the bankcan finance the whole of the loan by holding extra deposits of £1 billion at acost of four per cent.

The bank’s income position is shown in Table 9.2.

Income from loan (£1bn × 6%) = – £60m

Less paid on deposits (£1bn × 4%) = – £40m

Net interest income = – £20m

Table 9.2: Income (without capital regulations)

This gives a rate of return to the bank of £20 million ÷ £1 billion or two percent – the difference between the two interest rates.

By contrast, we now look at the situation where the Basle capital adequacyrequirements apply. In this case the bank has to raise additional capital in orderto maintain the eight per cent ratio. This means that some of the additionallending of £1 billion is financed partly by additional capital – the rest by extradeposits as before. The balance of the financing is:

Additional capital required to maintain ratio = eight per cent of £1bn = 0.08bn

Remaining funds raised from deposits = £1bn – 0.08bn = 0.92bn

The bank’s income position is shown in Table 9.3.

Income from loan (£1bn × 6%) = − £60.0m (as before)

Less cost of capital (£0.08bn × 15%) = − £12.0m

Less paid on deposits (£0.92bn × 4%) = − £36.8m

Net interest income = − £11.2m

Table 9.3: Income (with capital regulations)

This gives a rate of return to the bank of £11.2 million ÷ £1 billion = 0.0112 =1.12 per cent. In these circumstances, the bank may decide that the additionallending is not profitable at this rate and may raise the price of the loan so as torestore the original rate of return allowing for the capital requirement. By howmuch does the bank have to raise the cost of the loan? Its original profit was£20 million (= two per cent). With the capital adequacy requirement it earnsonly £11.2 million. In other words, if £20 million is the minimum acceptable

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return it is short by £8.8 million. It has to increase the interest charged on theloan to bring in the extra £8.8 million, that is a total income of £68.8 million.So, instead of charging six per cent it has to charge 6.88 per cent. Now look atFigure 9.1.

Figure 9.1: Showing the tax effect

The original equilibrium occurs at six per cent/£1 billion. But when we observethe capital requirement, the cost goes up to 6.88 per cent and the (‘after tax’)supply curve shifts vertically by 0.88 per cent. However, with a downwardsloping demand curve, £1 billion is unlikely to be demanded at 6.88 per cent,and the new equilibrium is likely to occur at an interest rate between six and6.88 per cent and a level of lending less than £1 billion.

The fact that regulation inevitably acts like a tax is not a convincing argumentagainst regulation, but it is important to remember that regulation does notcome free. Designing an optimal regulatory regime is not just a question offitting the regulations to the problem, it also requires a consideration of thesecosts.

Table 9.4 is a simplified version of a bank balance sheet.

Assets US$m Liabilities and capital US$m

Cash and deposits 500 Customer deposits 7,700at the central bank

Government bonds 1,600

Corporate bonds 1,400

Mortgage loans 1,000

Commercial loans 3,000

Other 500 Capital 300

Total 8,000 Total 8,000

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Loans and deposits

St loans

S loans

S deposits

£1bn

Inte

rest

rat

e %

6.88%+0.88%

6.0%

4.0%

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Assume that cash and central bank assets have a risk-weighting of 0, whilegovernment bonds are weighted at 0.2. Corporate bonds and mortgageloans have a risk weight of 0.5, while all else has a weighting of 1.

1. Calculate the risk-adjusted capital ratio for this bank.

2. Suppose that the result of 1 shows that the bank is just complying withthe current capital requirements. What adjustments might the bank beable to make in order to increase its commercial lending without raisingmore capital?

1. Firstly, find the risk-adjusted value of assets (= 0 + 320 + 700 + 500 +3000 + 500) = 5020. The risk-adjusted capital ratio is then 300/5020 =0.06 or six per cent.

2. To create room for additional commercial lending, it needs to raise itscurrent capital ratio above the six per cent minimum. It could do this byselling some corporate bonds and buying government bonds. A moreextreme solution would be to sell the bonds and hold increased depositsat the central bank. Both strategies will bring down the risk-adjustedcapital ratio and allow more risky lending.

Financial regulation in the USA, UK and EUWe begin this section by looking at international regulations which affectmarket behaviour in all countries. We then look at additional features ofregulatory regimes in the USA, the UK and EU.

Capital adequacyWe begin by looking at successive attempts to regulate the behaviour ofinternational banks by what is usually called the Basel Committee. We havesome understanding of what is involved, from our discussion at the end ofsection 9.1. The reason that the Basel regulations are relevant to markets is thatmuch trading in financial markets is carried out by banks (or their divisions, orsubsidiaries) and, indeed, trading (as opposed to loan and deposit-taking) hasbecome increasingly important to banks and their profits.

The Basel Committee was established by the central bank governors of the G10group of countries in 1974 and reports to them. In 2009 the Committee’s memberscome from Argentina, Australia, Belgium, Brazil, Canada, China, France,Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg,Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain,Sweden, Switzerland, Turkey, the United Kingdom and the United States. Therepresentatives are all people with experience of and interest in bankingsupervision. The Committee’s Secretariat is located at the Bank for InternationalSettlements in Basel, Switzerland, and is staffed mainly by professional supervisorson temporary secondment from member institutions. For this reason, details of the

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9.2

Recommended reading: Howells and Bain (2008) ‘The US

Financial System’, ‘The InternalEuropean Market’ and ‘The

Regulation of Financial Markets’;Mishkin (2007) ‘Economic

Analysis of Banking Regulation’.

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Basel Committee’s work, its reports, consultations and pronouncements can befound on the website of the BIS (<http:// www.Bis.org>).

In 1988, the Committee decided to introduce a capital measurement systemcommonly referred to as the Basle Capital Accord. This system provided for theimplementation of a credit risk measurement framework with a minimumcapital standard of eight per cent by end-1992. Since 1988, this framework hasbeen progressively introduced not only in member countries but also in virtuallyall other countries with internationally active banks. In June 1999, theCommittee issued a proposal for a revised capital adequacy framework whichis usually described as having ‘three pillars’. However, one of these remains arequirement that banks hold capital (or ‘equity’) equal to eight per cent of theirrisk-adjusted assets, as in our illustration above.

Why this preoccupation with banks’ capital? The answer is that this capitalrepresents the bank’s net worth (the excess of its assets over its liabilities) andbelongs to the shareholders, the owners of a bank. Since a bank’s solvencyrequires net worth to be positive, the size of this net worth shows by how mucha bank could take a reduction in asset values before it became insolvent. Thecapital acts as a buffer against negative shocks to asset values (and also meansthat the cost of such shocks falls upon the shareholders and not on the othercreditors of the bank, for example, its depositors). The strength of the bank isusually represented by the ratio of capital to total assets. However, since thepurpose of the capital is to provide a buffer against negative shocks to assetvalues, it is hardly appropriate to treat all assets equally. For example, notes andcoin and deposits with the central bank are entirely risk free. Governmentbonds are low risk. Loans to commercial property companies, by contrast arequite different. Therefore, capital adequacy requirements tend to express capitalin relation to risk-adjusted assets (again, as we saw above).

Until recently, capital adequacy ratios were a matter of international agreement,being laid down in the Basle Capital Accord (I) which was agreed in 1988.‘Basle I’ defined exactly what qualified as bank capital (dividing it into ‘tier 1’and ‘tier 2’) and provided a set of risk weights. It then specified that banks musthold capital equal to a minimum of eight per cent of risk-adjusted assets,although some national regulators insisted that banks hold a higher level andsome banks held a higher ratio as a matter of choice.

The Basle I terms were amended several times, in particular to take account ofbank activities which did not appear on the balance sheet. Much of this had todo with the trend toward securitisation. But a major overhaul followed withBasle II in 1999. After lengthy discussion and amendment, the Basle II require -ments began to be adopted in 2006. Compared with Basle I, Basle II had threepillars. The first continued the concept of a risk-adjusted capital require ment(which also remained at eight per cent). However, it introduced a greater rangeof weights and also allowed banks with adequate risk-management skills tocalculate their own weights (the ‘internal risk-weightings’). The idea was toproduce a more risk-sensitive capital ratio. In addition, a second pillar laid downprocedures for supervisory review of banks. This was intended to give thenational regulator a greater and more uniform role in bank supervision. Thethird pillar laid down requirements for the disclosure of key information relatingto risk management by banks. The argument here was that with this additional

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information, financial markets would be able to ‘discipline’ banks that were laxin their risk management by selling the shares and making the bank a takeovertarget.

How do these requirements relate to financial markets? The obvious connectionis that they were intended to give banks some protection against financialmarket shocks. Although bank loans are not tradable assets (and Basle I wasmainly concerned with loan defaults) many other assets on banks’ balancesheets are traded and therefore negative shocks may take the form of marketprice falls as much as defaults. Basle II made more effort to take this intoaccount.

In learning activity 9e, we observed a bank working at the limit of its capitaladequacy ratio and we asked what it could do in order to increase itslending without raising new capital. Suppose, instead, that we asked whatelse could a bank do to expand, without raising additional capital?

Since the capital adequacy ratio is calculated from assets on the balancesheet, the bank cannot expand by increasing its visible assets. But it mightbe able to engage in various kinds of off balance sheet activity. This activitywill generate profit without requiting any additional assets (or liabilities) toappear. For example, instead of lending to established clients (whichincreases its assets) it could offer to underwrite clients’ issues of their ownsecurities. This would enable a small, unknown firm to sell bills in the moneymarket at a good price/ low interest rate since the bills have a well-knownbank’s backing. The bank of course would make a charge for the guarantee,but it would have no corresponding asset. The bank might start trading infinancial securities and do it through a subsidiary. What is feasible, dependsupon the regulations. Under Basle I, as originally designed, banks couldengage in many off balance sheet activities. But with the passage of timeBasle I (and then Basle II) began to demand capital held against theseactivities, though often at levels which were low enough to encouragebanks into off balance sheet activity.

But there is another connection between banks and markets. Depending on thenature of a bank, financial market trading may be a large or small part of itsactivities. For investment banks, for example, proprietary trading will be thedominant activity. There will be very little traditional lending and deposit-taking, if any at all. For large banking groups with substantial retail business,trading will be of less importance. However, for all types of bank, securitiestrading and lending/deposit holding will be alternatives to some degree andbanks will allocate resources between them on the usual commercial criteria. Aswe have just seen, the profitability of various lines of business can besubstantially influenced by regulation and one effect of Basle I, which wasmainly focused on the credit risk attaching to on-balance sheet assets, was toencourage banks to develop their off-balance sheet activities amongst whichwas the trading in financial markets. Basel II recognised this. It required banks

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to hold capital against certain types of off-balance sheet activity at the risk-weighting that would have been given to it had it been on the balance sheet, butreduced by a ‘credit conversion factor’ which could range from a maximum of0.5 to a minimum of 0. When it came to trading activity, banks were requiredto hold capital equal to 0.15 of the value of the gross income from the activity.Notice that the riskiness of the activity did not feature in the requirement. Withthe benefit of hindsight (after the 2008 crisis) it now looks as though the capitalrequirements on trading activity were set far too low, especially since they wereunrelated to the risk. One reform of banking regulation that appeared to havewidespread support in 2009 was a modification of the capital adequacy rules,in three respects:

■ a general increase from eight per cent

■ a linking of the requirement to the rate of growth of lending in order togive the requirement a counter-cyclical character

■ an increase in the capital required against financial market trading.

The last has the potential to affect the volume of trading quite sharply,depending upon how it is done.

Market regulation in the USAWe turn now to three particular jurisdictions and the way that they approachthe regulation of financial markets. Suppose that we imagine a short continuumdescribed by the degree of ‘market optimism’ – the degree of confidence thatfree markets generally produce the best results. Then, we can place the USA atone end and the EU at the other, with the UK in between (but not in the middle).We see this, the moment we ask ‘who does the regulating?’, and before we getto any examination of the regulations themselves.

With regard to the form of regulation, we must first ask who should carry outthe regulation – the Government or a government agency, or the industry itself(self-regulation). The argument for self-regulation has two elements. Firstly, theindustry has a commercial incentive to protect its own reputation and somembers will be prepared to pay to achieve this, thus overcoming one of theprincipal market failure arguments for government regulation. Secondly,practitioners understand the needs of the industry and are likely to interfereless with its efficient functioning. This counters a common complaint againstpublic regulatory bodies that, because they will be heavily criticised over thecollapse of firms but not praised for actions that lead to lower prices, they willalways impose excessive safety standards, raising the cost of regulation to bothproducers and consumers.

The assumption then is that self-regulation is almost certain to be lighter thanregulation by an external body. There is a danger, however, that self-regulationmay turn out to be an awkward halfway house. To begin with, it must besupported by some government regulation at least to the extent that firms arelegally required to join the industry regulatory scheme. Otherwise, an incentivewould be created for some firms to act as free riders, hoping to benefit from anyincrease in reputation of the industry resulting from the behaviour of firmswithin the regulatory organisation without paying the costs of membership.In the USA, the high-level of market optimism has inevitably created apreference for self-regulation over regulation by government agency. Where

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financial markets are concerned, the chief authority is the Securities andExchange Commission (SEC) whose job is ‘...to protect investors, maintain fair,orderly, and efficient markets, and facilitate capital formation’ (SEC, 2009).The SEC was created by the Securities Exchange Act, 1934, which was passedin the aftermath of the Wall Street Crash and the following great depression of1931–3. The SEC claims that its role is based on two basic notions, whichreveal a great deal about its approach. These are:

■ ‘Companies publicly offering securities for investment dollars must tell thepublic the truth about their businesses, the securities they are selling, and therisks involved in investing.

■ People who sell and trade securities – brokers, dealers, and exchanges –must treat investors fairly and honestly, putting investors’ interests first.’(SEC, 2009).

Together they tell us that the SEC is primarily concerned with the issue ofinformation. It is the asymmetry of information that is the real danger. Providedthat everyone is well-informed, or is not prevented from being well-informed,then the best form of regulation is caveat emptor meaning ‘let the buyerbeware’. In other words, it is up to individuals to look after their own bestinterests. The job of the SEC is only to ensure that everyone has reasonableaccess to the key information. This is typical of the light touch approach thatone would expect to see in a regime that starts from the assumption thatmarkets work well.

The Commission’s responsibilities include:

■ interpretation of federal securities laws

■ issuing of new rules and amendment of existing rules

■ overseeing the inspection of securities firms, brokers, investment advisers,and ratings agencies

■ overseeing private regulatory organisations in the securities, accounting,and auditing fields (see ‘FINRA’ below)

■ co-ordinating US securities regulation with federal, state and foreignauthorities.

Over the years securities trading has been the subject of several key pieces oflegislation, amongst which are:

■ The Glass-Steagall Act 1933. This established the Federal Deposit InsuranceCompany (FDIC) and introduced a number of banking reforms designedto reduce the riskiness of commercial banks whose deposits were beinginsured. From the securities’ trading point of view, the most significantinnovation was to prevent deposit-taking (‘commercial’) banks from under -taking investment business. It also prohibited a bank holding company fromowning other types of financial company and it gave the US Federal Reservethe power to regulate interest on savings accounts (‘Regulation Q’). Manyof these provisions were repealed by later legislation listed below.

■ Depository Institutions Deregulation and Monetary Control Act 1980.Repealed Regulation Q and some other restrictions on bank operations.

■ Gramm-Leach-Bliley Act 1999. This removed the restriction on bankholding companies owning ‘other’ types of financial institutions. Hence abank holding company could also own investment companies and thisallowed commercial banks to engage in securities trading again.

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■ Sarbanes-Oxley Act 2002. This laid down enhanced standards for financialreporting of listed companies. The Act followed a number of corporate andfinancial scandals (Enron, WorldCo, Tyco and others) where investors hadlost billions of dollars when their share prices collapsed. It was subsequentlydiscovered that much critical information had been concealed by the firms’published accounts. The Act focused on 11 areas of improvement. Amongthem were enhanced disclosure requirements, the role of auditors andconflicts of interest, and a controversial requirement that senior executivestake individual and personal responsibility for the accuracy of companyreports.

The subject matter of Sarbanes-Oxley reminds us that, whatever regulationsmay be laid down by authorities like the SEC who are trying to regulate thebehaviour of financial markets, additional, relevant regulation will be providedby the legislation governing the conduct of publicly owned companies. Eachcountry will have a set of companies acts, laying down the obligations on firmsowned by shareholders. In particular, these will lay down rules for thedisclosure of information, for the rights of existing shareholders to be consultedabout major decisions and to be given the first opportunity to buy newly-issuedshares in order to prevent their ‘share’ of ownership being diluted.

How does the Sarbanes-Oxley Act seek to tackle the problem of asymmetricinformation?

The aim of Sarbanes-Oxley was to restore public confidence in corporatefinancial information following the scandals at Enron, WorldCom andothers. There are eleven provisions or ‘titles’. These include:

■ creates a board to oversee the conduct of auditing firms

■ lays down standards to ensure the independence of auditors and removeconflicts of interest

■ requires senior executives to take personal responsibility for publishedfinancial information

■ increases the degree of financial disclosure – especially regarding offbalance sheet items

■ sets out rules to reduce conflicts of interest for securities analysts

■ increases the power of the SEC to censure or bar securities analystsguilty of misconduct

■ increases the penalty for ‘white collar crimes’ like fraud and falseaccounting.

We noted above that the USA has opted largely for self-regulation where marketparticipants are concerned. The SEC makes the regulations and the respons -ibility for ensuring compliance rests with a body made up of representatives ofthe securities trading industry. This body is known as FINRA, The FinancialIndustry Regulatory Authority. FINRA was created in July 2007 through the

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consolidation of the National Association of Securities’ Dealers (NASD) and themember regulation, enforcement and arbitration functions of the New YorkStock Exchange. FINRA’s objective is to promote investor protection andmarket integrity through effective and efficient regulation and complementarycompliance and technology-based services. This involves registering andeducating industry participants, examining securities firms, writing rules,enforcing those rules and the federal securities laws (from the SEC), informingand educating the investing public, providing trade reporting and other industryutilities, providing resolution and arbitration facilities and administering thelargest dispute resolution forum for investors and registered firms. It also hasregulatory responsibility for the NASDAQ Stock Market, the American StockExchange, the International Securities Exchange and the Chicago ClimateExchange.

Market regulation in the UKWhere financial services are concerned, the UK also has a history of self-regulation. The principal Act is the Financial Services Act 1986, which createdan overall regulatory authority, the Securities and Investment Board (SIB) and,answering to the SIB, a number of self-regulatory organisations (SROs), whichwere composed of investment practitioners and which were given theresponsibility of regulating their own segment of the industry; a group ofrecognised professional bodies (RPBs) whose task it was to maintain the stan -dards of the lawyers, accountants, insurance brokers and actuaries whoparticipate in the market, and a number of regulated exchanges. Three prob -lems quickly emerged.

The first was that it was very difficult to define SROs so that all activities arecovered. This arises because financial firms engage in many different types ofactivity and so a firm may belong to the SRO to whom most of its activities arerelevant, while some lesser ones will go unsupervised. The only solution to thiswould be to require a firm to be a member of multiple SROs which isoppressive. A second problem was the danger of competitive laxity. Thisoccures when one SRO tries to attract members by offering less intrusive andburdensome regulation than others. This can develop into a race to the bottom.The third problem is regulatory capture (see above). SROs are staffed byrepresentatives of the industry that they regulate. They will have friends andloyalties in the regulated firms and indeed may well plan to work again in theregulated industry. It could be argued that this encourages them to be undulysympathetic and insufficiently critical in their role as regulator.

In 1997, the new Labour Government announced that it would create astatutory regulator, the Financial Services Authority or ‘FSA’. The currentregulatory arrangements in the UK are shown in the following chart, which isadapted from Blake (2000, p45).

The first column indicates that there are numerous pieces of legislation thathave some bearing on the functioning of financial markets. The three mostimportant are shown in the centre. But there are companies acts which regulatethe conduct of publicly listed firms, including their behaviour regarding theraising of capital. Financial activity is also subject to the general provisions ofthe criminal law (regarding theft, fraud, deception and so on). The 1987Banking Act places responsibilities on banks which extends to some degree to

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their use of financial markets and the Panel on Takeovers and Mergers operatestwo sets of regulations – a code on takeovers and mergers which specifies, interalia, how shareholders must be treated in the event of a takeover – and rules onthe disclosure of information in connection with the substantial acquisition ofshares.

Figure 9.2: Regulation in the UK financial system

The figure also shows that the core authority when it comes to the regulationof financial market behaviour is the FSA which authorises participants,supervises financial intermediaries (who are often the main market partici -pants), has powers of investigation, enforcement and discipline and regulatorypowers over exchanges and collective investment funds.

The detailed operations under these headings are detailed in Blake (2000, §1.5).

Market regulation in the EUAt the EU level the regulation and supervision of financial markets and financialservices providers remains fragmented. European member states still havediverse regulatory and supervisory cultures, for example, with regards to therole of the state, which is generally seen in a more positive light than in the UK

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Companies Act 1985

Criminal JusticeAct 1986

Financial Services Act 1986

Financial ServicesAuthority(FSA)

Authorisation of marketparticipants

Prudentialsupervision of financialintermediariesand fundmangers

Investigation,enforcementand discipline

Regulation ofinvestmentexchanges andclearing houses

Regulation ofcollectiveinvestmentschemes

Bank ofEngland

Operation ofmonetary policy

Ensuring stabilityof financialsystem

Bank ofEngland Act 1998

HMTreasury

FinancialServices andMarkets Act2000

Banking Act1987

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and (certainly) in the USA. They have retained a variety of regulations andsupervisory systems with competences remaining at national level withparliaments, banks or other supervisory institutions.

This fragmentation of financial regulation and supervision contrasts starklywith the expansion of the EU-wide financial markets and financial servicesproviders. Several banks now have a presence in multiple EU countries,conducting trans-border capital transfers and trans-border selling of highlycomplex and risky financial services. The creation of a European FinancialCommon Market was first envisaged in the Treaty of Rome (1957) but madelittle progress until the Single European Act (SEA) of 1986.

To achieve a single market in financial services, it was necessary to ensure:

■ the free mobility of capital

■ the right of establishment by firms in other member states

■ the right to supply cross-border services

■ the acceptance of common supervisory regulations

■ the harmonisation of taxes.

Fully mobile capital, in turn, could only be achieved with the removal of allexchange controls, ideally the disappearance of exchange rate uncertainties andthe full acceptance of the rights to raise capital and to invest in all EU markets.It was clearly always going to be difficult to meet all or even the majority ofthese requirements. The first three were largely met by the creation of theEuropean Monetary Union. But the acceptance of common supervisoryregulations still has some way to go (and the harmonisation of taxes furtherstill).

The EU has facilitated liberalisation of financial services providers and offinancial markets. Based on the Nice Treaty and the Lisbon Strategy theprinciples behind this liberalisation have been stronger competition in EUmarkets, with the purpose of reducing financing costs and improving allocationof resources, thus boosting the global competitiveness of the EU’s financialindustry. An effort to compete with the US financial industry, which has beendominant in some big earning sub-sectors such as investment banking, has hadan important influence on EU policies. But the harmonisation of regulation andsupervision lags behind the growth of cross-border activity.

At the centre of attempts to improve cooperation, convergence, harmonisationor standardisation of financial regulation and supervision is the Lamfalussyprocess. It has dealt with some important issues such as bank capital require -ments, and transparency in the issuing and selling of shares and other equities.Originally developed in March 2001, it is named after the chair of the EUadvisory committee that created it. It is composed of four ‘levels’, each focusingon a specific stage of the implementation of legislation. At the first level, theEuropean Parliament and Council of the European Union adopt a piece oflegislation, establishing the core values of a law and building guidelines on itsimplementation. The law then progresses to the second level, where sector-specific committees and regulators advise on technical details, then bring it toa vote in front of member-state representatives. At the third level, nationalregulators work on coordinating new regulations with other nations. The

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fourth level involves compliance and enforcement of the new rules and laws.From our point of view, the most significant European directive developedaccording to this approach is the Markets in Financial Instruments Directive,or MiFID.

The MiFID is a European Union law that provides harmonised regulation forinvestment services across the 30 member states of the European EconomicArea (the 27 Member States of the European Union plus Iceland, Norway andLiechtenstein). The main objectives of the Directive are to increase competitionand consumer protection in investment services. Firms covered by MiFID willbe authorised and regulated in their ‘home state’ (broadly, the country in whichthey have their registered office). Once a firm has been authorised, it will beable to use the MiFID ‘passport’ to provide services to customers in other EUmember states. These services will be regulated by the ‘home state’ (whereaspreviously under the EU’s 1993 Investment Services Directive a service wasregulated by the member state in which the service takes place).

Amidst many other provisions, MiFID requires:

■ firms to categorise clients as ‘eligible counterparties’, professional clients orretail clients (these have increasing levels of protection). Clear proceduresmust be in place to categorise clients and assess their suitability for eachtype of investment product

■ firms to capture specific information when accepting client orders, ensuringthat a firm is acting in a client’s best interests and lays down how ordersfrom different clients may be aggregated

■ that operators of continuous order-matching systems must make aggregatedorder information on ‘liquid shares’ available at the five best price levels onthe buy and sell side; for quote-driven markets, the best bids and offers ofmarket makers must be made available

■ firms to publish the price, volume and time of all trades in listed shares,even if executed outside of a regulated market, unless certain requirementsare met to allow for deferred publication.

The overall objective of MiFID is to ensure that firms take all reasonable stepsto obtain the best possible result in the execution of an order for a client. Thebest possible result is not limited to execution price but also includes cost,speed, likelihood of execution and likelihood of settlement and any otherfactors deemed relevant.

Other ‘Lamfalussy Directives’ affecting financial markets include:

■ The Prospectus Directive (PD): The PD sets out the initial disclosureobligations for issuers of securities that are offered to the public or admittedto trading on a regulated market in the EU. It provides a passport for issuersthat enables them to raise capital across the EU on the basis of a singleprospectus.

■ The Market Abuse Directive: The Market Abuse Directive creates a regimeto tackle market manipulation in the EC and update the existing EC insiderdealing legislation.

■ The Transparency Directive (TD): The Directive is designed to enhancetransparency on EU capital markets by establishing minimum requirementson periodic financial reporting and on the disclosure of major shareholdings

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for issuers whose securities are admitted to trading on a regulated marketin the EU. The TD also deals with the mechanisms through which thisinformation is to be stored and disseminated.

Globalisation and financial marketsSince the 1970s there has been a substantial increase in the internationalisationand globalisation of economic activity. This can be measured in a number ofways. If we are interested in real economic activity, for example, we could lookat the size of imports and exports as a fraction of GDP, calculate a cross-countryaverage and look at the trend over time. Alternatively, we could use measuresof the size of world trade. As a measure of financial integration Obstfeld andTaylor (1998) have compiled the existing data on the stocks of foreign assetsrelative to world GDP as well as foreign liabilities relative to GDP at benchmarkyears over the period 1825 to the present. The sample of countries coveredbefore 1914 are many of today’s advanced countries and a number of othercountries. The picture portrayed by this data, although it is fragmentary forthe early years, is of a U-shaped pattern. At its pre-1914 peak the share offoreign assets to world GDP was approximately 20 per cent. It declined fromthat level to alow point of five per cent in 1945 with the pre 1914 level onlybeing reached by 1985. Since then it has risen to 57 per cent. A similar pictureemerges from the ratio of liabilities to world GDP.

A number of organisations now publish their own indices of globalisation. TheUniversity of Maastricht’s website is useful in listing the criteria used in theconstruction of the index as well as providing a series of maps which show thedegree of globalisation (and its rate of change) for many countries (Maastricht,2009).

Behind this sharp rise in the stocks of financial assets/liabilities relative to worldGDP is, inevitably, an internationalisation of capital flows. The key factors thatbrought about the growth in these flows and in the structure of the globalfinancial market include the following:

■ liberalisation of national financial markets and the related growingcompetition among financial institutions

■ technological progress in IT and telecommunications

■ faster flow of information and its standardisation

■ globalisation of national economies in their various aspects (commerce,institutions, ownership structure, capital and knowledge).

The potential benefits of globalisation are considerable. Firstly, globalisationallows investors to benefit from international diversification. In theory, thisreduces the degree of market risk to which they are exposed (see Unit 4) sincethey can invest in several countries where market fluctuations are likely to beless than perfectly correlated. It also allows firms access to a larger range ofcapital sources, some of which may be cheaper than domestic sources. Theglobalisation process itself is closely linked with technological innovation,which itself benefits in reducing costs. Globalisation requires large amounts ofinformation to be available instantly at a large number of locations. Communi -cations technology is especially important here. And it is the same technologythat has allowed large firms to relocate some of their activities to less developed

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9.3

Recommended reading: Howells and Bain (2008) ‘The US,

Financial System’, ‘The InternalEuropean Market’ and ‘The

Regulation of Financial Markets’;Mishkin (2007) ‘Economic

Analysis of Banking Regulation’.

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parts of the world where costs are lower and where the relocation may have amajor impact on local incomes.

However, it also poses considerable problems for regulators. We have just seenhow the growing internationalisation of financial markets and services in theEU has out-run the regulatory framework, and much the same is true at theinternational level. The nearest the world has to any form of internationalregulator is the Basle Committee and it is worth remembering that the firstBasle Accord (1988) was an attempt to lay down some rules of conduct forinternational banks.

But for markets, regulation still relies heavily on national institutions (includingeuro-wide institutions within the EU). Leaving aside the efforts of the BasleCommittee, responses to the challenge posed by globalisation of marketsinclude:

■ improved standards of information, including the quantity, quality andcomparability of data

■ unification of principles that govern the functioning of individual financialmarket areas (see for example the Lamfalussy Directives above)

■ the development of international accounting standards (over 100 countrieshave adopted or based their own accounting standards on the InternationalAccounting Standards (IAS) or the International Financial ReportingStandards (IFRS))

■ introduction of master agreements on executing transactions on theinterbank and other markets sponsored by professional bodies in thosemarkets

■ development of statistical methodologies elaborated by, inter alia, the IMF,the BIS, and the World Bank that ensure compliance of the data gatheredwith the statistical guidelines and their international comparability

■ the principles of best practice, elaborated by professional associations offinanciers

■ the development of the modern financial market infrastructure has alsocovered regulatory changes (for example, the bankruptcy law) and theestablishment of modern transactional systems, payment systems, settlementsystems, risk management systems, and information services – such asReuters or Bloomberg.

Consider critically the argument that globalisation reduces the level of riskfaced by investors.

The argument that globalisation reduces risk rests upon the benefits ofdiversification. In Unit 4, we saw that diversification reduces the level of riskrelative to the rate of return, because the returns on assets are imperfectlycorrelated. Furthermore, in Figure 4.1 we distinguished between specific risk(which is reduced by diversification) and market risk (which is not). Marketrisk persists because all assets are subject to some degree to market-wideevents and therefore while correlation is imperfect, it remains positive.However, markets themselves are unlikely to be perfectly correlated. Rapid

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economic growth in one country is not necessarily accompanied by rapidgrowth in others. Hence, assets which are drawn from different nationalmarkets are likely to have lower correlation coefficients than those drawnfrom just one. Adding overseas assets to a portfolio should therefore reducerisk below what can be achieved only by diversification across the domesticmarket.

Notice, however, that the argument rests upon the fact that marketsthroughout the world are less than perfectly correlated. This may be true,but it is not fixed for ever and it may well be that another consequence ofglobalisation is to increase the degree of convergence between economies.As the world emerged from recession in 2009, countries in the West hopedthat rapid growth in China and sout east Asia would help them recover; inearlier years, it was the performance of the US economy that mattered toother countries. While globalisation may offer some benefits fromdiversification at the moment, those benefits may well be eroded by theconsequences of globalisation.

Preventing market abuseRead the following and answer the questions at the end.

Extract from a speech by Jamie Symington, Head of WholesaleDepartment, FSACity and Financial Market Abuse Conference6 November 2008

We live in ‘interesting times’ people keep saying to me. There have beenseismic shifts in the financial markets in the last few months, as we allknow, and the landscape has changed in ways that seemed unimaginable.For the regulators (along with governments, central banks and thebanking industries) the world over, it has been all hands to the pumps tofight the fires that have raged through the markets. It has been anextremely busy time for all of us.

But no-one should make the mistake of thinking that this means that thebusiness of ordinary regulation of the markets does not go on. Our remitis to maintain clean as well as orderly markets at all times. The FSA’scommitment to combating market abuse remains as high as ever. We mayhave other immediate and pressing priorities, but the effort andresourcing that we put into the prevention, detection, investigation andprosecution of market abuse has not diminished. On the contrary, it hasbeen enhanced in the last year.

Markets and the outlook for the economy are changing on a daily basis.This makes it difficult to predict what the future holds for us in terms ofthe risks of market abuse.

Take mergers and acquisitions, for example. This has been identified as a

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key risk area for us. Unusual trading around takeovers is something wehave monitored closely. It is an indicator of the incidence of market abuse. It has been the source of many of our enforcement referrals. Who knows what will happen to M&A activity in the near or mediumterm? M&A activity may increase or decrease during a recession. It is hardto say. Sometimes harsh economic conditions lead to consolidation ofenterprises in particular sectors. Sometimes there isn’t the money there to finance it.

But even if the corporate merger sector is less active there will still beparticular risks to abuse of information in the markets. For example,information concerning re-financing packages. One of the FSA’s landmarkmarket abuse cases, our record fines for GLG and Philippe Jabre in 2006,concerned misuse of information about the re-capitalisation of a Japanesebank. That, Sumitomo bank, was going through a similar re-financingprocess in the aftermath of Japan’s financial crisis to what many of our ownbanks are doing today. Also, if we are entering into a recession, thelikelihood is that we will see more examples of companies needing to giveprofit warnings, or even announcements concerning liquidity. Again, thisposes a high risk of market abuse. Ordinary investors need to be protected.

So we are keeping a very close eye on the changing world and thedeveloping trends in markets. Also, as you have all seen, we havedemonstrated that we are prepared to use all our regulatory tools asnecessary to prevent and deter market abuse in response to the challengingmarket conditions.

One example is the introduction of new rules concerning short selling.While the FSA still regards short-selling as a legitimate investmenttechnique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, the FSA hastaken decisive action, after careful consideration, to protect thefundamental integrity and quality of markets and to guard against furtherinstability.

In July we introduced the provisions requiring disclosure of net shortpositions over a certain threshold. In September we took more targetedmeasures to prevent short selling completely in the shares of financialinstitutions. These provisions have been reviewed and will remain in placeuntil January. Meanwhile, a wider review of short selling is ongoing and wewill seek to look at, amongst other things, legal issues, the cross-borderlandscape and the quantitative impact of ban/disclosure requirements. Weaim to publish a Consultation Paper in early January.

Another example is the thematic work we have done concerning marketrumours. Disseminating false or misleading information, particularly innervous market conditions, can be very damaging. This has been the caseparticularly in the recent months, when unfounded rumours contributed tosubstantial share price movements in a number of UK financial institutions.While the most publicised cases pertained to falls in share prices resultingfrom the spread of unsubstantiated stories, all price movements triggered

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by unfounded rumours have the potential to distort markets andundermine market confidence.

Since spring 2008, our Market Conduct team has investigated a series ofunfounded rumours which were circulated in the market and we reportedon this work at the start of August. We also began a tailored review offirms’ policies in relation to handling of market rumours. Obviously differentfirms have different compliance resources. Unsurprisingly, we identified agreat disparity amongst firms’ approach to the issue of rumours.

We take this matter very seriously. We will publish the findings of ourrumours thematic review, including a case study, in Market Watch 30 – thisis due out later this month and will build on what I have said here.

In short, therefore, in answer to the question what is the FSA doing aboutmarket abuse in the current market conditions I would say three things:

One – we are staying on the beat. We are busy with other things, but weare continuing to monitor market abuse and enforce with our usual rigour.

Two – we are carefully watching events and developments in marketconditions. We are monitoring what risks areas are emerging for marketabuse in the changing world.

And three – we are using all the tools we have to respond rapidly butthoughtfully to market conditions. Where necessary, we are changing therules to address the needs of the day.

1. In section 9.1, we identify two major sources of market failure. To whichof these does the speech relate? (Hint: answering question 2 might help.)

2. What is meant by ‘market abuse’?

3. In the paragraph relating to mergers and acquisitions, how does theregulator detect suspicious behaviour and why might that behaviour beillegal?

4. Why might the need for firms to give profit warnings (and otherannouncements) increase the possibility of market abuse?

5. Why might ‘rumours’ be a matter of concern to a financial regulator?

1. Of the two sources of market failure that we discussed, the speech ismainly concerned with ‘information’. There is a hint of this in the secondparagraph which refers to ‘clean and orderly markets’. But it becomesclear in the paragraph about mergers and acquisitions where it mentions‘suspicious trading’. It also mentions ‘rumours’ or potentially falseinformation as a problem.

2. Market abuse can take many forms but (see answer 1) the FSA here ismainly concerned about the improper use of information in order toobtain an unfair advantage in market trading.

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3. It mentions ‘unusual trading’ as the first sign of improper behaviour. Wedo not know the details, but it may mean that there has been a suddenincrease in the demand for shares in a company before a merger ortakeover bid is announced. One of the consequences of the introductionof electronic ‘trading platforms’ in recent years is that every trade thattakes place, its size, timing and other details is recorded and the recordscan be searched at almost zero cost and the information analysed anddisplayed in many different ways. Unusual patterns are easy to spot. Ifthere is suspicious trading behaviour, this may be an indication of‘insider trading’, meaning that someone inside the firms concerned isusing their privileged information to buy the shares (or more likely to tip-off someone else to buy the shares on their behalf). Spotting theunusual trading may be easy but proving abuse may be difficult.Remember that in Unit 5, we noted that the stronger forms of theefficient market hypothesis expected prices to have adjusted by the timea public announcement too place. And this is what event studies show.Prices cannot change unless trading takes place, so relying on timingalone to prove insider trading is usually insufficient.

4. Most securities markets require firms to make an immediate disclosureof a significant change in their trading position. In a recession, therefore,we can expect a number of ‘profit warnings’ and other statements of anegative kind. On the other hand, firms will be wanting to maintain aspositive an outlook as possible. Remember that a sharp fall in the shareprice may make the firm a target for a takeover. The regulator isconcerned that some of these negative announcements may not tell thewhole truth.

5. Rumours are unsubstantiated information. Nonetheless, since financialmarkets are very sensitive to ‘news’ of all kinds, rumours can moveprices. Rumours may start for all sorts of reasons and many will be quiteinnocent. But suppose that a firm wished to raise its share price, or aseller of stock who feared bad news in the future wanted to sell thestock now at a good price, they might think it worth spreading somegood news rumour. There may be a link here to the earlier paragraphthat mentions ‘short-selling’. Short-selling is a situation where investorsborrow and sell stock that they do not own, hoping that it wall fall inprice. They then buy at the lower price, return it to the owner andpocket the difference in price. In this case, short-sellers might betempted to spread negative rumours about the stock. Recall, though,that if the efficient market hypothesis holds, investors should not beeasily deceived by rumours.

Self-assessment questions1. Consider the arguments for and against self-regulation of financial

markets as opposed to statutory regulation.

2. Under what circumstances might regulation decrease rather than increasethe stability of an industry?

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3. Why is it thought that simple capital adequacy ratios are insufficient as abasis for supervising the activities of firms engaged in securities trading?

4 What have been the impacts on financial markets of: (a) internationalisa -tion of the markets; and (b) technological change?

5. Why might you expect the theories of regulation outlined under ‘Eco -nomic theories of regulation’ in section 9.1 to be critical of self-regulatoryarrangements?

Feedback on self-assessment questions1. Self-regulation is held to be more flexible and to be carried out by people

who understand the needs of the industry. They are, thus, held to be lesslikely to interfere with the efficient functioning of the industry. The coststo firms in the industry are likely to be much lower than with statutoryregulation. The problem with self-regulation is that it might be too light,leaving too large an element of risk for consumers and producers,particularly consumers. Self-regulation might also result in existingproducers using regulation to increase barriers to entry to the industry.

2. One possibility follows from the previous answer. Regulation givesparticipants a feeling of greater security. As individuals, they then takegreater risks, adding to the total riskiness of the system as a whole.Another possibility is that regulation greatly increases compliance costsand encourages people to avoid these costs by behaving illegally. Regula -tors seeking to tighten the rules and participants find new ways aroundthe regulations. It becomes difficult for consumers to know what theregulations are or who is following them.

3. The major concern has been with the speed with which positions inderivatives trading can change. This, together with the complexity ofderivatives trading, makes it very difficult to estimate the degree of riskfaced by financial institutions and hence to calculate the amount of capitalbanks should maintain to cover themselves against potential losses. Thisis particularly so in the case of market risk, the variation in return onassets that results from events that affect all assets. The 1988 BaselConcordat, which stressed static capital adequacy ratios, dealt only withspecific risk.

4. We should note initially that the word ‘globalisation’ has taken over from‘internationalisation’. We should also note that the ideas of globalisationand technological change are linked since one of the several causes ofglobalisation has been the great improvement in the speed and quality ofinternational communications.(a) Globalisation has allowed investors to gain from international port -

folio diversification and has increased the ability of firms, faced byincreased foreign exchange risk, to manage that risk. It has alsoincreased the ability of borrowers to raise funds in the currency andform that best suits their needs. On the other hand, globalisationcarries with it a loss of local knowledge, the possibility of crises inone country spreading to others, and increased problems in detect -ing wrongdoing. It has thus posed many problems for regulators. Itmay well, also, have increased even further the dominant positionof developed countries in relation to the Third World.

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(b) Technological change has led to screen-based trading in stockexchanges and in many derivatives markets. Improved informationsystems have allowed much easier and quicker transfer of price-sensitive information around the world. The greater ability to storeand analyse vast amounts of data has aided the development andpricing of complex new products. Technology has also dramaticallyaffected the way in which banks process and dispense payments andhas permitted the financial industry to become more efficient and tooffer its clients a better range of products and quality of service.Many operations have been moved to cheaper locations away fromexpensive financial centres. On the other hand, the introduction ofnew technology can be very expensive and a number of expensivemistakes have been made. Savings in a number of areas have beenpartially offset by an increased dependence on expensive IT staff.There has been considerable concern about issues of security andreliability of information. New technology has changed the balancebetween fixed and variable costs and, in so doing, has made marketshare more important. Together, globalisation and technologicalchange have increased the importance of size and contributed to theconsolidation of the industry through mergers and takeovers.

5. The approach taken in our original discussion is to see regulation as a‘good’ which agents wish to ‘consume’ because it brings them benefits ofsome sort. Thus they explain the presence of regulation by reference tobenefits or advantages that it brings to the regulated. These often takethe form of barriers to entry (since one can only enter by meeting therequirements of the regulator). For those who are already in the industry,the higher the barriers (the more regulation) the better. Having excludedpotential rivals, the next step is to ensure that the regulations do notdisturb the smooth running of the business. This can be achieved by‘regulatory capture’ – ensuring that the regulator is sympathetic to therequirements of the regulated. The theories outlined see regulatorycapture as widespread and it is particularly likely to happen in connectionwith self-regulation since the regulators are drawn from the regulatedfirms and may well intend to work again in the regulated firms. Theyhave a strong incentive to remain on good terms with the firms theyregulate.

SummaryIn this unit we look at the case for regulating financial markets and at differentapproaches adopted in different jurisdictions.

On completing this unit, you should be able to:

■ identify the need for regulation as a result of market failure

■ identify information as the principle source of financial market failure

■ distinguish between ‘public interest’ and ‘self-interest’ approaches toregulation

■ be able to show why regulation acts as a tax

■ distinguish different approaches to market regulation in the USA, UK andEU

■ understand how globalisation presents major challenges for regulators.

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2008 financial crisis 187

ABS see asset-backed securitiesabsent coping mechanisms 188–9, 190absolute purchasing power parity 147–8accounting, regulation 216accrued interest 49–50, 61–2acquisitions, regulation 211, 217–18,

219–20adjustable peg system 175, 176–7,

191–2adverse selection 196–7, 198aggregate trade studies 162allocative efficiency 97–8American options 134anchor currency 171arbitrage

efficient market hypothesis 116–17, 121, 122–3

foreign exchange markets 130–1, 138, 142, 157–9, 164, 165

money market users 36Asian economies 177–80asset-backed securities (ABS) 43assets, company shares 82, 83asymmetric information, regulation 7,

196–8asymmetric shock 184, 189at the money options 135

Banking Act (1987) 211–12Bank for International Settlements (BIS)

125–6, 216Bank of Japan 39, 40Bank Of England 35, 36–7Basel Capital Accord 206Basel capital adequacy 202–8, 221Basel Committee 205–6, 216Basel I & II 206–7, 209basis points 25behavioural finance 114–21best practice principles 216beta coefficients 84–6, 90–2, 93bid-ask spread 11bills 26–30, 33–4, 37–40BIS see Bank for International

Settlementsbonds

bond spreads 189–91capital markets 42–64expectations hypothesis 54–6financial system end users 6fixed interest securities 42–64interest rates 44–6, 50–60, 62–4liquidity premia 54market segmentation 56–7market trading arrangements

58–62maturity 51, 61–2, 65period to maturity 65price elasticity 52–8, 61–4pricing 32–3, 37–8, 44–58, 61–5spreads 189–91trading arrangements 58–62users 58–62yields 32–3, 37–8, 44–6, 50–2, 54,

56–8, 63–4booms and crashes 108–10, 117–21borrowing 5–7, 9–14, 58BP share prices 70–1Bretton Woods 175–80, 191–3Bretton Woods II 177–80, 191–3BRIC countries 111bubbles 108–10, 119–20

call options 134–7, 141Canadian dollar 162–4capital account 149–50capital adequacy 202–8, 221capital asset pricing model (CAPM)

82–6, 91–3capital costs 17–18capital markets 41–95

bonds 42–64company shares 66–95efficient market hypothesis 117–21financial systems 4fixed interest securities 42–64money markets 24, 38, 39

capital ratio 202–5, 221capital requirements 201CAPM see capital asset pricing modelCD see certificates of depositCDO see collateralised debt obligationscentral banks

exchange rate systems 171–5

Index

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foreign exchange markets 138, 157money market users 34–8

certificates of deposit (CD) 30–2, 37–40chartism 72, 78–81China 111–12, 177–80clean price 48, 49–50cointegration analysis 162collateralised debt obligations (CDO) 43collateralised loans 32–3commercial banks 35–6common stock 67company shares 73, 81–6, 90–5

beta coefficients 84–6, 90–2, 93capital asset pricing model 82–6,

91–3capital markets 66–95characteristics 67–8data 68–72discounting 72–3, 75–6, 81–2dividends 72–6, 90–2, 94–5earnings/price ratios 69, 75–6, 91,

92equity 67, 87, 89–90interest rates 82, 91–3market capitalisation 88, 91, 92portfolios 82–3, 87–8, 91, 93price/earnings ratios 69, 75–6, 91,

92pricing 68–81, 89–90quote-driven markets 87, 92–4rate of return 73, 81–6, 90–3returns 73, 81–6, 90–3risk 81–6trading 86–91, 92–4types 67–8uses 67–8

competitive laxity 211conservatism 116constant growth models 73, 75, 94contagion issues 8–9contract costs 9convergence requirements 184–5convertible bonds 42convertible preferred shares 68corporate bond data 44–6corridor systems 35, 36costs

economic development 17–18financial systems 9–10, 17–18monetary unions 187–91reduction 10–11

coupon payments 47–9

coupon rates 42–3, 62, 63coupons 42–3, 47–9, 63, 64crashes 108–10, 117–21crisis of 2008 187cross rates 128, 142cross-subsidisation 201–2cumulative preferred shares 68currency

board 186regimes 186–7unions 181–2, 187–93see also foreign exchange markets

datacompany shares 68–72fixed interest securities 44–6foreign exchange markets 125–8

daylight-savings-time arrangement 189Debt Management Office (DMO) 59deep discount bonds 42delegation 119demand frameworks

bond market users 59–60company share trading 89–90pricing money market instruments

33–4deposit

certificates of deposit 30–2, 37–40contracts 29–30financial institutions 3

Depository Institutions Deregulationand Monetary Control Act (1980)209

depreciation 171–2derivatives

financial systems 5foreign exchange markets 128–44regulation 202–8, 221

devaluations 175Directives 214–15direct quotations 127dirty price 48, 49–50, 61–2discount/discounting

bonds 42company shares 72–3, 75–6, 81–2fixed interest securities 47–8foreign exchange markets 129–30money market instruments 24–5,

27–8, 38, 39diversification 82, 83dividends 72–6, 90–2, 94–5

see also returns

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DMO see Debt Management Officedollarisation 186domestic currency 125Dornbusch overshooting hypothesis

150–3, 155dot.com boom/bust 110, 119–20downgrading 60–1duration, bond price elasticity 52–8,

61–2, 63, 64Dutch tulip mania 108

earnings/price ratios 69, 75–6, 91, 92ECB see European Central Bankeconomic growth 13–20, 21economic risk 138, 161economic theory in regulation 201–5,

221–2economy

financial systems 13–20, 21market efficiency 13–16money markets 39, 40

efficiencyinformational efficiency 15–17,

97–114operational efficiency 13–14, 97–8

efficient market hypothesis (EMH) 16,96–123

allocative efficiency 97–8arbitrage 116–17, 121, 122–3basis 97–105behavioural finance 114–21booms and crashes 108–10,

117–21bubbles 108–10, 119–20capital markets 117–21crashes 108–10, 117–21dot.com boom/bust 110, 119–20failure of arbitrage 116–17forecasting 99–101growth strategies 105–8heuristics 115–16implications 105–8informational efficiency 97–114insider trading 102–3market rationality 104–5mis-pricing 115–16, 118–21momentum 118, 120operational efficiency 97–8optimal forecast 99–101pricing 103–5, 110–16, 118–22principal-agent investment 118–19,

120

rationality 118–19, 120science-based theory 118semi-strong efficiency 101, 104–8,

112–13, 121–2shares 106–8strong efficiency 101, 104–5, 107,

113–14testing 112–14unified theory of finance 118weak efficiency 101, 110–12yields 103–5

elasticity of bond prices 52–8, 61–4electronic data sources 68, 69–70EMH see efficient market hypothesisempirical testing 18EMU see European Monetary Unionendogenous money supplies 35end users

financial systems 5–7foreign exchange markets 137, 157

enforcement costs 9equity

company shares 67, 87, 89–90efficient market hypothesis 105–8

ERM see Exchange Rate MechanismEU see European Unioneuro-dollar exchange rates 155Euronet exchange 87, 88European Central Bank (ECB) 7, 35,

156, 189–93European Financial Common Market

213European Monetary Union (EMU) 170,

181–5European options 134European Union (EU) regulations

212–15euros 187–91evidence interpretations, foreign

exchange markets 154–7Exchange Rate Mechanism (ERM),

exchange rate systems 183, 185exchange rates 169–93

adjustable peg system 175, 176–7, 191–2

anchor currency 171arbitrage 157–9asymmetric shock 184, 189Bretton Woods 175–80, 191–3Bretton Woods II 177–80, 191–3central banks 171–5currency board 186

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currency regimes 186–7currency unions 180–2, 187–93depreciation 171–2determination 146–57dollarisation 186European Monetary Union 170,

181–5exchange rate targeting 185–6fixed exchange rates 170–80flexibility 184floating exchange rates 170–80Government intervention 171–3interest rates 173–87, 189, 191–3International Monetary Fund

175–6, 190monetary policy 172–3, 187monetary unions 181–2, 187–93optimal currency area 181–2,

191–2other currency systems 185–91seignorage 186shocks 184, 186, 189–90symmetric economic shock 189–90targeting 185–6theory 170–3Triffin dilemma/paradox 177,

191–2variability 161–4see also foreign exchange markets

exchange-traded products 132–4expectations, foreign exchange markets

149–50expectations hypothesis 54–6expected returns 81–6externalities, regulation 199–201

failure of arbitrage 116–17fair game 106fallibility 114FDIC see Federal Deposit Insurance

CompanyFederal Deposit Insurance Company

(FDIC) 209Federal Reserve 35financial crisis of 2008 187Financial Industry Regulation Authority

(FINRA) 210–11financial institutions 2–3financial intermediaries 6–7financial markets and financial systems

3–5, 10–12financial regulation 194–222

see also regulationFinancial Services Act (1986) 211Financial Services Authority (FSA) 211,

217, 219financial systems 1–22

borrowing 5–7, 9–14characteristics 2–9costs 9–10, 17–18economic growth 13–20, 21end users 5–7financial institutions 2–3financial markets 3–5, 10–12lending 5–7, 9–14liquidity 10, 11–12real economy 13–20, 21regulation 7–9, 17, 20risk 8–10, 11–12, 20secondary markets 10–12, 20, 21

FINRA see Financial IndustryRegulation Authority

Fisher hypothesis 149fixed exchange rates

advantages 170–80central banks 174–5gold standard 173–5in practice 173–80theory 170–3

fixed interest securities 42–64bonds 42–64characteristics 42–3coupons 42–3, 47–9, 63, 64interest rates 44–6, 50–60, 62–4pricing 44–58, 62–3returns 44–6, 50–2uses 42–3yields 44–6, 50–2, 54, 56–8, 63–4

flexibility, exchange rates 184floating exchange rates

advantages 170–80Bretton Woods II 177–80theory 170–3

floating rate notes (FRN) 42fluctuations in foreign exchange markets

145–68forecasting 99–101foreign exchange markets 127–37,

138–44American options 134arbitrage 130–1, 138, 142, 157–9,

164, 165at the money options 135call options 134–7, 141

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Canadian dollar 162–4capital account 149–50central banks 138, 157cross rates 128, 142data 125–8derivatives 128–44discounting 129–30end users 137, 157European options 134evidence interpretations 154–7exchange rate arbitrage 157–9exchange rate determination

146–57exchange rate variability 161–4exchange-traded products 132–4expectations 149–50fluctuations 145–68forward rates 128–37forwards 125, 128–37, 139,

142–3, 164, 166–8futures 132–4, 139–40, 142–3hedging 138–41, 161, 164, 165inflation 147–8, 155influencing factors 145–68instruments 124–44interest rate parity condition 131,

159interest rates 149–50, 155, 159,

164in the money options 135–6long positions 141, 164, 165loonie Canadian dollar 162–4margins 133–4market makers 137, 157moral hazard 143–4options 132, 134–7, 139, 142–3out of the money options 135–6overshooting 150–3, 155premia 129–30, 137pricing 127–37profits 158–9purchasing power parity 147–8,

150–1put options 134–7random walks 153risk 138–43, 145, 161–4, 166–8riskless arbitrage 130–1speculation 157, 159–60, 164,

165–6spot markets 164, 166–8spot rates 125, 127–8, 129, 139spread 127

testing 155–6transaction data 125–8using derivatives 137–41yen 139–41see also exchange rates

forex markets see foreign exchangemarkets

forwards 125, 128–37, 139, 142–3,164, 166–8

fractional reserve ratios 35free markets 175–80FRN see floating rate notesFSA see Financial Services AuthorityFTSE-100 index 70–1, 109functions of money markets 23–40fundamental analysis 72–8, 80–1futures 132–4, 139–40, 142–3

gaps 125GATT see General Agreement on Tariff

and TradeGDP see Gross Domestic ProductGEMMS see Gilt Edge Market MakersGeneral Agreement on Tariff and Trade

(GATT) 176Germany 183–4gilt bonds 32–3, 37–8Gilt Edge Market Makers (GEMMS) 58Glass-Steagall Act (1933) 209globalisation and regulation 215–20,

221–2gold quotas 176gold standard 173–5goods markets 152–3Gordon's growth model 73, 75, 94Governing Council 35Government

exchange rate systems 171–3foreign exchange markets 162regulation 208–12

government bondsfinancial system end users 6fixed interest securities 46market users 59pricing yield instruments 32–3,

37–8Gramm-Leach-Bliley Act (1999) 209Greece 45–6, 187–8, 190Gross Domestic Product (GDP) 215growth

efficient market hypothesis 105–8market efficiency 13–14

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pricing company shares 73, 75, 94

half-coupons 62, 63head and shoulders patterns 80hedging 138–41, 161, 164, 165heuristics 115–16

IAS see International AccountingStandards

IFRS see International FinancialReporting Standards

illiquidity 10IMF see International Monetary FundIndia 177indirect quotations 127industry-specific studies 162industry stability 213, 220–1inflation

exchange rate systems 187fixed interest securities 63foreign exchange markets 147–8,

155money markets 39, 40

information abuse 218informational efficiency 15–16, 97–114initial maturity 24in the money options 135–6insider trading 102–3, 198insolvency 110instruments

foreign exchange markets 124–44money markets 24–34, 37–40

interbank deposits 28–32interest elasticity 52–8interest rates

bonds 44–6, 50–60, 62–4company shares 82, 91–3duration 57–8exchange rate systems 173–87,

189, 191–3fixed interest securities 44–6,

50–60, 62–4foreign exchange markets 131,

140, 149–50, 155, 159, 164money market instruments 24–5,

28, 37–40parity condition 131, 159risk and duration 57–8term structure 52–8

interest yields 50–2intermediaries 6–7International Accounting Standards

(IAS) 216

International Financial ReportingStandards (IFRS) 216

international Fisher hypothesis 149internationalisation 215–16, 221–2International Monetary Fund (IMF)

175–6, 190, 216interstate transfers 188–9, 190intrinsic value 135investment 13–14, 17–20Ireland 189–91

Japan 39, 40, 139–41jurisdictions and financial regulation

194–222

labour markets 152–3Lamfalussy process 213–15lending 5–7, 9–14, 58liberalisation

Bretton Woods 176, 177–80regulation 213, 215

LIBOR see London Interbank OfferRate

liquidity 10, 11–12, 54Lisbon Strategy 213loans 32–3London Equity Market 87London Interbank Offer Rate (LIBOR)

29, 36, 37–8London Stock Exchange 59long positions 141, 164, 165long-term markets 4, 20loonie Canadian dollar 162–4losses 141

margins 133–4market abuse 214, 217–20market capitalisation 88, 91, 92Market Conduct team 219market efficiency 13–16, 20, 21market failure 195–201, 217–20market makers

bond market users 58company share trading 86–7cost reduction 11foreign exchange markets 137, 157

market optimism 208market rationality 104–5market regulation see regulationmarket risk 82–5market rumours 218–19markets

cost reduction 10–11

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liquidity 11–12risk 11–12

market segmentation 56–7Markets in Financial Instruments

Directive (MiFID) 214Market Watch 30 219master agreements 216maturity

bonds 51, 61–2, 65financial systems 4money market instruments 24yields 51, 61–2

membership of exchanges 201mergers and acquisitions 211, 217–18,

219–20MFI see monetary financial institutionsMiFID see Markets in Financial

Instruments Directivemis-pricing 115–16, 118–21momentum, efficient market hypothesis

118, 120monetary financial institutions (MFI) 3monetary policy 172–3, 187Monetary Policy Committee (MPC) 35,

36–7monetary unions 181–2, 187–93money markets 23–40

Bank of Japan 39, 40capital markets 24, 38, 39characteristics of instruments 24–5financial systems 4functions 23–40instruments 24–34, 37–40operations 23–40pricing of instruments 25–34,

37–40users 34–8uses of instruments 24–5

moral hazard 143–4, 196, 197–8moving averages 79MPC see Monetary Policy Committeemyopia and financial regulation 200–1

NASDAQ market 88National Association of Securities’

Dealers (NASD) 211need for financial regulation 195–205New York Stock Exchange (NYSE) 87,

88Nice Treaty 213nominal convergence 185NYSE see New York Stock Exchange

obligations 134OCA see optimal currency areaOpen Market Committee 35operational efficiency 13–14, 97–8operations, money markets 23–40optimal currency area (OCA) 181–2,

191–2optimal forecast 99–101options 132, 134–7, 139, 142–3order-driven markets 87ordinary company shares 67out of the money options 135–6over the counter transactions 29overshooting 150–3, 155

Panel on Takeovers and Mergers 211PD see Prospectus Directivepeg systems 175, 176–7, 191–2period to maturity 65policy rates 37–8portfolios 82–3, 87–8, 91, 93PPP see purchasing power paritypreferred shares 67, 68premia 129–30, 137price/earnings ratios 69, 75–6, 91, 92price elasticity 52–8, 61–4prices/pricing

bonds 32–3, 37–8, 44–58, 61–5company shares 68–81, 89–90discount instruments 24–5, 27–8,

38, 39efficient market hypothesis 103–5,

110–16, 118–22fixed interest securities 44–58,

62–3foreign exchange markets 127–37money market instruments 25–34,

37–40yield instruments 24–5, 28–33,

37–40primary currency 127primary markets

bond market users 58–9company share trading 87financial systems 10pricing money market instruments

33–4principal-agent investment 118–19, 120printed data sources 68–9profits 158–9, 218–20Prospectus Directive (PD) 214purchasing power parity (PPP) 147–8,

150–1

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put options 134–7

quotations 127quote-driven markets 87, 92–4

random walks 153rate of interest see interest ratesrate of return 73, 81–6, 90–3rationality 118–19, 120real economy 13–20, 21recessions 63redemption yields 51regulation 199–201, 215–20

acquisitions 211, 217–18, 219–20asymmetric information 7, 196–8Bretton Woods 175–80, 191–3capital adequacy rules 202–8, 221capital ratio 202–5, 221derivatives 202–8, 221economic theories 201–5, 221–2European Union 212–15financial markets 194–222financial systems 7–9, 17, 20globalisation 215–20, 221–2Government 208–12internationalisation 215–16, 221–2

Lamfalussy process 213–15liberalisation 213, 215market abuse 214, 217–20market failure 195–201, 217–20mergers and acquisitions 211,

217–18, 219–20need for 195–205regulatory capture 202, 211risk 196–8, 216–17rumour issues 218–20self-regulation issues 208, 211,

220–2taxes 202–5United Kingdom 211–12United States of America 208–11

relative purchasing power parity 147–8repo deals 32–3, 37, 39, 40representiveness, efficient market

hypothesis 116repurchase agreements 32–3, 37, 39, 40reputational issues 77–8reserves/reserve ratios 35residual maturity 24, 42resource allocation 15–16returns

company shares 73, 81–6, 90–5

economic development 17–20fixed interest securities 44–6, 50–2pricing money market instruments

26–30Revived Bretton Woods 177–80, 191–3risk

asymmetric information 196–8company shares 81–6contagion 8–9financial systems 8–10, 11–12, 20foreign exchange markets 138–44,

145, 161–4, 166–8free bonds 52free interest rates 91markets 11–12premium 43regulation 196–8, 216–17risk-adjusted assets 202–5riskless arbitrage 130–1

rumour issues 218–20

Sarbanes-Oxley Act (2002) 210science-based, unified theory of finance

118SEA see Single European Act (SEA)search costs 9, 10–11SE Asian economies 177–80SEC see Securities and Exchange

Commissionsecondary currency 127secondary markets

bond market users 58–9company share trading 87, 88–9financial systems 10–12, 20, 21liquidity and risk 11–12pricing money market instruments

33–4Securities and Exchange Commission

(SEC) 209–11Securities and Investment Board (SIB)

211securitised loans 32–3security 15–16, 98–105seignorage 186self-regulation issues 208, 211, 220–2semi-strong efficiency 101, 104–8,

112–13, 121–2sensitivity of bond prices 65shareholders 66–95shares

economic development 17–20efficient market hypothesis 106–8

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market efficiency 15–16, 20, 21regulatory authorities 8–9see also company shares

shocks 184, 186, 189–90short selling 218short-term markets 4, 20SIB see Securities and Investment Boardsimple yield to maturity 51, 61–2Single European Act (SEA) (1986) 213South Sea Bubble 108–9sovereign debt 45–6sovereign risk 163Spain 189–91specific risk 82–3speculation/speculators 138, 157, 159–

60, 164, 165–6spot markets 164, 166–8spot rates 125, 127–8, 129, 139spot transactions 125spreads

bonds 189–91cost reduction 11foreign exchange markets 127

standard deviation 81–2Sterling-Dollar exchange rate 154stock exchanges 59, 87stock markets 11–12, 86–91strikes 76strips 42strong efficiency 101, 104–5, 107,

113–14Subprime Crisis 187subsidisation 201–2supply and demand

bond market users 59–60company shares 89–90pricing money market instruments

33–4swaps 125Swiss National Bank/Swiss Franc 163,

164symmetric economic shock 189–90

takeovers 105–6, 211taxes, regulation 202–5TD see Transparency Directivetechnical analysis 72, 78–81technological changes and globalisation

215–16, 221–2term structure, interest rates 52–8testing

economic development 18

efficient market hypothesis 112–14foreign exchange markets 155–6

theoryeconomic theory in regulation

201–5, 221–2exchange rate systems 170–3unified theory of finance 118

three-point foreign exchange arbitrage158–9, 164, 165

time value 135trading

bond markets 58–62company shares 86–91, 92–4foreign exchange markets 126

transaction costs 9–10transaction data 125–8transaction risk 138, 161translation risk 138, 161Transparency Directive (TD) 214–15Treasury 6.25 2010 46treasury bills 26–30, 33–4, 37–40Triffin dilemma/paradox 177, 191–2two-point arbitrage 158–9

UK see United Kingdomultimate borrowers/lenders 5–7, 58unified theory of finance 118United Kingdom (UK)

bond market users 59money markets 26–30, 33–4, 35,

37–40pricing money market instruments

26–30, 33–4, 37–40regulation 211–12treasury bills 26–30, 33–4, 37–40

United States of America (USA)Bretton Woods 175–80, 191–3exchange rate systems 171,

174–83, 188, 191–3money markets 35regulation 208–11

unlimited losses 141USA see United States of Americausers/uses

bond markets 58–62fixed interest securities 42–3foreign exchange derivatives

137–41money markets 34–8

vanilla bonds 42–3variance in company shares 81–2

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weak efficiency 101, 110–12weighted averages 53, 93Werner Committee 183World Bank 176, 216World Trade Organisation 176

yen 39, 40, 139–41yields

bonds 32–3, 37–8, 44–6, 50–2, 54,56–8, 63–4

efficient market hypothesis 103–5fixed interest securities 44–6, 50–2,

54, 56–8, 63–4money market instruments 24–5,

28–33, 37–40yield to maturity 51, 61–2

zero coupon bonds 42

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