list of tables list of figures list of boxes acknowledgements resources … · · 2013-11-061.7...

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CONTENTSList of Tables xvi

List of Figures xix

List of Boxes xxii

Preface xxiii

Acknowledgements xxvi

1 Th e World of Finance 1 1.1 Introduction 3 1.2 Financial centres 4 1.3 Th e role of a fi nancial centre 4 1.4 Money markets, capital markets and the banking system 6 1.5 Services of a fi nancial centre 8 1.6 Th e growth of the fi nancial services industry 11 1.7 Th e globalization of fi nancial markets 11 1.8 Technology 12 1.9 Deregulation 13 1.10 Financial innovation 15 1.11 Types of fi nancial innovations 17 1.12 Emerging markets 17 1.13 Problems concerning investment in emerging markets 20 1.14 Th e future 21 1.15 Conclusions 23

2 Financial Intermediation and Financial Markets 25 2.1 Introduction 27 2.2 Surplus and defi cit agents 27 2.3 What is a fi nancial security? 28 2.4 Types of fi nancial claims: debt and equity 28 2.5 Th e role of fi nancial intermediaries 30 2.6 Provision of a payments mechanism 30 2.7 Maturity transformation 30 2.8 Risk transformation 31 2.9 Liquidity provision 32

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2.10 Reduction of contracting, search and information costs 32 2.11 Types of fi nancial markets 33 2.12 Th e classifi cation of fi nancial markets 35 2.13 Th e role played by fi nancial markets 36 2.14 Participants in fi nancial markets 37 2.15 Conclusions 38

3 Financial Institutions 41 3.1 Introduction 43 3.2 Th e central bank 43 3.3 Th e implementation of monetary policy 44 3.4 Management of the national debt 44 3.5 Supervisory function 44 3.6 Types of fi nancial intermediaries 46 3.7 Deposit institutions 46 3.8 Th e banking sector 47 3.9 Savings institutions 47 3.10 Insurance companies 50 3.11 Th e phenomenon of Bancassurance 51 3.12 Mutual funds or unit trusts 52 3.13 Investment companies and investment trusts 53 3.14 Exchange traded funds 54 3.15 Pension funds 56 3.16 Hedge funds 57 3.17 Private equity 59 3.18 Specialist fi nancial institutions 61 3.19 Venture capital companies 61 3.20 Finance companies or fi nance houses 62 3.21 Factoring agencies 63 3.22 Th e role of fi nancial institutions 63 3.23 Conclusions 66

4 Monetary Policy and Interest Rate Determination 69 4.1 Introduction 71 4.2 Th e functions of money 71 4.3 Bills and bonds 72 4.4 Th e operation of monetary policy 73 4.5 Monetary policy in practice and the announcement eff ect 76 4.6 Th e commercial banking system and the narrow and broad

money supply 78 4.7 Formula for the money multiplier 80 4.8 Controlling the money supply 82 4.9 Th e determination of interest rates 82 4.10 Th e loanable funds approach to interest rate determination 84 4.11 Money market or loanable funds theory? 86 4.12 Infl ation and interest rates 87

C O N T E N T S ix

4.13 Fiscal policy and interest rates 89 4.14 Other factors infl uencing the interest rate 90 4.15 Th eories of the yield curve 90 4.16 Expectations theory 91 4.17 Liquidity preference theory 93 4.18 Preferred habitat theory 94 4.19 Market segmentation theory 94 4.20 Th e importance of alternative views of the term structure 95 4.21 Problems with monetary policy 96 4.22 Conclusions 96

5 Domestic and International Money Markets 99 5.1 Introduction 101 5.2 Types of domestic money market instruments 101 5.3 Treasury bills 101 5.4 Commercial paper 103 5.5 Th e interbank market 103 5.6 Banker’s acceptances 104 5.7 Repurchase agreements 105 5.8 Certifi cates of deposit 105 5.9 Th e international money market 105 5.10 Euromarkets 106 5.11 Th e origins and development of the Euromarkets 106 5.12 Th e characteristics of the Eurodollar market 108 5.13 Th e competitive advantage of Eurobanks 110 5.14 Th e coexistence of domestic and Eurobanking 111 5.15 Th e creation of Eurodeposits 111 5.16 Th e pros and cons of the Eurocurrency markets 112 5.17 Syndicated loans 113 5.18 Euronotes 113 5.19 Conclusions 114

6 Th e Domestic and International Bond Market 117 6.1 Introduction 119 6.2 Trading in government bonds 119 6.3 Determining the price of government bonds 119 6.4 Clean and dirty bond prices 121 6.5 Th e current yield 121 6.6 Th e simple yield to maturity 122 6.7 Yield to maturity 122 6.8 Th e par value relation 124 6.9 Bond price volatility 124 6.10 Duration 125 6.11 Modifi ed duration 126 6.12 Th e duration for a portfolio of bonds 128 6.13 A formula to calculate duration 129

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6.14 Duration and the problem of curvature of the bond–price relationship 129

6.15 Th e usefulness of the duration measure 130 6.16 Yield curves 131 6.17 Corporate bonds 131 6.18 Credit ratings 132 6.19 Risks associated with corporate bonds 136 6.20 Financial innovation and corporate bonds 137 6.21 Junk bonds 138 6.22 Medium-term notes 139 6.23 Th e international capital market 140 6.24 Motivations behind international capital fl ows 140 6.25 Th e origins and development of the Eurobond market 141 6.26 Typical features of a Eurobond 141 6.27 Control and regulation of the Eurobond market 144 6.28 Th e management of a Eurobond issue 145 6.29 Innovations in the Eurobond market 146 6.30 Conclusions 147

7 Portfolio Analysis: Risk and Return in Financial Markets 151 7.1 Introduction 153 7.2 Determining the price of a fi nancial asset 153 7.3 Th e rate of return on a security 154 7.4 Th e variance and standard deviation of the rate of return 155 7.5 Risk on a security 156 7.6 Covariance and correlation of rates of return 157 7.7 Diff erent types of investors 158 7.8 Th e indiff erence curves of risk-averse investors 159 7.9 Portfolio theory 160 7.10 Reducing risk through diversifi cation 160 7.11 Measuring risk on a portfolio 161 7.12 Th e two-asset effi ciency frontier 163 7.13 Th e minimum variance portfolio in the two risky asset case 165 7.14 Th e portfolio effi ciency frontier 166 7.15 Market risk and specifi c risk 168 7.16 Th e effi cient set with a riskless security 170 7.17 Th e market portfolio 172 7.18 Th e market price of risk 173 7.19 Measuring the market index 174 7.20 Conclusions 174

8 Th e Capital Asset Pricing Model 177 8.1 Introduction 179 8.2 Th e market model 179 8.3 Portfolio risk and return using the market model 181 8.4 Th e capital asset pricing model 182

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8.5 Assumptions of the CAPM 182 8.6 Th e theory behind the CAPM 183 8.7 Expressing the CAPM in risk premium form 186 8.8 Th e securities market line 186 8.9 Th e CAPM in action: measuring the beta coeffi cient 189 8.10 Empirical testing of the CAPM 191 8.11 Th e empirical evidence on the CAPM 195 8.12 Th e multifactor CAPM 196 8.13 Th e arbitrage pricing theory (APT) critique of the CAPM 197 8.14 Conclusions 198

9 Stockmarkets and Equities 203 9.1 Introduction 205 9.2 Th e major international stockmarkets 205 9.3 Stockmarket participants 207 9.4 Th e primary and secondary market 207 9.5 Diff erent types of equity 208 9.6 Th e buying and selling of shares 211 9.7 A rights issue 211 9.8 A simple model of the pricing of a rights issue 214 9.9 Does the performance of the stockmarket matter? 214 9.10 Th e pricing of equities 215 9.11 Th e dividend pricing approach 216 9.12 Th e Gordon growth model 216 9.13 A non-constant growth version of the dividend discount model 218 9.14 Th e dividend irrelevance theorem 219 9.15 Measurement of the required rate of return 220 9.16 Th e subjectivity of share pricing 221 9.17 Forecasting future dividends: business risk and the eff ects

of gearing 221 9.18 Debt or equity fi nance? 227 9.19 Other approaches to equity valuation: fi nancial ratio analysis 228 9.20 Th e usefulness of fi nancial ratios 232 9.21 Conclusions 232

10 Th e Effi ciency of Financial Markets 235 10.1 Introduction 237 10.2 Th ree levels of effi ciency 238 10.3 Th e effi cient market hypothesis and a random walk 238 10.4 Implications of various forms of effi ciency tests 240 10.5 Active versus passive fund management 241 10.6 Testing for weak market effi ciency 241 10.7 Tests of the random-walk hypothesis 241 10.8 Filter-rule tests 242 10.9 Other statistical tests 243 10.10 Th e day-of-the-week eff ect 243

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10.11 Th e January eff ect 243 10.12 Th e winner–loser problem 244 10.13 Testing for semi-strong market effi ciency 245 10.14 Th e results of event studies 250 10.15 Th e size eff ect 250 10.16 Th e price–earnings eff ect 250 10.17 Th e earnings-announcement eff ect 251 10.18 Stockmarket crashes 252 10.19 Testing the strong-form of market effi ciency 252 10.20 Directors’/managers’ share purchases 253 10.21 Information content of analysts’ forecasts 253 10.22 Conclusions 254

11 Th e Foreign Exchange Market 257 11.1 Introduction 259 11.2 Exchange rate defi nitions 260 11.3 Characteristics of and participants in the foreign exchange

market 260 11.4 Arbitrage in the foreign exchange market 264 11.5 Th e spot and forward exchange rates 265 11.6 A simple model for determining the spot exchange rate 265 11.7 Alternative exchange-rate regimes 268 11.8 Determination of the forward exchange rate 272 11.9 Nominal, real and eff ective exchange rates 279 11.10 Conclusions 285

12 Th eories of Exchange Rate Determination 287 12.1 Introduction 289 12.2 Purchasing power parity theory 289 12.3 Absolute PPP 290 12.4 Relative PPP 290 12.5 Measurement problems in testing for PPP 291 12.6 Empirical evidence on PPP 294 12.7 Summary of the empirical evidence on PPP 297 12.8 Explaining the poor performance of purchasing power parity 298 12.9 Modern theories of exchange rate determination 299 12.10 Uncovered interest rate parity 299 12.11 Monetary models of exchange rate determination 300 12.12 Th e fl exible-price monetary model 301 12.13 Th e Dornbusch sticky-price monetarist model 305 12.14 A simple explanation of the Dornbusch model 306 12.15 A formal explanation of the Dornbusch model 307 12.16 A money supply expansion and exchange rate overshooting 311 12.17 Importance of the Dornbusch overshooting model 313 12.18 Th e Frankel real interest rate diff erential model 313 12.19 Conclusions 315

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13 Financial Futures 319 13.1 Introduction 321 13.2 Th e growth of futures exchanges 321 13.3 Comparison between futures and forward contracts 322 13.4 Exchange-traded derivative contracts versus the

over-the-counter market 324 13.5 Trading in exchange futures contracts 324 13.6 Th e role of the clearing house 325 13.7 Open interest and reversing trades 325 13.8 Stock index futures 326 13.9 Th e symmetry of profi ts/losses on futures/forward positions 332 13.10 Th e pricing of stock index futures 334 13.11 Short-term interest rate futures 335 13.12 Th e pricing of a Euribor interest rate futures contract 337 13.13 Using interest rate futures 338 13.14 Bond futures contracts 339 13.15 Currency futures 340 13.16 Th e pricing of currency futures 342 13.17 Conclusions 343

14 Options 347 14.1 Introduction 349 14.2 Th e growth of options markets 349 14.3 Options contracts 350 14.4 A call option contract 351 14.5 A put option contract 353 14.6 Stock index options 354 14.7 Interest rate options 357 14.8 Currency options 358 14.9 Th e uses of option contracts 359 14.10 Diff erences between options and futures contracts 360 14.11 A currency option versus a forward contract for hedging 361 14.12 A currency option versus a forward contract for speculating 361 14.13 Option strategies 364 14.14 Exotic options 367 14.15 Conclusions 368

15 Option Pricing 371 15.1 Introduction 373 15.2 Principles of option pricing 373 15.3 Intrinsic value and time value 374 15.4 Th e distribution of the option premium between time and

intrinsic value 375 15.5 Th e Black–Scholes option pricing formula 379 15.6 Diff erent measures of volatility 383 15.7 Th e calculation of historical volatility 383

xiv C O N T E N T S

15.8 Problems with the Black–Scholes option pricing formula 386 15.9 Th e sensitivity of options prices 386 15.10 Put–call parity 387 15.11 Conclusions 389

16 Swap Markets 393 16.1 Introduction 395 16.2 Potential swap scenarios 395 16.3 An interest rate swap 398 16.4 A currency swap agreement 402 16.5 Th e role of the intermediary in the swap 405 16.6 Th e secondary market in swaps 407 16.7 Distinguishing characteristics of the swap market from

the forward and futures markets 408 16.8 Reasons for the existence of the swap market 408 16.9 Innovations in the swap market 409 16.10 Conclusions 410

17 Financial Innovation and the Credit Crunch 411 17.1 Introduction 412 17.2 Financial innovation: collateralized debt obligations and

credit default swaps 413 17.3 Special purpose vehicle/special purpose entity 416 17.4 A structured investment vehicle 417 17.5 Credit derivatives and credit default swaps 418 17.6 Th e pricing of credit derivatives 424 17.7 Th e credit crunch 427 17.8 Causes of the credit crunch 429 17.9 Legislative changes and deregulation 429 17.10 Deterioration in bank lending standards and adverse selection 432 17.11 Increase in household indebtedness 433 17.12 Financial innovation and the credit rating agencies 434 17.13 Increased leverage in the fi nancial system 434 17.14 Mispricing of risk 435 17.15 Incentive structures and risk management practices in

the banks 436 17.16 Th e response to the credit crunch 437 17.17 Cuts in offi cial short-term interest rates 440 17.18 Liquidity provision 441 17.19 Quantitative easing 442 17.20 Fiscal stimulus 443 17.21 Bailouts of fi nancial institutions 444 17.22 Conclusions 450

C O N T E N T S xv

18 Regulation of the Financial Sector 457 18.1 Introduction 459 18.2 Th e rationale for government intervention 459 18.3 Th e objectives of government regulation 461 18.4 Types of government regulation 461 18.5 Regulation of the banking sector 463 18.6 Statutory versus self-regulation 465 18.7 Regulation in the UK 465 18.8 Big bang, 1986 466 18.9 Th e Financial Services Act 1986 467 18.10 Th e Banking Act 1987 468 18.11 Th e Bank of England Act 1998 469 18.12 Financial Services and Markets Act 2000 469 18. 13 Banking Act 2009 469 18.14 European regulation 472 18.15 Th e First Banking Directive 1977 472 18.16 Th e Second Banking Directive 1989 473 18.17 International regulation: the Basel I Accord 1988 474 18.18 Th e Basel II Accord 2004 476 18.19 Issues for regulatory reform raised by the credit crunch 478 18.20 Conclusions 480

Glossary 483References 507Bibliography 510Index 513

1.1 Introduction

1.2 Financial centres

1.3 Th e role of a fi nancial centre

1.4 Money markets, capital markets and the banking system

1.5 Services of a fi nancial centre

1.6 Th e growth of the fi nancial services industry

1.7 Th e globalization of fi nancial markets

1.8 Technology

1.9 Deregulation

1.10 Financial innovation

1.11 Types of fi nancial innovations

1.12 Emerging markets

1.13 Problems concerning investment in emerging markets

1.14 Th e future

1.15 Conclusions

1THE WORLD OF FINANCE

Learning objectives

In this chapter you will learn about:

the various statistics on international fi nancial markets

the various forces for change in international fi nancial markets

the role of fi nancial centres such as London, New York and Tokyo

the globalization of fi nancial markets

the various types of fi nancial innovation

the growing importance of emerging markets

1.1 IntroductionTh e world of fi nance has changed beyond all recognition over the last few decades, and among the most important changes have been:

1 the so-called globalization of the world of fi nance with literally trillions of dollars swirling around the global fi nancial markets;

2 the unprecedented increase in the volume of funds and the size of the fi nancial services industry;

3 the growing institutionalization of markets with funds increasingly managed on behalf of individual investors by pension funds, unit trusts/mutual funds, insurance companies, hedge funds and the like;

4 the range of new instruments traded such as junk bonds, collateralized debt obligations (CDOs), credit default swaps (CDS) and derivative instruments such as futures, options and swaps;

5 the use of new technology;6 the development of the internet, enabling retail customers to access online

dealing, extensive information and banking services;7 increased pressures on banks as they have seen corporate lending fall

dramatically due to the development of new forms of corporate fi nance such as Eurobonds;

8 the trend towards deregulation of the fi nancial sector;9 the use of the Euro in fi nancial markets following the creation of a European

Monetary Union in January 1999 and its introduction at street level in January 2002;

10 the increased importance of so-called emerging markets and their economies; 11 the impact of the so-called ‘credit crunch’, which started on 9 August 2007 and

was ongoing in 2010, and its eff ect on the fi nancial sector which will take many years to become fully known.

Th ese changes have not taken place in isolation, rather they have fed off each other, and interacted in a dynamic self-reinforcing manner. Th e credit crunch mentioned in point 11 was the culmination of many years of debt build-up, deregulation, fi nancial innovation and other forces that were not fully understood by market participants.

In this opening chapter we attempt to give an overview of the world of fi nance. We look at some of the factors that have infl uenced the development of the fi nancial services industry from the 1980s up to the present. In particular we focus upon four factors: the globalization of fi nancial markets; the impact of technology; the deregulation of the fi nancial services industry and the importance of product

emerging market the market of a country which is experiencing rapid economic growth but whose income per capita usually makes it a low to middle income economy

F I N A N C E A N D F I N A N C I A L M A R K E T S

innovation. We then proceed to a brief look at the so-called emerging markets which are becoming more important to the global fi nancial system, and some of the issues and obstacles that these markets will have to tackle as they develop. Th e chapter concludes with a rather speculative gaze into the fi nancial crystal ball.

1.2 Financial centresMost developed countries of the world have a major fi nancial centre that meets much of the demand for fi nancial services of the domestic market, and these centres compete to various degrees for international business. Inter-market competition is on the increase. New York, London and Tokyo vie with each other for recognition as the foremost fi nancial centre. At the European level, London is the pre-eminent fi nancial centre but in some areas it faces healthy competition from Paris and Frankfurt. In Southeast Asia, although Tokyo is the dominant fi nancial centre it fi nds itself increasingly in competition with Shanghai, Singapore and Hong Kong. Qatar and Dubai have become important regional centres serving the specifi c needs of the Middle East region, and have begun to make an impact at the global level. Financial centres, whether major or relatively minor, increasingly fi nd themselves competing in a global marketplace, both to retain their domestic market and for international business. Many governments have sought to enhance the status of their fi nancial centres, especially since a competitive fi nancial centre can prove to be an important foreign exchange earner and provide employment for substantial numbers of people. A healthy fi nancial centre can also aid an economy by channelling investors’ funds into the best-performing investments and businesses.

1.3 Th e role of a fi nancial centreA fi nancial centre has a number of diverse and important roles to play. Perhaps the most important is to recycle funds from surplus to defi cit agents as effi ciently as possible. Th is process is illustrated in Figure 1.1 which shows surplus agents, made up of individuals, companies and public/private bodies including central government, with surplus funds that they wish to invest. On the other hand, there are individuals, companies and public/private bodies including central government that need to borrow money and do not have suffi cient current funds themselves. A key role of a fi nancial centre is to channel funds from the surplus agents to the defi cit agents in as effi cient a manner as possible. However, it must be recognized that there is an enormous amount of heterogeneity within the two groups. Agents with surplus funds vary enormously, with some individuals saving only for the short term, some for the long term, for retirement and the like. Similarly, companies with excess money balances might wish to invest only for the short run or in some cases for the long term. When it comes to the defi cit agents, their needs are again very varied, with some individuals requiring just short- or medium-term loans to solve a short-term cash problem, whereas others borrow long-term, for example by taking out a mortgage to fi nance a house purchase. Similarly, some companies need to borrow only short-term to iron out certain cash-fl ow problems, while others need to borrow long-term to undertake new investment.

1 T H E W O R L D O F F I N A N C E

One of the prime functions of a fi nancial centre is to facilitate the transfer of funds from surplus to defi cit agents. For this purpose, a fi nancial centre will have a range of what are known as fi nancial intermediaries that design products/securities to facilitate the exchange of funds between the surplus and defi cit agents. In designing such products/securities, fi nancial intermediaries must recognize that there are signifi cant problems to overcome. In general, surplus agents tend to be risk-averse, that is only willing to take increasing risks with their surplus funds so long as there is a suffi cient increase in expected return to compensate them for those risks. Because they are risk-averse, surplus agents tend to want to invest in fairly low-risk fi nancial instruments. Also, surplus agents in general have quite short-term time horizons and usually require the ability to access their funds at very short notice. By contrast, in general the defi cit agents frequently require funds to undertake risky ventures – for example, a company may borrow money to set up a new factory that may or may not succeed, an individual may borrow to set up a company that may or may not succeed. Also, the time frame of defi cit agents is typically longer than that of surplus agents, they require funds normally for the medium- to long-term time horizon. Th e heterogeneity within the two groups and the diff erent risk and time preferences of defi cit and surplus agents need to be somehow reconciled if there are to be economically signifi cant transfers of funds between the two groups. As we shall see in Chapter 3, there exists a wide range of fi nancial intermediaries with niches that try to meet the varying needs of both surplus and defi cit agents. In much of this book we shall also be looking at a range of fi nancial securities such as Treasury bills,

Figure 1.1 Th e role of a fi nancial centre

Interest, profits, dividends

capital gains/losses

funds loans

funds debtequity

Financial intermediaries

Financial securities

Surplus agentsHouseholds,companies,government

Deficit agentsHouseholds, companies,government

Notes:Surplus agents are generally risk-averse, with relatively short-term horizons. Deficit agents are generally risk-taking, with medium- to long-term horizons.

risk-averse an investor that will only take on increased risk if there is suffi cient prospective return to compensate


commercial bills, Treasury and corporate bonds and equities that exist to meet the varying risk–return and time preferences of both surplus and defi cit agents.

Today’s fi nancial centres are increasingly global, concerned not only with channelling funds from domestic savers to domestic borrowers but also from international investors to international borrowers. In transferring these funds a fi nancial centre must provide a range of products to meet investors’ and borrowers’ diverse demands at a competitive price. In addition, a fi nancial centre should provide a range of fi nancial services to meet the demands of investors, borrowers, fi rms, governments and households. Among the services most in demand are foreign exchange, risk management, insurance, swaps, secondary and primary markets in bonds and equities, domestic and international bank lending, a range of derivative instruments and research/advisory services.

1.4 Money markets, capital markets and the banking systemTh e transfer of funds in the fi nancial system is carried out by several means, three of the most important being money markets, capital markets (bond and equity markets) and the banking system. Th ere are considerable diff erences in the relative importance of these as a means of recycling funds between economic agents. In Table 1.1 we present the fi gures for stockmarket capitalization in July 2009, which shows the importance of the stockmarket particularly for the United States and the

Table 1.1 Global stockmarkets 2009 in US$ billions

StockmarketListings

Capitalization Domestic/Foreign

NYSE Euronext (US) 9,829 5,448/792

Tokyo 3,331 2,373/16

NASDAQ 2,812 2,714/294

London 2,416 2,399/673

NYSE Euronext (Europe) 2,196 1,013/0

Shanghai 2,724 244/2

Hong Kong 2,052 2,399/673

Deutsche Borse 1,195 742/90

BME Spanish Exchanges 1,211 3,517/40

Bombay Stock Exchange 1,072 4,925/0

National Stock Exchange India 1,004 1,405/0

World 40,555

Notes:Figures at at July 20091 Th e USA has two national exchanges: the New York Stock Exchange and the National Associa-

tion of Securities Dealers Automatic Quotations (NASDAQ). Th e NYSE Euronext took over the AMEX exchange in 2008.

2 Th e NYSE Euronext Europe is a merger of the Paris, Lisbon, Brussels and Amsterdam exchanges.

Source: World Federation of Exchanges

Risk management the process of identifying and reducing risks facing an institution or individual. Th e aim is to quantify the risks and take action to achieve a target risk–return trade-off

Capital market a market in which individuals and institutions trade fi nancial securities of greater than one year to maturity such as stocks and bonds


United Kingdom. In those economies there has been a long tradition of fi rms relying on stockmarkets as a source of fi nance. Th is is much less the case in countries like Germany and Japan which have tended to rely on their banking systems as a means of recycling fi nance.

Debts markets are another key means of defi cit agents raising fi nance through the issue of short-term debt instruments like Treasury and commercial bills (less than a year) or Treasury and corporate bonds (usually 1 to 30 years). As Table 1.2 shows, there are considerable diff erences in both the size of the debt markets and the balance between government and private-sector debt issuance. In the United States there is also huge use by corporations of the debt markets to raise fi nance. In Europe the corporate bond market is less developed and is much more extensively used by governments to fi nance their fi scal defi cits, and this has also been true of Japan where since the collapse of its bubble economy in the early 1990s the government has made frequent recourse to debt fi nance to prop up its economy.

Countries like Germany and Japan have traditionally relied on close relationships between their banking systems and corporations as a means of fi nancing their corporations, and banks have been allowed to have stakes in companies – a situation not normally allowed in the USA or the UK. As Table 1.3 shows, the Japanese banking system, despite Japan’s much smaller economy, has assets which are actually not far behind those of the US banking system. In fact, it can be seen that the US banking system’s assets are signifi cantly lower as a percentage of gross domestic product (GDP) compared to the other economies listed in Table 1.3. Interestingly, there is a signifi cant diff erence in the importance of the banking system in terms of GDP between the USA and the UK despite their similarities with respect to the importance of stockmarkets and debt securities.

Table 1.2 Global debt securities 2008 in US $billions

PublicPrivate

fi nancialPrivate

corporate Total debt

USA 7,888 13,819 2,914 24,622

Japan 9,113 1,197 767 11,077

Italy 1,780 1,055 427 3,262

France 1,437 1,160 324 2,921

Germany 1,364 929 300 2,593

Spain 540 543 663 1,746

UK 827 378 19 1,223

Canada 670 254 110 1,035

Belgium 373 144 36 553

Others 5,795 3,795 1,045 10,634

World 29,787 23,274 6,605 59,666

Source IFSL, Bank for International Settlements

bubble a rapid and substantial rise in equity prices that is not warranted by the economic fundamentals; it is ultimately followed by a dramatic price decline when the bubble bursts


1.5 Services of a fi nancial centreTo stake a claim to being a key international fi nancial centre, a centre should have some or all of the following characteristics and off er the following kinds of services:

Th ere should be a large number of both domestic and foreign banks, and the centre • should have a reasonable share of international bank lending.A substantial amount of foreign exchange business should be conducted.• Th ere should be a signifi cant off shore market; that is, deposit and lending markets • that deal in currencies diff erent from those of the fi nancial centre.Th e stockmarket should be well capitalized and off er investors a high degree of • liquidity.Th e centre should be a major market for corporate bond fi nance, be it with • domestic bond issues, foreign bond issues or Eurobond issues.Th ere should be a range of fi nancial institutions and associated services other than • commercial banks, such as merchant/investment banks, insurance companies, securities houses, brokers, accountancy fi rms, commercial law fi rms and consultancy services.Th e centre should have a signifi cant presence in derivative markets such as future • and forward contracts, options and swaps.

In Table 1.4 we present some comparative statistics on three key fi nancial centres of the world, namely London, New York and Tokyo, and, for comparative purposes, those of France and Germany. London diff ers from the other two key fi nancial centres in one very important respect: its claim to be a pre-eminent fi nancial centre is heavily dependent on international business. New York is supported in its claim of being a pre-eminent fi nancial centre by the huge size of the US economy, and Tokyo’s claim is similarly supported because Japan has the second largest global economy. Th ese two fi nancial centres are much more domestically oriented in their business than London. Th e international nature of the UK fi nancial sector is amply illustrated by the high number of foreign fi rms listed on the UK stockmarket (see Table 1.1), the large share

Table 1.3 Bank deposits 2005

Bank deposits($ billions)

Number of banks

Banking assets% GDP

USA 5,153 7,526 41.5

UK 4,555 335 206.9

Japan 4,442 1,771 98.0

Germany 3,071 2,344 109.9

France 1,519 318 71.4

Italy 1,159 784 65.8

Switzerland 926 337 252.3

Source: European Banking Federation, US Federal Reserve, Bank of Japan


of cross-border bank lending shown in Table 1.4 and its 70% share of international bond issues, that is bonds issued by foreign entities or denominated in a currency other than the domestic currency. In addition, London is by far the biggest centre for foreign exchange trading and for trading in over-the-counter derivative contracts, that is, non-exchange traded derivatives.

Table 1.5 shows that the insurance industry is also a signifi cant part of the fi nancial services sector, with the United States and Japan by far the largest markets followed by the UK. However, in terms of insurance premiums per capita, the UK is in fact a more signifi cant market with premiums per capita being signifi cantly lower in France, Germany and Italy. In Table 1.6 we can see that in terms of institutional funds under management, the US market is clearly a dominant player, with its pension funds and mutual funds of roughly equal signifi cance as institutional investors. By contrast, in Japan mutual funds are less signifi cant as institutional investors, while the insurance industry is more signifi cant. Table 1.6 shows that the balance of funds between these diff erent forms of institutional investors varies signifi cantly between countries. Table 1.7 presents some statistics on three of the key global derivatives markets, with the Chicago Mercantile Exchange being followed by Eurex and Korea Futures Exchange. NYSE Euronext-LIFFE exchange, a merger of the London, Amsterdam, Brussels, Lisbon and Paris exchanges, comes fourth in terms of volume of contracts traded annually.

Table 1.4 Th e importance of diff erent fi nancial centres (2007/8) (percentage shares)

UK USA Japan France Germany Others

Cross-border bank lending 18 8 8 8 11 47

Foreign equities turnover 22 67 – – 2 9

Derivatives turnover

Exchange traded 6 39 2 1 12 40

Over the counter 43 24 4 7 4 18

Marine insurance net premium income 20 10 11 6 8 45

International bonds secondary market 70 na na na na na

Foreign exchange 35 16 6 na na 43

Hedge fund assets 18 69 2 1 na 10

Private equity investment value 7 71 na 2 1 10

Securitization issuance 14 55 2 na 3 26

Notes: Mixture of 2007/2008 dataSource: IFSL, BIS

Over-the-counter derivatives ‘tailor made’ derivative contracts that are not traded on organized exchanges but between banks and other fi nancial institutions/dealers and with their clients


Table 1.5 World’s largest insurance markets in 2007

Gross insurance premiums

(in US$ billions) Premium per capitaWorld percentage

share

USA 1,230 $4,087 30.3

UK 464 $7,114 11.4

Japan 425 $3,320 10.5

France 269 $4,148 6.6

Germany 223 $2,662 5.5

Italy 142 $2,322 3.5

South Korea 117 $2,384 2.9

Others 1,191 na 29.3

World 4,061 $608 100.0

Source: Swiss Re

Table 1.6 Sources of global assets under management at the end of 2007

Pensions($billions)

Insurance($billions)

Mutual funds($billions)

Total($billions)

Share(%)

USA 17,205 6,324 12,012 35,541 48

Japan 3,161 2,862 945 6,968 9

UK 1,803 2,839 714 4,636 6

France 167 2,230 1,990 4,387 6

Germany 563 1,880 372 2,814 4

Netherlands 999 493 114 1,606 2

Switzerland 491 395 176 1,061 1

Other 4,463 2,813 9,877 17,153 23

World 28,228 19,836 26,200 74,264 100

Source: IFSL

Table 1.7 Derivative exchanges 2008, annual number of contracts traded in millions

Chicago Mercantile Exchange 3,278

Eurex 3,173

Korea Futures Exchange 2,865

NYSE Euronext-Liff e 1,674

CBOE Holdings 1,195

Notes:Eurex is a merger of the German and Swiss derivatives exchanges.NYSE Euronext includes NYSE Liff e markets in London, Amsterdam, Paris, Brussels and Lisbon.

Source: IFSL, Futures Industry Association


1.6 Th e growth of the fi nancial services industryTh e fi nancial services sector has expanded since the 1980s to become important both in terms of employment and as a percentage of GDP. In the UK, employment in the fi nancial services industry rose from 782,000 in 1981 to over one million in 2007. Not only that, but in 2008 it is estimated that the sector was a net exporter for the British economy to the tune of £43.3 billion and accounted for 7.6% of UK GDP. A number of infl uences have led to the rapid expansion of the fi nancial services industry since the 1980s, in particular the continued globalization of fi nance, the adoption and impact of new technology, government deregulation of fi nancial services, and an unprecedented amount of fi nancial innovation resulting in a range of new fi nancial instruments and products. Given that there were so many positive infl uences combining at the same time, and to a large extent feeding off each other, it is not surprising that the sector grew and changed so dramatically. We now briefl y examine some of the major forces for change since 1980.

1.7 Th e globalization of fi nancial marketsTh e term ‘globalization’ was one of the buzzwords that characterized the fi nancial services industry in the 1980s. In the modern world people communicate with one another almost instantaneously and at low cost, information is speedily disseminated, and governments have greatly reduced, and in many cases removed, controls on the movement of funds. Th e growth of international trade has outpaced the economic growth rates of most countries, making them more trade-dependent. In turn, these factors have stimulated the demand for trade-fi nance products, such as foreign exchange management and borrowing and lending facilities in foreign countries and currencies. Th e breakdown of the Bretton Woods system of pegged exchange rates in the early 1970s made currencies more volatile both in the short and medium term. At the same time businesses have become more global and so too have international investors who have sought the benefi ts of international portfolio diversifi cation. All these factors have contributed to the phenomenon of the ‘globalization’ of fi nancial markets.

Globalization is a loose term capturing the idea that the world of fi nance has become a globalized industry; national fi nancial markets are increasingly integrated into a globally integrated network of markets. In layman’s terms the concept is about the ability to ‘do anything anywhere’. Globalization has many characteristics. Borrowers seeking to raise funds are no longer limited purely to their national markets, they can raise funds on the fi nancial markets of other countries. Similarly, investors with surplus funds are no longer restricted to the investment opportunities of their national markets but can increasingly take advantage of investment opportunities in other nations. Financial institutions seek to have a global presence both as a means of expansion and to retain their existing customers who are ever more reliant on trade and economic interactions with foreign residents. By abolishing exchange controls, as the Conservative government did on coming into offi ce in the United Kingdom in 1979, or by relaxing controls, governments have enabled fi nancial capital to seek out investment opportunities in other countries.

Bretton Woods a fi xed but adjustable exchange rate regime (1947–71) whereby the major currencies were pegged to the US dollar within a ±1 per cent band; the dollar was pegged to gold at $35 per ounce

Globalization the tendency of fi nancial institutions and their customers to move beyond their domestic markets to other markets around the globe


Globalization is not always benefi cial. One problem is the loss of local knowledge – do bankers in London really know the best fi rms to lend to or the best banks to buy in the United States? In the 1970s and early 1980s huge sums of money were lent to countries in Latin America, and Mexico’s moratorium on its debt repayments in 1982 sparked off an international debt crisis as the Mexicans were quickly followed by Brazil, Argentina and Venezuela. More recently, the American subprime problem was exported around the world as foreign banks and other investors invested heavily in securities made up of subprime mortgages. Globalization has also led to problems in detecting wrongdoing. Th e main operations of Bank of Commerce and Credit International (BCCI) were based in the UK, but its headquarters was in Luxembourg. In 1995, Barings Bank was brought to the brink of collapse by the infamous Nick Leeson operating on behalf of the bank on the SIMEX exchange in Singapore. Wealthy investors around the world also faced huge losses in 2008 when they learnt that their investments held by Bernard Madoff were in fact invested in a huge ponzi scheme.

Globalization has also brought with it increased interactions and spillovers between markets, amply illustrated during the Asian fi nancial crisis of 1997 when investors decided to pull out of Asian stocks and currencies almost indiscriminately. Th is led to large falls in the values of some Asian currencies and stockmarkets and caused major economic disruption to their economies. Th e credit crunch has amply demonstrated the interlinked nature of today’s Global fi nancial system, as problems in the US subprime mortgage market and housing market got transmitted around the world leading to large falls in global equity markets and huge bank losses worldwide. In general, across the globe it seems to be the case that stockmarkets and bond markets move increasingly in synch with each other and, as we shall see, this reduces the potential for investors and fund managers to reduce risks to their portfolios.

1.8 TechnologyTh e 1980s witnessed an unprecedented increase in the use of new technology, and especially the widespread use of computers in the fi nancial services industry. New technology has enabled some markets such as the London Stock Exchange to switch over to screen-based trading. Improved information systems mean the almost instantaneous transfer of price-sensitive information around the globe, and computers have enabled the industry to store and analyze masses of information. More importantly, computers have enabled new complex products to be devised and priced in real time. Th e complexity of some of these products has meant that higher skills are required than those of traditional traders, and many advertisements for trading positions in the fi nancial services industry require PhDs in mathematics, engineering and physics.

Technology has also had a dramatic eff ect on the way banks conduct their business, process and dispense payments. Automatic telling machines (ATMs) have reduced the need for cashiers and the increased use of debit cards has dramatically reduced the cost of processing payments – the marginal cost of making a transfer made by a debit card is less than 5 per cent of processing a cheque payment. Technology has enabled retail banks to off er a wider range of services, including internet banking which gives customers the ability to examine their balances and make transfers

moratorium a situation in which a debtor declares that it is suspending repayments of principal and interest

ponzi scheme a fraudulent investment scheme off ering a high rate of return which is fi nanced by payments made by newly acquired investors; eventually the scheme will collapse with large losses for the late joiners

subprime mortgages mortgages made to people with a poor credit rating; they have a higher rate of interest than conventional mortgages to compensate for the higher risk of default


speedily. Th e use of sophisticated databases means that new services can be targeted at the customer, rather than waiting for customers to enter branches.

Th e adoption of new technology has enabled the fi nancial services industry to become more effi cient and off er its clients a better range of products and quality of service. Many back-room operations and processing operations can now be carried out in cheaper locations than traditional, more expensive, fi nancial centres, and in recent years many banks have relocated some of their information technology (IT) functions to India where labour costs are signifi cantly cheaper. Technological advances have greatly reduced communication costs and improved the speed and capacity to act because information is rapidly transmitted from one fi nancial centre to another, reducing the cost of executing orders and enhancing the ability of fi nancial markets to monitor and analyze fi nancial, political and economic developments.

Nonetheless, new technology has not always been viewed as purely advantageous by the industry. New technology can be very expensive to implement and some extremely costly mistakes have been made. For example, the London Stock Exchange had to abandon a planned paperless trading system called TAURUS in 1995 at an estimated cost of £400 million due to problems with the system. Another problem with new technology is that, while it can bring cost savings, there can be increased costs in the way of expensive IT staff . In addition, new hardware and software are very expensive. Th e need for backward compatibility with previous systems means that it is often very diffi cult for existing fi rms to take full advantage of the latest developments, while being less so for new entrants, who can in some cases quickly establish signifi cant market shares.

Th ere are also issues of security and reliability associated with new technology; cases of ‘hacking’ and people gaining access to confi dential client information are big worries for many companies. New technology also increases the mobility and demands of customers who shop around for the best quotes. In sum, many fi nancial institutions that have invested heavily in new technology fi nd it diffi cult to earn an adequate return on their capital investments, especially as any advantage they may gain is usually transient, lasting only until their competitors catch up. One very important aspect of new technology is that it has changed the balance between fi xed and variable costs, and in so doing has made market share an increasingly important issue. For example, new ATMs and debit payments systems are extremely costly to install and set up, but the marginal operating costs are relatively low. Th is has tended to mean that fi rms require a large and increasing market share to cover the high initial investments and to reap rewards from their investment.

1.9 DeregulationGovernments have always intervened to regulate the fi nancial services industry, but since the 1980s there has been a fundamental shift towards less regulation by many governments. Th is shift is known as the process of deregulation.

Government policies in the 1980s were particularly favourable for the development of the fi nancial services industry, as deregulation in the UK was followed by deregulation on the continent. Th e UK government introduced a range of tax breaks for savers such as TESSAs (tax exempt special savings accounts) and

deregulation the reduction or elimination of regulations designed to increase competition and reduce prices facing consumers

backward compatibility the need for new information technology, such as computers and software, to work with older technology in order to service existing clients


personal equity plans (PEPs), and shifted the tax structure from taxes on income to taxes on expenditure, which left consumers with larger disposable incomes. While indirect taxes were increased on goods and services, fi nancial products remained largely exempt, which increased their relative attractiveness.

Th e UK government adopted a privatization programme that benefi ted the fi nancial services through advice, consultancy and underwriting fees. Th e programme also increased public interest in shares in general. While technology may have been the driving force enabling fi rms to off er a wider range of fi nancial services, deregulation has been essential in permitting fi nancial institutions to off er the new services. Th ere are numerous arguments in favour of and against regulation and these are worth reviewing.

One of the major arguments in favour of regulation is the need for investor protection. Investors need to be protected from misinformation which encourages them to invest in products that are unsuitable, and they need to be protected against the misuse of their funds once they have been handed over (for example, fraud). However, many in the fi nancial services industry oppose regulation which they argue increases costs to meet compliance. In addition, regulation can prevent the introduction of new innovative products. Another problem is that fi nancial centres around the world fi nd themselves in competition with one another for business, and for this reason centres are especially keen to avoid heavy-handed regulations which drive business away to other centres that adopt a more light-handed approach. Th is is one of the lessons to be learnt from the Eurodollar market in which US regulations clearly stimulated the development of the market.

Another problem of regulation is that too much investor protection can create a problem known as moral hazard. Moral hazard occurs when insuring against an event makes the insured-against event itself more likely to occur. For example, if governments guarantee investors’ money this may encourage investors to place their money in institutions off ering the highest return because, regardless of the risks involved, investors know that their principal is safe. Overall, this can then lead investors to place too much of their funds with high-risk institutions resulting in a misallocation of savings. Th is factor undoubtedly played a signifi cant part in the savings-and-loans fi asco in the USA at the end of the 1980s. In the early 1980s, the savings-and-loans business was deregulated and competition for funds led to many institutions off ering high rates of interest. Most investors’ deposits were insured by the Federal Deposit Insurance Corporation (up to $100,000), and investors consequently placed their funds with the highest-interest-paying institution. In a bid to meet these interest payments many savings institutions lent money to increasingly risky ventures, a large number of which subsequently failed, making those savings-and-loans institutions insolvent. Th e result was that the Federal Deposit Insurance Corporation was required to pay out far more than it had received in premiums. Ultimately, the US taxpayer had to foot a bill which is estimated to be close to $300 billion spread over 30 years.

It is clear that most governments need to strike a balance between regulation and the need to allow their fi nancial services industry to develop without over-burdensome restrictions. Th e 1980s witnessed considerable fi nancial deregulation. London experienced the ‘big bang’ in 1986, which involved ending the broker–jobber divide and fi xed commissions for share-dealing. Th e reform was motivated by the desire to improve

privatization the sale of state-owned enterprises to the private sector, often through the sale of shares to the public and institutions

moral hazard the existence of an insurance policy makes the insured event more likely to occur than in the absence of the insurance policy

Federal Deposit Insurance Corporation (FDIC) a US corporation that insures US bank deposits up to the value of $250,000; it was created in 1933 to maintain public confi dence in the banking system

regulation the set of rules or laws governing the conduct of fi nancial institutions, markets and instruments


the competitiveness of London share-dealing, and has been considered important in maintaining London’s competitiveness as an international fi nancial centre.

However, although there was a general trend towards deregulation of national fi nancial systems, there was one clear exception to this trend at the global level in the Basel Accord of 1988. During the 1980s regulators and central banks had become increasingly concerned that the process of globalization had led to increased interactions between banks from diff erent countries, with a perceived danger that a banking crisis in one country could transmit itself to other countries. Hence there was an attempt to ensure that banks had suffi cient capital to absorb potential losses, which resulted in the Basel Accord of 1988. As we shall see in Chapter 17, this fi rst initiative in global regulation inevitably encountered much criticism and the Basel II Accord, which came into force in 2006, was negotiated to address these problems.

1.10 Financial innovationBy fi nancial innovation we mean the design of new fi nancial instruments or the packaging together of existing ones. Th ere are two main views on why fi nancial innovation occurs. One cynical view is that innovations are primarily designed to overcome the eff ects of regulations and to exploit tax loopholes, whilst the more positive view is that they are all about designing products to meet the wide variety of needs of investors and to improve the effi ciency with which they can achieve those objectives. Since the 1980s we have witnessed the rapid development and widespread availability of a whole range of fi nancial products; examples include the proliferation of new types of options and futures contracts, warrants, swaps, junk bonds, index-tracking unit trusts, exchange traded funds (ETFs) and secondary markets in third-world debt. Th e greater availability and wider fi nancial product range means that fi rms and investors are better able to achieve their risk–return investment objectives,. In addition, the wider range helps to attract new custom.

Th ere were a number of forces in the 1970s and 1980s that lay behind the rapid pace of fi nancial innovations. One was the greater volatility in both goods and fi nancial markets. Th e early 1970s witnessed the breakdown of the Bretton Woods system of fi xed exchange rates and witnessed high exchange rate, stockmarket and interest rate volatility. Following the fi rst oil price shock of 1973 when the price of oil was quadrupled by the OPEC cartel, many countries suff ered high and volatile infl ation rates. Th e more turbulent environment greatly increased the demand for fi nancial products to protect investors’ and borrowers’ interests.

Th e 1980s witnessed the widespread introduction of highly sophisticated computers and the development of appropriate software, enabling new and more complex products to be brought to the marketplace. Deregulation and greater competition in the fi nancial sector undoubtedly had the eff ect of increasing both the range and quality of fi nancial products off ered. Information fl ows greatly improved and this led customers to demand products that enabled them to cope with rapidly changing forces. Th e 1990s witnessed the rise of the internet and the ability of retail customers to buy and sell shares, access fi nancial information, and carry out their banking online. Th e impact and implications of all of this are still being felt by the fi nancial services industry.

Basel Accords two agreements, emanating from the Bank for International Settlements in 1988 and 2004, that require large international banks to set aside capital reserves against potential losses equivalent to 8% of their risk-adjusted assets

fi nancial innovation the design of new fi nancial securities and methods of delivering fi nancial services


Box 1.1 Securitization

One of the biggest innovations in the debt markets during the 1980s to the present has been the process of securitization. In its simplest form the idea of securitization is to turn relatively illiquid assets with cash fl ows into a liquid asset by combining the cash fl ows from the illiquid assets into a security to investors. Th e basics of securitization can be illustrated with an example. Imagine that Bank ABC wishes to raise $1 billion to take over Bank XYZ. Th e problem Bank ABC has is that it does not have any spare cash – it could of course undertake a rights issue, that is sell new shares to its existing shareholders or perhaps increase its debt burden by issuing a corporate bond. Alternatively, it could consider turning some of its illiquid assets, such as loans and mortgages which generate a cash fl ow to the bank, into an asset backed security (ABS). Th e cash fl ows of the ABS can be bought by investors which will then give Bank ABC the money it requires to complete the takeover of Bank XYZ. Th e process of securitization is illustrated in Figure 1.2.

As can be seen in Figure 1.2 Bank ABC identifi es a pool of loans or mortgages on which it is currently receiving interest and principal payments and it packages them together. A master trust is set up to manage the cash fl ows from the loans to ensure payments are made to investors in the ABS. In return for giving up the cash fl ows from the loans and mortgages Bank ABC receives $1 billion cash from the sale of the ABS to fund its takeover of Bank XYZ. Th e process of securitization has enabled Bank ABC to turn some relatively illiquid assets into cash for operational purposes today.

Th e process of securitization can be used to turn existing assets such as loans and mortgages into cash but it can also be used to turn prospective future cash fl ows into cash today. In a famous issuance the UK rock star David Bowie raised $55 million in 1997 by selling an ABS, the cash fl ows for which were fi nanced by

Figure 1.2 Th e process of securitization

Master trustpools the

assetsBank ABC identifies cash flows from $1 billion of illiquid loans or mortgages

10-year ABS is created. The ABS is backed by the cash flows from Bank ABC’s loans/mortgages and is sold to investors with an annual coupon and principal returned on maturity

$1 billion proceeds from sale of ABS can be used by Bank ABC

Investorsbuy the ABS


1.11 Types of fi nancial innovationsExamples from the wide range of innovations include the following:

1 Market-broadening innovations – these work to increase the liquidity of markets by attracting new investors and providing new opportunities for borrowers.

2 Risk-management innovations – these have the eff ect of redistributing fi nancial risk exposure from agents that are risk-averse to agents that are willing to undertake the risks.

3 Arbitraging innovations – in these agents exploit arbitrage opportunities either within or between diff erent markets, often to take advantage of loopholes in the regulatory or tax framework.

4 Pricing innovations – these seek to reduce the cost of achieving a specifi c investment objective.

5 Marketing innovations – in addition to innovative fi nancial instruments, fi nancial markets are also adept at fi nding innovative methods of selling and distributing fi nancial products.

1.12 Emerging marketsSince the 1980s there has been a rapid rise in the signifi cance of fi nancial markets in most of the so-called emerging market countries. Countries in Southeast Asia and Latin America have increasingly found themselves attracting the interest of investors from the industrialized nations, this interest being very much spurred on by the rapid rates of economic growth of these countries. In more recent years, the newly independent countries of Eastern Europe that have emerged since the break-up of the Soviet bloc in the 1990s have also attracted the interest of international investors. In particular, countries like Poland, Hungary and Russia have attracted signifi cant capital infl ows. Many of these Eastern-bloc countries joined the European

future sales and royalties from 25 of the albums he produced prior to 1990. Th e so-called ‘Bowie Bond’ paid a rate of interest of 7.9% per annum, and the Prudential Insurance Corporation bought the entire issue. Th e ABS matured in 2007 and Bowie once again collects the royalties from sales of 25 of his early albums.

Securitization is a vital part of the modern fi nancial landscape enabling banks and fi rms to generate cash based on their existing assets or prospective future cash fl ows. Th e construction of many commercial properties is fi nanced by issuing ABSs based upon future cash fl ows likely to be generated by renting out the property over the years. Without securitization of future cash fl ows many projects might not go ahead, to the detriment of the economy, society and jobs.

As we shall see later in the book, securitization has been taken even further than our simple examples. Th is occurs when the ABS is in eff ect divided up into various tranches with diff erent risk return characteristics.

Box 1.1 Securitization – continued


Box 1.2 Th e growth of Islamic banking and fi nance

Th e credit crunch which started in August 2007 led many to question the foundations of the Western banking system. By contrast, Islamic banking and fi nance was far less severely impacted by the crisis than its Western counterpart. Islamic banking is a system of banking that is consistent with the principles of Sharia law (or Islamic law) whose primary sources are the Koran and the sayings of the Prophet Muhammad. Th e rules of Islamic commercial jurisprudence are known as fi qh al-mu’amalat. Fiqh al-mu’amalat focuses on what contracts are permissible and desirable (halal) and which are prohibited and undesirable (haram). A small group of Islamic scholars in each country determine whether a product is Sharia compliant. Sharia law prohibits the payment of interest (riba) on the borrowing of money and also forbids the investment of money in businesses that provide goods or services that are contrary to its principles, such as alcohol, tobacco, gambling or pornography, or companies that have too high debt levels (typically meaning more than 33% of stockmaket capitalization). In addition, the use of money to fi nance speculation (qimar) or gambling (maysir) is prohibited, as are contracts involving ambiguity as to subject matter (gharar). Th ere can be diff erences between national jurisdictions – a product deemed Sharia compliant in more liberal Malaysia may not be deemed compliant in more conservative Saudi Arabia.

In the late 20th century a number of Islamic banks were formed to off er banking services based on Sharia principles to personal and corporate entities within the Muslim community. Th e fi rst experiment with modern Islamic banking started in Egypt in 1963, led by Ahmad Elnaggar who set up a form of a savings bank based upon profi t sharing. In 1975 the Islamic Development Bank was set up to provide funding for member countries. Today Islamic banking has more than 300 institutions in more than 50 countries and some 250 mutual funds with over $500 billion of assets under management according to Islamic principles (see Table 1.8). Many Western banks such as Citibank, Goldman Sachs and Standard Chartered also off er Sharia compliant products. Th e basic principle of Islamic banking is that profi ts and losses are shared (mudharabah, which means profi t sharing). Other useful terms are wadiah (meaning safekeeping), murabahah (meaning cost plus) and ijarah (leasing/rent).

Table 1.8 Sharia compliant assets 2007

$billions $billions

Iran 154.6 Brunei 31.5

Saudi Arabia 69.4 Bahrain 26.3

Malaysia 65.1 Pakistan 15.9

Kuwait 37.7 Lebanon 14.3

United Arab Emirates 35.4 Britain 10.4


Box 1.2 Th e growth of Islamic banking and fi nance – continued

Because interest cannot be charged, a typical house purchase can be fi nanced by the bank purchasing a house on behalf of a buyer and then selling the house to the buyer at a higher price. Th e bank allows the buyer to pay it back in instalments under a contract known as a musharakah mutanaqisah partnership. Similarly, a car purchase can be fi nanced by the bank buying the car, then selling it on to the buyer at a higher price and allowing payment by instalments, with the bank retaining ownership of the vehicle until the fi nal instalment is paid. Such a contract is known as murabaha. In a business transaction an Islamic bank may lend money to the company based on a certain percentage of the company’s profi ts. Once the principal amount of the loan plus cost is repaid, the cost plus contract, which is known as mudarabahah, ends. A partnership or joint venture, namely muskarakah, is an arrangement whereby an entrepreneur provides labour and the bank provides fi nancing so that both profi ts and losses are shared. Th e sharing of the capital provided by the bank and the labour by the business refl ects the Islamic view that the borrower must not bear all the risk and cost of a failure. Th is results in a balanced distribution of income and means that the lender is not allowed to monopolize the economy. Depositors in Islamic banks keep their money in mudoraba or wakala accounts and receive a percentage of the profi ts rather than a given rate of interest, although most Islamic banks maintain ‘profi t equalization reserves’ to ensure minimum payments even if losses are made. More recently Islamic fi nance has developed Sharia compliant bonds called sukuks which have been used to fi nance companies and development in Islamic countries. A typical sukuk is based upon an asset backed ijarah structure, which is an asset backed bond on a sale and leaseback arrangement that uses revenue from an asset, usually a property, to pay investors. Th ese payments are based on rent or profi ts which are not considered to provide a guaranteed return as the property could fall in value, although investors invariably get their principal back. While a conventional bond is a promise to repay a loan, purchasing a sukuk constitutes partial ownership of a debt, asset, project, business or investment.

Sharia principles meant that Islamic banks did relatively well compared to their Western counterparts during the fi nancial crisis which started in 2007. Th ey had low amounts of leverage, little exposure to the toxic subprime mortgages and a relatively stable deposit base. Th e main hit to the Islamic banks was their exposure to the real estate market in the Middle East which had boomed prior to the outbreak of the crisis but was signifi cantly hit during the downturn. Th ere are still some problems that confront Islamic banks. One particular problem is that they cannot access the interbank market because they are not allowed to pay interest, so short-term liquidity has to be managed by other means. Th e use of derivatives may be sanctioned if they are used to hedge risk, but not for speculative purposes. Th e future development of the Islamic fi nance sector will depend on its ability to innovate and off er wider ranges of products and services at competitive prices so as to be able to compete with Western-based banks.


Union in April 2004. Th is will, over time, no doubt lead to further strengthening of their economies and lead them to further develop their fi nancial systems, including measures to attract foreign investment. Th e emerging markets’ stockmarkets have often off ered spectacular returns, but also on many occasions the falls have led to equally large losses such as during the Mexican crisis of late 1994–early 1995 and the East Asian fi nancial crisis of 1997. During this crisis markets like Hong Kong fell from 16,500 to a low of around 6,500, although by late 2009 the Hong Kong index had recovered to above 20,000. One of the lessons for investors is that overexposure to a single emerging market is a risky business, but this does not necessarily apply to exposure to a portfolio of emerging markets.

1.13 Problems concerning investment in emerging markets

Although there is a strong theoretical case for international portfolio diversifi cation, there are a number of reasons why investment managers in developed countries are reluctant to invest more signifi cant amounts of money in emerging markets, and why investors are often warned to be wary of investment in such markets. Th ese reasons include:

Poor accounting standards. In developed fi nancial markets there are usually strict • regulations and standards regarding reporting the fi nancial positions of companies. In many emerging markets, however, standards are often relatively poor making it extremely diffi cult for investors to ascertain a clear picture of the fi nancial worth of a company.Governance of companies. In developed fi nancial markets companies are run • by directors who act as agents for shareholders. In theory, at least, directors are selected on merit and can be replaced if performance is unsatisfactory. In many emerging markets, control of companies is often exerted by a board made up of founding family shareholders who are not necessarily best suited to the job.Information costs. In developed fi nancial markets, most quoted companies • are subject to detailed fi nancial analysis and the costs of acquiring good quality information are relatively low. When investing in emerging markets, however, there are language barriers and also far less dissemination of information, which means that the costs of acquiring good quality information are relatively high.Political risks. In developed fi nancial markets governments are relatively stable • and the election of the opposition to government does not necessarily have any signifi cant infl uence on fi nancial markets. In emerging markets, however, foreign investors face the risk of controls being imposed which will restrict the outfl ow of their investments, and often face withholding taxes (that is, taxes on dividends and interest paid to foreign investors) or the threat of such taxes. Th ere are some tax treaties between countries that enable investors to gain a credit for the payment of such taxes so that they do not pay double taxation, but this is not always the case and the process of claiming the tax credit can be cumbersome. In extreme instances, foreign investors face the risk of expropriation of their assets and even nationalization of the enterprises they have invested in.

witholding tax a tax on investment income aimed specifi cally at foreign investors


Foreign exchange risk. Investment in emerging markets may result in a capital and • income gain measured in the currency of the emerging market economy. However, these investments need to be converted back into the developed country’s currency for a comparison to be made with domestic investments. Th e currency change may provide a gain or loss representing an additional risk that is not present with domestic investments.Controls on foreign investments. In many emerging markets, governments can • impose costly restrictions on how foreigners can invest and manipulate their investments. For example, foreign investors may only be allowed a certain proportion of investment in domestic companies, or allowed shares that have more limited voting rights than domestic investors.Higher transaction costs. In developed fi nancial markets, deregulation and greater • competition have had the eff ect of greatly reducing brokerage commissions. In most emerging markets these costs are signifi cantly higher, and there are also additional costs associated with foreign exchange commissions and communication for the execution of orders.

More recently there has been a growth of interest in what are known as frontier markets which refers to a subset of emerging markets that have low market capitalizations, relatively low turnover and poorer liquidity conditions than other emerging markets. While there is no decisive means of classifying frontier markets as distinct from other emerging markets a country may be classifi ed as a frontier market due to its relatively small size, its lower level of development compared to other emerging markets and also higher level of investment restrictions. Th e countries classifi ed by MSCI Barra as frontier markets are Argentina, Bahrain, Bangladesh, Botswana, Bulgaria, Croatia, Cyprus, Estonia, Ghana, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Saudi Arabia, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates and Vietnam.

1.14 Th e futurePredicting the future is a hazardous business. Looking back over the last 40 years many of the important events for fi nancial markets have been shocks that were largely unforeseeable. Th e oil-price hike of 1973–74 meant that huge OPEC (Organization of Petroleum Exporting Countries) surpluses were placed on the international money markets, much of which was then lent on to Latin America. In 1982, a moratorium on Mexico’s debt repayments triggered off the international debt crisis. By then many major international banks had heavy exposure to the Latin American countries, and were preoccupied by the crisis throughout the 1980s. Th e global 1987 stockmarket collapse hit trading volumes on stockmarkets overnight. Th e reunifi cation of East and West Germany in 1990 led to Germany becoming a big borrower of funds on global fi nancial markets. Similarly, the Asian fi nancial crisis of 1997 was largely unforeseen, yet it was undoubtedly one of the most turbulent events to ever aff ect global fi nancial markets. Th e disintegration of the Soviet empire provided new opportunities and risks as witnessed by the 1998 Russian default. Likewise, stockmarkets went into a

frontier markets countries with stockmarkets that are less developed than emerging markets


major downswing following the 11 September 2001 attacks on the twin buildings of the World Trade Center, a single shock that was totally unforeseen. Barely any commentators predicted the size and extent of losses and seize-up of the fi nancial system that started in August 2007. Major fi nancial institutions such as Citigroup, American International Group, Bank of America, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac, the Royal Bank of Scotland Group, Halifax Bank of Scotland, Lloyds Bank and countless other fi nancial institutions from around the world were drawn into the biggest fi nancial crisis since the 1930s banking crisis. To some extent the future of the fi nancial system will for many years to come be shaped by policy response and lessons to be learnt from the credit crunch.

Nonetheless, there are a number of trends that will undoubtedly have a major impact. One is that fi nancial technology will continue to penetrate the home consumer market. Th e internet enables consumers to manage their bank accounts and make payments for goods and services directly from home. People in more and more countries will be able to trade stocks, bonds and other fi nancial securities from their homes. Retail banking will increasingly become a tough commodity business, with consumers allocating more of their money to deposit accounts and less to current accounts. On the loan side, the ability to easily search the market for the most competitive loan rates will further erode profi t margins.

Technology is also likely to impact heavily upon the way many fi nancial instruments are traded. In New York and Tokyo, shares are still traded on the stock exchange fl oor and futures and options contracts involve traders gathering around a pit. Th e plain fact is that technology makes such arrangements an anachronism and it is only a matter of time before screen-based trading becomes the norm. Th e experience of London is instructive in this regard. When screen-based trading was fi rst introduced following the big bang in 1986, it was supposed to complement trading on the stock exchange fl oor. However, within two weeks trading on the fl oor ceased and screen trading became the London norm. Electronic exchanges such as the NASDAQ in the United States have tended to gain share over rivals that do not fully utilise the benefi ts of modern technology.

In Europe the successful introduction of monetary union in 1999 and the euro at street level in 2002 had a profound eff ect, with mergers between the Amsterdam, Paris, Lisbon and Brussels stock exchanges to form the Euronext exchange. Since its introduction, the euro has proven to be a sound low-infl ation currency and it may eventually emerge as a major reserve currency to rival the US dollar. Th e euro is leading to greater demands for a truly single market in the European fi nancial services industry, and the removal of national governments’ ability to unilaterally print money has led to a greater focus on economic reforms of social security and pension systems.

Th e regulatory environment in Europe is also changing rapidly, and the ability of fi nancial fi rms to sell their services in other European Union (EU) countries is increasing. European policy is based on the concept of ‘mutual recognition’ and the so-called ‘passport’ principle. Th e concept of mutual recognition is that countries in the EU agree on the minimum standard for an insurance company or bank, and once this standard is agreed the fi nancial institution is free to sell its services in all the EU countries. In eff ect, once a licence to operate is obtained in one EU country,


the fi nancial institution has a ‘passport’ to operate in every other EU state. Th is new regulatory environment contrasts with the old days when attempts to agree on full standards never got anywhere, and fi nancial institutions required a separate licence to operate in each EU member country.

Th e signifi cance of emerging market economies will no doubt be one of the biggest events over the next few decades. Countries like China and India have relatively low GDPs per capita and underdeveloped fi nancial systems, but they have rapidly growing economies and their demands for fi nance and fi nancial products will grow signifi cantly. Th ere is no doubt that they will look to developed capital markets such as the USA, UK and Japan for sources of fi nance and for models on which to develop their own fi nancial services industries. Th e demand for Indian and Chinese investment bankers can be safely predicted to rise! Similarly, the Eastern-bloc economies can be expected to grow rapidly over time and they too will seek to further develop their own fi nancial sectors.

1.15 ConclusionsTh e world of fi nance like the global economy has undergone major changes since the 1980s and many further changes can be expected in the future. To quote an old adage, ‘the only constant is change’. Present-day fi nancial institutions and the way of doing business today are likely to look very outdated in 30 years’ time. Nonetheless, there are some fundamental principles of fi nance that do not change; one is that higher return is usually associated with higher risk, and another is that fi nancial instruments and fi nancial institutions will only survive in a marketplace if they are able to meet clients’ needs at a competitive price. In the rest of this book we shall be looking in more detail at the role played by the fi nancial sector of the economy, and the various fi nancial instruments that exist.

Further readingBain, K. and Howells, P. (2007) Financial Markets and Institutions, 5th edn, Financial

Times/Prentice-Hall.Bodie, Z., Kane, A. and Marcus, A. (2008) Investments, 6th edn, McGraw-Hill.Buckle, M. and Th ompson, J. (2004) Th e UK Financial System: Th eory and Practice, 3rd

edn, Manchester University Press.Valdez, S. (2010) Introduction to Global Financial Markets, 6th edn, Palgrave Macmillan.

Chapter 1 Revision questions

1 What are the key roles of a fi nancial centre and to what extent is London a diff erent fi nancial centre than New York?

2 Discuss the pros and cons of the use of new technology in fi nancial institutions.

3 What is meant by securitization?


Chapter 1 Revision questions – continued

4 Discuss what is meant by fi nancial innovation. What are the fi ve types of fi nancial innovation that can occur?

5 What is meant by ‘globalization of fi nancial markets’? Discuss the pros and cons of the globalization process in the world of fi nance.

6 Briefl y describe fi ve reasons why emerging markets may not prove popular with international investors.

Multiple choice questions available at www.palgrave.com/business/pilbeam

ABS see asset backed securityAbsolute PPP 290–1Active fund management 241Adverse selection 433Aggressive securities 187–8AIG see American International GroupAllotment policy 208Alpha 193–4Amaranth 58American International Group 410, 425–6,

437Anchoring 246Announcement eff ect 76–8Annuities 51Arbitrage 37, 278, 296, 306, 312, 337–8,

341–2, 387, 389, 401, 405cross currency 264fi nancial centre 264

Arbitrage pricing theory 197–8Arbitrageur 37, 275–6, 277–8, 359Asset backed security 16–17, 416–17Association of International Bond

Dealers 144Assurance 50Asymmetric information 460Auction issue 102

Bancassurance 51Banker’s acceptance 104Banking Acts 468–9Banks

commercial 47, 78–80, 103, 119, 262investment 47, 103, 433–4merchant 47retail 47universal 47

Bank of England Act 469Bank run 427Base rate 440Basel Accords 48, 434, 474–8Basis point 401Basis risk 342Bearer form 144Behavioural fi nance 246–8Beta 179, 186–99, 221, 238, 244–5, 250–1Bid–ask spread 145, 207, 263Big bang 140, 146–7, 205,Big Mac index 291–2Bills 72Black–Scholes option pricing

formula 379–90Bonds

clean price 121, 123convertible 137corporate 131–9dirty price 121, 123 domestic 140Eurobond 140 foreign 140futures 338–9government 215price formula 120–1price volatility 124–31

Bought deal 34Bretton Woods 137, 322Bradford & Bingley 446–7Broad money supply 80–1Brokers 37, 466Bubble 7, 252Building societies 47, 50Business risk 221, 224Buy-hold strategy 242–3

INDEX

I N D E X

Call back 146Call market 35Call option see optionsCall provision 132–3, 146Call risk 136Capital adequacy 45, 463, 468, 474–9Capital asset pricing model (CAPM) 177–99, 220–1,

245, 250Capital fl ows 140–1Capital market line 170–3, 184–8CAPM see capital asset pricing modelCarry trade 302–3Cash market 35CDO see collateralized debt obligationCDS see credit default swapsCentral bank 43–5, 114–5, 262, 461Certifi cate of deposit 105, 110Characteristic line 180Chartism 222–3, 240, 254Cheapest-to-deliver bond 340Chinese wall 242Clearing house 324–5Collateralized bond obligation 415Collateralized debt obligation 413–18Collateralized loan obligation 415Commercial banks 47, 78–80, 103, 119, 262Commercial bills/paper 103Conduit 431Continuous market 35Contracting cost 18Contractionary monetary policy 74–8, 82Convertible bond 137Convexity 125–6Corporate bonds 131–9, 153, 228Correlation coeffi cient 158Cost of carry 207Counterparty risk 322–3, 423, 437, 453,Coupon payment 119–20Covariance 157Covenants 415Covered interest parity 275–9Credit crunch 3, 22, 412–54Credit default swaps 3, 418–27Credit event 418–24Credit rating 132–8, 141–2, 414, 416–17, 425, 434,

478Credit risk 135, 323, 415, 474, 476Cross rates 264Currency swap 395, 398, 402–5Current ratio 231Current yield 121–2Curvature 125–6

Day of the week eff ect 243Debt 28–9

coverage 231 instrument 153market 7security 153

Debenture bonds 132Debt–equity ratio 224–8, 232–3Debt versus equity fi nance 227–8Default rates 135–6, 406–7, 409Default risk 46, 101, 103, 111, 324 Defensive securities 187–8Defi cit agents 4–6, 27–8Deposit

insurance 108, 462-taking institutions 32, 46, 105

Deregulation 13–15, 67Determination of interest rates 82–7Diminishing marginal utility of wealth 158–9Direct placement 102Discipline function 36Disposition eff ect 246Diversifi able risk 173, 168–9, 182, 185, 187–8Diversifi cation 160–74Dividend

payout ratio 230pricing model 216–9yield 229, 333–5

Dividend irrelevance theorem 219Domestic bond 140Dominance principle 166–7, 173Dornbusch model 299, 305–13Dot com bubble 209–10Double bottom 222Duration 125–30

Earningsannouncements 251–2 per share 229–30yield 229–30

Effi ciencyallocative 237operational 237

Effi ciency frontier 163–8, 183–4Effi cient diversifi cation 170, 174Effi cient market hypothesis 36, 182, 237–54

weak form 238, 241–5semi-strong form 238, 240–1, 245, 248–53strong form 23, 240–1, 252–4, 388

Eligible reserves 103Emerging markets 20–1, 52, 147Endowment policies 50–1

I N D E X

Equitydiff erent types of 28–9, 153fi nance 28–9pricing of 215–21

ETFs see exchange traded fundsEurobonds 140–7Eurocommercial paper 114Eurocurrency markets 105, 106–13Eurodollar 106–13, 338–9European Central Bank 412Euro medium term notes 114European Monetary Union 22, 43European option see optionsEvent risk 136–7Event studies 249–52Exchange rate

bid–off er spread 260, 263defi nition 260determination 264–7eff ective 279–83forward rate 259, 265nominal 279–80spot rate 259, 265real 279–80turnover 260, 262

Exchange traded funds 54–5Expansionary monetary policy 73–8, 83, 115Expectations theory 91–3Exposure limits 462Exotic options see optionsExternalities problem 459–60

Factoring agency 63Federal Deposit Insurance Corporation (FDIC) 14, 111,

417, 431Federal Funds rate 440Federal Open Markets Committee (FOMC) 76Filter rule tests 242–3Financial centres 4–6Finance companies 62–3Financial innovation 15–7, 137–9, 146–7, 412–24, 434Financial institutions 63. 66Financial intermediaries

role of 30–3types of 46–66

Financial intermediation 27, 111Financial liabilities 29–30Financial markets

classifi cation 35–6role of 36–7

Financial ratio analysis 228–233Financial security 27–8

Financial Services Act 467–8Financial Services Authority 469–70Financial Services and Market Act 469–70First Banking Directive 472–3Fiscal policy 89–90, 443–4Fixed exchange rate 96, 259, 269–72Fixed recovery CDS 423Floating exchange rate 259, 268–9Floating interest rate 108Floating rate note 142–3, 146Foreign exchange market 259–85 Forward exchange rate 272, 275–9, 322–4Forward/forward rate 337Frankel model 313–15Fraud 461, 464–5Futures 321–43

bond 339–40comparison with forwards 322–4currency 340–3distant contract 327exchanges 321–6nearby contract 327short-term interest rate 335–40stock index 326–35

Gearing 224–27General insurance 50Gilt edged market makers (GEMMS) 119Glass-Steagall Act 431Globalization 11–2Gordon growth model 216–8, 220, 240

Head and shoulders 222Hedge funds 57–9, 64, 302, 414, 419, 433, 435Hedgers 37, 274–5, 277, 359, 368, 405Hedging 328, 332–3, 336, 338–9, 349, 359–63, 396–9,

423Hire purchase 63Home country preference 409

IBFs see international banking facilitiesIndex tracking funds 24Infl ation 87–9,

target 270Information costs 32Initial margin 325, 328–30Initial public off ering 60, 209–10Insider trading 252–3, 460–1Institutionalization 37Insurance 9–11, 420–1Insurance companies 30–1, 50–1, 119Interbank market 103–4, 109, 441

I N D E X

Interest coverage 231Interest equalization tax 107Interest rate

determination 72–9, 82–88, 119long term 71, 91, 96nominal 71, 87–9, 304–5real 71, 87–9, 303–4short term 71, 91–3, 96Internal ratings based approach 477

International banking facilities 108International Swaps and Derivatives Association 39Internet 3, 15, 22Intrinsic value 374–9Investment banks 47, 103, 433–4Investment companies 53–4Islamic fi nance 18–19

January eff ect 243–4Jensen’s alpha 193–4Jobber 466Junk bonds 138–9

LBO see leveraged buy outLead manager 145–6Leeson, Nick 12Lehman brothers 427, 430–1, 437, 449Lender of last resort 104Letter of credit 103, 143Leveraged buy out 60–1Life insurance 50LIBOR 104, 108–9, 113–4, 142, 398Liquid asset ratio 231Liquidation 231Liquidity 32, 45, 101, 324, 350, 475, 478Liquidity preference theory 93Liquidity provision 440–1Liquidity requirements 32Liquidity risk 46, 48Listing requirements 61, 208Loanable funds theory 84–7Long futures 328, 330–2Long-term capital management 58

Madoff , Bernard 12Margin payments 325, 343Market capitalization 229Market-maker 35, 37, 145Market model 179–81, 199Market portfolio 172–3, 183–4, 195, 197Market price of risk 173–4Market risk 168–70, 179, 180–2, 185, 188, 197–8Market segmentation theory 94–5

Maturity transformation 30–1MBS see market backed securitiesMedium-term notes 114, 131, 139Minimum variance portfolio 164–5Monetary base 78–80Monetary models 299–316Monetary policy 73–8Monetary Policy Committee 76Money

functions of 71demand 82–4, 96, 301, 304

Money market 6, 35, 82–4Money multiplier 80–1Moody’s 133–4, 414, 425Moral hazard 14, 431, 460Mortgage backed securities 424, 433Mortgage equity withdrawal 434Multifactor CAPM 196–7, 199Mutual fund 9–10, 254Mutual recognition 22–3, 52–3, 472

Naïve diversifi cation 168, 174National debt 44, 89–90, 444Nationalization 447–8NINJA loans 432Non-sterilized intervention 269–72Northern Rock 446–8Note-issuing facilities (NIFs) 114

Off -balance-sheet exposure 45, 410, 453, 474–5, 479

Off shore market 106OPEC 21, 107Open interest 325–6Open market operations 73–8, 82, 270–72Opening price 327Open position 277Options 349–68

at-the-money 374–9American 350, 379, 386 call 350–3, 358currency 358–64delta 386European 350, 379, 386 exercise price 350exotic 367–8gamma 386growth of 349in-the-money 374–9interest rate 357–9intrinsic value 374–80kappa 387

I N D E X

lambda 387out-of-the-money 374–9premium 350–3, 364pricing of 371–90profi t/loss profi le on a call 351–3profi t/loss profi le on a put 351–3put 350, 353–4put–call parity 387–90rho 387stock index 354, 356–7strategies 364–7strike price 350theta 386time value 374–9versus futures 360–4

Ordinary shares 208Over-the-counter (OTC) market 9, 324, 349, 403, 419,

452–3, 478Overshooting 305–8, 312–15

Par value relation 124, 138Passive fund management 241Payments mechanism 30Pension funds 3, 10, 37, 46, 54, 56–7People’s Bank of China 272–3Pillars 1, 2 and 3 476–7PIMCO 132Political risks 20 Portfolio diversifi cation 20, 52, 166–74Portfolio theory 164–74PPP see purchasing power parityPre-emptive rights off ering 34Preference shares 208 Price–earnings eff ect 251–2Price–earnings ratio 230, 250–1Price-to-book ratio 231Primary gearing 224Primary market 33–4, 145, 207Principal–agent problem 460Private equity 59–61, 64Private placements 34Privatization 14, 47Proprietary trading 262Public issue 102Purchasing power parity 287–99, 311–16Put–call parity 387–90Put option see optionsPutable bond 138

Quality spread 407Quantitave easing 442–3Quantity theory of money 89

Random walk 239–42Rate of interest 87–9, 312–14Rational bubble 252Reference entity 418–20Regulation of fi nancial sector 459–81

benefi ts/costs 460–1disclosure requirements 460Eurobonds 144investor protection 461licensing 462objectives of 461prudential 461rationale for 459–61statutory versus self-regulation 465structural 461types of 460–1United Kingdom 465–71

Regulation Q 107Regulatory arbitrage 476Relative PPP 290–1Repurchase agreement (Repo) 105Required rate of return 217–220Reserve

ratio 78–81requirement 81, 103, 108, 110 Return on capital employed 229

Reversing trade 325–6Rights issue 137, 211–5Risk 156–7

-aversion 158–60, 183default 29, 31–2, 46, 101, 103, 111, 324 -free 101, 153, 156, 159, 170–3, 182–9, 376, 379, 387liquidity 46, 48-loving 158management 364 -neutral 158re-investment 94ratios 231 regulatory 46transformation 31–2

Risk premium 87–9, 191, 220–1, 409, 443Riskless security 170–2Run test 243

Screen-based market 22, 35Second Banking Directive 473Secondary buy out 60Secondary market 145, 207, 214–15, 407–8, 415, 420–2,

475Securities Exchange Commission 410–12, 479–80Securities market 34–5Securities market line 186–9

I N D E X

Securitization 16–7, 416, 451Selling group 145Senior debt 423Settlement price 327Shares in issue 228–9Sharpe ratio 192–3Short futures 328–34Short selling 210–3, 471SIV see structured investment vehicleSize eff ect 250–1Sovereign Wealth Funds 59, 64–5, 132Special purpose vehicle/entity 416, 455Specifi c risk 169–9, 181, 198Speculator 38, 277–9, 326–7, 339, 343, 360–4SPV see special purpose vehicleStandard and Poor’s ratings 133, 414, 425Sterilized intervention 269–72Stock index futures 326–35Stockmarket crash 21, 252Stockmarkets 205–7Straddle 364–5Straight 142–3, 146Strangle 366–7Stress tests 445–6Structured investment vehicle 417–18, 454Subprime mortgage 4, 18, 413, 430–2, 450Sukuk 19Supervision 44–5Surplus agents 4–6, 27–8Swap 395–410

absolute advantage 398–9 basis 409buy back 407 callable 410comparative advantage 399–402comparison with forward 401–2, 407currency 395, 398, 401–5fi nancial press 403forward rate 401–2, 407, 409index 409innovations in 409–10interest rate 395, 399–402plain vanilla 398putable 410role of intermediary 405–7roller coaster 409secondary market 407 swap reversal 407swap sale 407swaption 409zero coupon 409

Syndicated loans 113Systematic risk 168–70, 180–2, 187–8, 193, 198

Takeover 12–3, 215, 250TALF see Term Asset Backed Securities Loan FacilityTARP see Troubled Asset Relief ProgramTAURUS 13Technical analysis 222–3, 240, 254Technology 12–3TED spread 109Tender issue 102Term Asset Backed Securities Loan Facility 444–5Tier 1 and 2 capital 474–8Tranches 102, 413–15Transaction costs 21, 35, 94, 111, 182, 237, 243–4Treasury bills 72, 114–15Treasury bonds 72–3, 101–2, 119–31, 153Treynor ratio 192–3Troubled Asset Relief Program 439, 444Type I, II, III and IV liabilities 29–30

Uncovered interest parity 299–300, 302–4, 308, 311Underwriting 33–4, 45, 209, 212, 214Underwriting group 33–4Unit trust 9–10, 254Universal banks 47Unsystematic risk 168–70, 180–2, 193, 198

Value at risk 48–9, 437Variation margin 325, 328–30Vehicle currency 261Venture capital companies 61–2VIX index 384–5Volatility 32, 373, 383–5, 389

Warrant 137–8, 146Winner–loser problem 244–5Withholding tax 20, 141, 143–4World Bank 140Writing covered 355Writing naked 355

Yieldcurrent 121–2simple 122to maturity 122–3, 147

Yield curve 90–5expectations theory 91–3liquidity preference theory 93 preferred habitat theory 94 market segmentation theory 94–5

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