FINS1612: Capital Markets and Institutions

Sam Eager

Semester 2, 2014
Week 1 – Introduction to Financial Systems
Explain the functions of a financial system

- Financial System – consists of financial institutions, financial instruments and financial markets
that facilitate the flow of funds through the system
- Money
o Medium of exchange, saving, store of wealth, allows specialisation in production
- Role of Markets
o Facilitate exchange of g/s by bringing parties together and establishing rates of exchange
- Surplus Units  Savings available for lending
- Deficit Units  Borrowings for capital investment/consumption
- Financial Instruments
o Issued by party raising funds
o Acknowledges financial commitment and entitling holder to FCF

-
- Double Coincidence of Wants Satisfied – transaction that meets needs of both parties
- Flow of Funds – flow of funds through FS that gives rise to instruments
- Attributes of Financial Assets
o Return on Yield – Total compensation received (%)
o Liquidity – Ability to sell an asset within a reasonable time at a current price for a
reasonable transaction cost
o Risk – Probability actual return doesn’t equal expected return
o Pattern of Cash Flows – When expected CF to be received by lender/borrower
- Portfolio Restructuring – combination of desired Assets/liabilities that provide the desired risk,
return, liquidity, pattern of CF
- Implementation of Monetary Policy
o Inflationary objectives is the main target
o CB influences cash rate to achieve objectives
- An efficient Financial System:
o Encourages savings
o Directs savings to the most efficient users of it (low hanging fruit…)
o Implement Monetary Policy of governments
o Is a combination of a/l comprising the desired attributes of financial assets
Categorise the main types of financial institutions

- Fin Institutions = depositary fin institutions, investment banks, merchant banks, contractual
savings institutions, finance companies, unit trusts)
- Permit Flow of Funds by facilitating financial tranasctions
- Categories of Fin Institutions
o Depositary
 Attract savings (TD) and savings accounts
 Loans to borrowers (biz/hh sector)
o Inv and Merchant Banks
 Provide OBS advisory services to support corporate/gov clients
 Advise on raising funds in K markets
o Contractual Savings Institutions (Insurance companies etc.)
 Receive periodic payments in return for a payout if a specified event occurs
 Invest the pools of funds
o Finance Companies
 Funds are raised through issuing financial securities
 Funds used to make loans/lease finance to hh/biz sector
o Unit Trusts
 Formed under trust deed
 Managed by trustee
 Units are sold to the public to raise funds

Describe the main classes of financial instruments issued in a financial system

- Equity
o Interest in Asset (Ownership)
o Residual claim on earnings/assets (Dividend/liquidation)
o Ordinary or Hybrid/Preference
- Debt
o Contractual claim to period interest payment + principle
o Ranked above equity
o Variations – st/lt, secured/unsecured, negotiable/non-negotiable
- Derivatives
o Synthetic security that provides future rights
o Derives price from an underlying commodity or fin instrument
o Hedge/speculate
o Futures, forwards, options, swaps

Discuss the flow of funds between savers and borrowers, and through the financial system and
economy

- Matching Principle
o ST Assets should be funded with ST Liabilities (Money Market)
o LT Assets should be funded with LT Liabilities (K Market)
- Primary and Secondary Market Transactions
o Primary – Issue of new financial instruments to raise funds
o Secondary – Buying/selling of existing financial instruments
 Transfer of ownership
 Provides liquidity  Makes primary market financing cheaper (lower risk)
- Direct and Intermediate Finance – obtain funds through direct relationship with savers
o Direct Finance
 Advantages
• No intermediate costs
• Increase flexibility as issuers can issue for specific needs
• Increases access to diverse range of markets (diversification)
 Disadvantages
• Matching of presences
• Decrease liquidity/marketability of security
• Increase search costs
• Assessment of Risk (Default Risk)
o Intermediate Finance
 Advantages
• Asset Transformation
o Range of products for borrowers/savers
• Maturity Transformation
o Range of maturities on offer
• Credit Risk Distribution
o Credit risk borne by intermediary who has expertise in area
• Liquidity Transformation
o Convert Financial Asset into cash
• Eos
o Benefits of organisation size/volume  lower costs

Distinguish between the various types of financial markets according to function

- Wholesale and Retail Markets

o Wholesale – Direct fin flow transactions between institutional investors and borrowers
o Retail – transactions primarily through fin intermediaries by hh/small-med biz
- Money Markets
o ST highly liquid securities are issued and traded
o Wholesale
o Enables liquidity management
o Instruments
 Exchange settlement account, Treasury note, gov bonds, commercial bills…
o Market Participants
 Banks, CB, Super funds, corporations, investment banks…
o Submarket exists for CB, bills market …
- Capital Markets
o Market in which LT securities are issued/traded with original term-to-maturity > 1 yr
 Equity, debt, derivatives
o Forex Markets
o All sectors involved
- Note: Promissory Notes are traded on the Commercial Paper Market

Appreciate the importance of globalisation of financial markets

Understand the effects and consequences of a financial crisis on a financial system and economy
Week 2 – Financial Markets and Institutions
Evaluation the functions and activities of commercial banks

- Full range of financial services

- Asset Management (Pre-1980s)
o High Regulation
o Banks matched/restricted their loan activity (assets) to the funds deposited with them
- Liability Management (Post-1980s)
o Deregulation
o Banks borrowed in the Capital Market (Liabilities) in order to meet their loans (assets)
 Importance of Matching Principle
• Finance ST Assets with ST Liabilities  LT Assets of banks
 If loan demand increases  borrow money from K Markets to meet demand
• Banks can obtain credit cheaply
- Off BS Business
o Transactions that represent a contingent liability
 Basel: Push to recognise K impact of OBS business in capital requirements by
bringing them ‘on BS’

Identify the main sources and uses of funds for commercial banks

- Appear as liability/Shareholders Equity

- A range of instruments available to attract funds (return, maturity, liquidity, CF Pattern)
o Current Account Deposits (operating Account)
 Liquid funds (Cheque Account)
• Pay for g/s
 Interest (low) or non-interest bearing
o Call/Demand Deposits
 Funds held in savings accounts
 Can be withdrawn at any time  Liquid
 Interest payment, but low
o Term Deposits
 Funds lodged in an account for pre-determined period at a fixed interest rate
• Reduced liquidity  higher interest rate
 Low Risk
 Term: 1 month  5 years
o Negotiable Certificates of Deposit
 ST Discount securities  Pay Face Value@maturity (Issued at $96 and pay $100)
 Highly negotiable
 30 – 180 days
o Bill Acceptance Liabilities
 Bill of Exchange
• ST securities issued in money market at a discount to the Face Value.
• FV repayable at maturity
 Bank-accepted Bill: A bank will guarantee the FV is paid at maturity
• Increases its credit worthiness
o Debt Liabilities
 MT-LT debt
  Debenture – bond that is securitised
 Unsecured Note – bond with no security
o Foreign Currency Liabilities
 Debt issued in foreign currency in foreign K markets
• Diversification of funding sources
• Hedging foreign currency transactions  Matching principle
• Meet demand of foreign customers
• Euromarket  debt issue into another country and denominated in a
different currency (eg. Aus company issuing debt in US denominated in
Euro)
o Loan Capital (Hybrid) and Shareholders’ Equity
 Loan K – source of funds that have both debt/equity characteristics
• Subordinated loans  repayments after creditors and before ordinary
shareholders
- Uses of Funds
o Personal Lending
 CC, mortgages, Fixed-Term Loan, Investment Property
o Commercial Lending
 Lending to other financial institutions
 Fixed-Term Loan
• Loan with negotiated t&cs (period, interest, timing of repayments…)
 Overdraft
• A facility allowing business to take their account into debit (limit)
 Bills of Exchange
• Bank Bills Held – bills of exchange accepted/discounted by a bank and
held as assets
• Commercial Bills – same as above but issued directly by business to raise
finance
• Rollover facility – bank agrees to discount new bills over a specified
period as existing bills mature
 Leasing
o Government Lending
 Treasury notes – ST discount securities issued by Commonwealth Government
 Treasury Bonds – MT-LT securities issued by government that pay specified
coupon stream
 Low Risk  Low return
o Other bank assets  eg. Investing in shares etc

Outline the nature and importance of banks’ off-balance-sheet business

- OBS Transactions include:

o Direct Credit Substitutes (guarantees etc)
 Guarantee for banks clients that they will satisfy their fin obligations
• If A doesn’t pay, Bank will pay.
o Trade and Performance Related Items
 Guarantees made by bank on behalf of client to support a client’s non-financial
contractual obligation
 • Documentary Letters of Credit (DLC) – Guarantee once A delivers good
to B, that B will pay A (eg. Exports/import situation)
• Performance Guarantee – Bank guarantees
o Commitments
 The contractual financial obligations of a bank that are yet to be
completed/delivered
• Advancing funds to clients, underwriting debt/equity, purchase assets at
some future date
o Outright Forward Purchase – forex purchase at a future date for
a specified rate at t = 0
o Underwriting facilities – bank will cover shortfall in funds
received from a primary market debt/equity issue
o Loans approved but not yet drawn
o Credit card limit approvals that haven’t been used by CC holders
o Forex, int rate and other market-rate-related contracts
 Principally – use of derivative products
 Hedge Risk or speculate
 Forward exchange contract – bank offers to buy/sell specified amount on set
date at exchange rate set today
 Currency Swap – Bank exchanges principle amount and ongoing interest
repayments that are denominated in foreign currency
• Eg. US company gives USD to swiss company in return for franks.
Interest repayments for US company will be in franks and vv.
 Forward rate agreements – compensation agreement based on a principal
amount. One party compensates the other party if interest rates move
above/below agreed interest rate
 Int rate futures – exchange traded agreement to buy/sell specific interest
bearing securitiy in the future at a specific date for a specific price
 Int rate options, equity contracts
- OBS raises concerns over banking regulation as OBS is very large

Examine the main risk exposures and consider related issues of regulation and prudential
supervision of banks

- Matching Principle: Loans (assets) are generally not matched with liabilities that are of similar
maturity
o Mortgages 30 years, whereas loans are generally 5 years and need to be refinanced
- GFC  Financial System Regulation
o Fin institutions collapsed due to high leverage and poor liability management
- Goal of regulators  stable financial system
o Banks extremely important for strong economy
- Prudential Supervision – imposition of monitoring/standards designed to ensure stable FS
- AUS Regulatory structure
o RBA – System stability + Payment System
o APRA – Prudential regulation and supervision of deposit taking institutions
o ASIC – Market Integrity + Consumer Protection
o ACCC – Competition Policy
- Governments may provide guarantees over bank deposits
Understand the background and application of the capital adequacy standards

- Capital acts as a buffer for abnormal losses that a business has to write off
o If K inadequate, insolvency will occur
o Basel  Capital adequacy standards  define minimum capital adequacy for banks in
order to encourage financial stability
- Functions of Capital
o Equity Funding
o Enables growth in a business (future investment)
o Demonstrates shareholder commitment in a business
o Necessary to ‘write-off’ abnormal losses against
- Unstable FS
o Deregulation + globalisation + tech. development + sophistication of Fin Products
- G-10 Senior Banking Coordinators  ‘Basel Committee on Banking Supervision’
o Overriding Purpose:
 Develop Framework to maintain soundness of international FS
 Allow individual banks to make their own investment choices
 Increase competition between the banks
- Basel I (1988)
o Initially successful in increasing K held by banks  increase FS stability
o Increasing diversification/sophistication of global markets  reduced effectiveness
o Principally focused on credit risk
- Basel II (2008)
o Includes other regulated institutions
o Increased sensitivity to different risks above and beyond credit risk. Focus on:
 Credit Risk – bank’s assets + OBS business
 Market Risk – Trading activities
 Operational Risk – Banks business operations
 Quality of K held – Tier 1/Tier 2
 Risk Identification measurement/processes
 Transparency through accumulation and reporting of related info
- Background to Capital Adequacy Standards
o Minimum K adequacy requirement for banks/other fin institutions
o Requires, at a minimum, to hold risk-based capital ratio of 8% of total risk weighted
assets or above
 At least half of requirement has to be Tier 1
 Risk Weighted Assets = banks assets/OBS weighted according to risk
• OBS brought ‘on BS’
o Tier 1 Capital
 Highest Quality Capital
• Provide a permanent and unrestricted commitment of funds
• Freely available to absorb losses
• Don’t impose unavoidable servicing charges against earnings
• Rank behind the claims of depositors/other creditors in the event of
winding-up
 Ordinary shares (paid up), RE, General Reserves
o Tier 2 Capital
 Other Capital
  Upper Tier 2 = elements that are essentially permanent in nature
• Hybrid instruments, subordinated debt, preference shares
 Lower Tier 2 = instruments that aren’t permanent (limited life)
• Limited-life preference shares, some subordinated debt

- Pillar 1 – Capital Adequacy

 Credit Risk
• Standardised Approach
• Internal Ratings Approach
o Foundation Internal Ratings based approach
o Advanced Internal Ratings based approach
 Operational Risk
• Standardised Approach
• Advanced Measurement Approach
 Market Risk
• Standardised Approach
 Internal Model Approach
o Credit Risk – Risk the borrower won’t meet commitments when they fall due
 3 Measures:
• 1. Standardised Approach  APRA Return credit ratings. 3 measures:
o i. Risk weight applied to BS/OBS items to calc min K
o ii. Risk weights derived from external rating grade/supervisor
o iii. Loan-to-Valuation Ratio (LVR) and level of mortgage
insurance applied for housing loans
• OBC converted to Balance Sheet equivalents according to credit
conversion factors  credit risk subsequently determined
o 2 Methods:
 Current Exposure Method: Current + Potential credit
exposure (Mark-to-Market)
 Original Exposure Method: Notionally contract value x
Credit Conversion Factor
 • 2. Internal Ratings Approach – Bank uses their own risk measurement
model factors subject to APRA’s approval
o 1. Foundation Internal Ratings Based Approach (FIRB)
 Bank Calc’s probability of default + effective maturity
 Relies on APRA’s estimates for credit risk components
o 2. Advanced Internal Ratings Based Approach (AIRB)
 Bank provides all credit risk components
o Operational Risk – Exposures that may impact on normal day-to-day business functions
of an organisation
 Fraud, natural disasters, damage to physical assets, system failure etc.
 Main aim: develop development of strategies to enable a bank to recover
functionality and resume critical business functions within a certain time-frame.
3 Overarching objectives of operational management:
• Operational Objective  associated with impact on a bank of the loss of
business function integrity/capability
• Financial Objective  relates to direct losses incurred as a result of an
operational risk exposure, the cost of recovering normal business
operations and consequential financial losses to reduced business
effectiveness
• Regulatory Objectives  Derive from prudential standards established
by bank supervisors
 Business Continuity Management (BCM)
o Market Risk – risk of losses from changes in market rates (forex interest, equities,
commodities)
 General Market Risk – changes in overall market for int rates, forex, equities,
commodities
 Specific Market Risk – changes in value of security due to issuer specific factors
such as change to credit rating of issuer
• Relevant to equity/interest rate positions only
 2 Approaches:
• Standardised Approach
• Internal Model – statistical probability model that measures financial
risk exposures. Value-at-risk models (VaR)
o Use past portfolio performance and future assumptions
o Sensitivity of portfolio to changes in prices
o Account for effects of diversification
- Pillar 2 – Supervisory Review of Capital
o Goal
 Ensure all banks are sufficiently capitalised to support risk
 Improve risk management policies/practises in identifying/managing/measuring
risk exposure
o Supervisor will evaluate how well bank is assessing K needs relative to risk
 Will intervene if insufficient K needs for risk profile
o 4 key principles:
 Bank should have a process for assessing their overall K adequacy in relation to
their risk profile
  Supervisors should review/evaluate banks internal K adequacy
assessment/strategies, and their ability to monitor/comply with reg K ratios
 Supervisors should expect banks to operate above min K ratios and have ability
to require banks to hold K in excess of the minimum
 Supervisors should seek to intervene at an early stage to prevent K falling below
the min K levels required to support their specific particular risk portfolio
- Pillar 3 – Market Discipline
o Purpose: to encourage market discipline by developing a set of disclosure requirements
that allow participants to assess info on a bank’s capital adequacy
 Increase transparency
 Supervisors determine the min requirement
 Basel II recommends:
• Quant + Qual disclosure requirements
o Methodologies used
o K structure
o Determination of Credit Risk exposures etc
• Allows participants to judge bank on their processes  encourage best
practise
- Basel III  NOT SURE IF EXAMINABLE
o Aim: To Increase K adequacy requirements to increase risk coverage of Basel II
 AUS ADIs are well placed to meet Basel II
o 3 Principle aims
 Boost banking sectors ability to absorb fin/eco shocks
 Improve risk management and governance
 Strengthen Bank’s transparency and disclosure
o Broad Framework
 Strengthen K Base
• Increase Tier 1 K to 6% of risk-weighted-assets
• Increase common equity to Tier1 K to 4.5%
• Improve quality of K capital
• Create K conservative buffer
 Improve Liquidity Requirements
• Min Liquidity Coverage Ratio (LCR)  ensure banks have sufficient high-
quality liquid assets (HQLA) to meet expected net cash outflow in a 30
day scenario
o HQLA – gov bonds etc. In Aus, banks have gov guarantee
(committed liquidity facility provided by the government for a
fee)
o APRA’s current standard is 5 days
• Min Net stable Fund Ratio (NSFR)  Ensures assets with greater risk of
suffering 1 year stress event are matched with LT financing
 Governance and Systematic Risk Mitigation
• Create Firm wide governance and Risk Management
• Set maximum leverage ratios to prevent excess leverage in good periods
• Identify global systematically important banks for special treatment

Examine liquidity management and other controls applied by APRA

- Liquidity – access to funds to meet ST expenses and commitments
- Liquidity problems for banks
o Mismatch in security structure of BS Assets and Liabs CFs  Matching Principle
 Assets = LT, Liabilities = ST
o Role of banks in payment system  require funds for everyday transactions (bank runs)
- Liquidity Prudential Standard APS210 (APRA). Liquidity management strategy must include:
o Board must implement and annually review liquidity management strategy (ICAAP)
o A system for measuring, assessing and reporting liquidity
o Procedures for managing liquidity relevant to for BS/OBS activities
o A formal Contingency Plan for dealing with potential liquidity crisis
o Clearly defined managerial responsibilities and controls
- APRA reserves the right to set minimum level of liquid assets
- APRA stipulates two scenarios that must be addressed:
o The going concern – a bank must be able to able to satisfy its commitments and meet
day-to-day basis over at least 30 days
o The name crisis – a bank must be able to demonstrate that it’s able to obtain sufficiently
liquidity to keep operating during the crisis situation for at least 5 business days.
- Significant focus on internal management practises to manage liquidity:
o Setting limits on maturity mismatch between assets/liabilities
o Holding high-quality liquid assets
o Diversifying liability sources to maintain stable funding base
o Access to foreign currency markets to diversify and meet foreign-currency-denominated
commitments
o Use of assets through sales etc to provide liquidity
- Other regulatory/supervisory controls:
o Audit  reliability of statistical data used for capital adequacy
o Risk management systems certification  An annual attestation from CEO, endorsed by
the board, of the efficacy of the bank’s risk management systems
o BCM  board must ensure that policies/procedures in place to identify, measure and
manage business continuity risk (operational – critical functions)
o Disclosure and transparency  bank supervisors expect banks to improve quality of
publicly disclosed information. Assists in getting market participants to exercise their
own discipline  encourages best practise
o Foreign currency exposure  currency exposure limits for banks
o Subsidiaries  transparency between subsidiaries to ensure appropriate K support
o Ownership and control – an individual, entity or group isn’t permitted to have an
aggregate interest > 15% of voting shares of an institution – exemption can be sought
from treasurer of Australia
- Ultimate responsibility for sound/prudent operation lies with the board of directors

Week 3 – Equity Market 1

- Corporations
o Share Market – formal exchange facilitates buy/selling of equity securities
o Publicly Listed Corporation – company whose shares are quoted/traded on ASX
o Ordinary Share – principal form of equity issued by a corporation. Residual CF,
ownership and voting rights.
 o Ownership differs from other businesses
 Ownership is widespread and don’t affect day-to-day operations
 Shareholder’s liability is limited to share price
• No liability company – shareholder isn’t required to pay the call options
on partly paid shares
- Advantages of the corporate form
o Easier and cheaper to raise large amounts of finance
 Because secondary market  liquid investment
• Investors more willing to purchase
 Cheaper funds for larger corporations than smaller firms (lower ROE required)
o Liquidity of securities facilitates investor diversification
o Separation of ownership
 Can appoint specialised management
 Allows a corporation to plan/implement strategic decisions
o Perpetual Succession – corporate form is unaffected by changes in ownership/mgmt.
- Disadvantages of the corporate form
o Agency Problem – conflict of interest between mgmt (agent) and owners (principals)
 Ie. Mgmt may run business for personal benefit rather than shareholder value
 An efficient market should minimise concern of conflict of interest
• Owners would express satisfaction through purchase/sale of shares
o Ie. Dissatisfaction  sale of shares  lower price  reduce
managements reputation
• However, management could implement ST maximisation strategies…
 Align interest of owners and management – performance incentives
 Improve corporate governance (relationship b/w shareholders, board & mgmt)
• Ensures accountability and transparency
- Roles of Stock Exchange
o Primary, secondary, managed product, derivative, interest rate market roles and trading
and settlement, information, regulatory roles
o Primary Market
 Initial Public Offerings (IPOs) – listing of corporation on stock exchange
• Prospectus
 Rights issue – issue of additional shares to existing shareholders (pro-rata)
 Placements – issue of new shares to selected institutional investors
 Dividend Reinvestment Plans – RI of Dividends for additional shares
o Secondary Market
 Facilitates trading of existing shares
• Improves the appeal of buy new shares in primary market
 Market liquidity – ratio of (value of share turnover)/(market capitalisation)
 Market Capitalisation – number of shares on issue x current share price
o Managed Product Role
 Equity Based Managed Products – professionally managed funds
• Buy units in these funds. The fund pools together capital and invests it
into other securities on the exchange. Units bought/sold like shares
o Exchange Traded Funds (ETF) – investment in a basket of
securities
 ASX 200 ETF
 • Value of fund is based on underlying securities
o Infrastructure funds, Real estate investment funds…
o Derivative Market Roles
 Derivative – financial security that derives price from an underlying commodity
or financial instrument. Used to hedge or speculate.
• Exchange Traded Contracts – standardised financial contract traded on
exchange – options, warrants, futures contracts, CFD…
• Over the counter contracts – non-standardised negotiated contracts
 Contract For Difference (CFD)
• Contract on ASX to exchange the difference in value of an underlying
security between contract start/close values
 Options
• Gives the buyer the option, but not obligation, to buy (call) or sell (put) a
specified security at a predetermined price, on or before a
predetermined date
 Warrants
• A financial instrument that conveys a right in the form of an option.
Conditions are determined by the warrant issuer (eg. Bank)
 Futures Contracts
• A contract between two parties to either buy/sell a specified commodity
or financial instrument at the expiry date of the contract
o Settlement can be delivery of underlying security or payment of
a cash equivalent
o Interest Market Role
 Listing, quotation and trading of debt (typically LT) on the stock exchange
• Straight Corp. bonds – fixed interest security
o Secured = debenture
o Unsecured = unsecured note
• Floating rate notes – corporate bond that pays variable interest rate
• Convertible notes – hybrid security. Fixed-interest debt that includes an
option to convert the note into ordinary shares at a future date
• Preference shares – hybrid security. Fixed dividend for a set period.
Option to redeem the preference shares for cash or convert into
ordinary shares.
 Prospectus required for debt issue
 Adds value to a debt issue:
• Transparency: information on price, yield, maturity, credit rating of debt
instruments
• Ease of entry and exit: investors can place orders electronically to
buy/sell at minimum cost/delay and at current prices
• Liquidity: quotation on stock exchange provides access to wider market
- The trading and settlement roles of a stock exchange
o ASX Trade (equity) and ASX Trade24 (derivatives) – integrated computer-based trading
systems to trade all securities and derivatives
 Orders executed via brokers computer
• Executed in order of time and then buy/sell price
o Contract Note – sent by a strockbroker to advice a client of a share transaction
 o CHESS (Clearance House Electronic Sub-register System)
 Settlement (transfer of ownership)
 T+3
 Electronic Sub-register records the ownership of listed securities
- Information Role of a Stock Exchange
o Investor confidence in ASX relies on information efficiency
 Current share price should reflect all available in the market. Determined by:
• Speed at which information flows to the market
• Speed at which the information is absorbed/reflect in share prices
o Continuous Disclosure
 Listing rules of the ASX requires information that may materially affect share
price to be given to the ASX immediately – Corporations Act
• ASX disseminates information to market participants
 Example of info disclosure
• Change in forecasts, appointment of liquidator, dividend declaration,
takeover bid, disclosure of directors’ interests
- Regulatory Role of Stock Exchange
o Aim of Regulation: Ensure market participants have confidence in integrity of market
o ASX
 Continuous Disclosure – Listed companies required to meet specific disclosure
standards
 Sanctions (penalties, loss of license) – prescribes appropriate behaviour of
brokers on exchange
 Electronic Surveillance Systems to monitoring trading behaviour – detect
suspicious trading activity and abnormalities
o ASIC
 Supervision of Corporations Law and markets in Australia
 Covers the financial system (investment, insurance, super products)
 Supervises ASX (addresses conflict of interest posed by ASX being publicly listed)

5.1 Investment Decision: Capital Budgeting  Invest in which assets

- Invest to maximise shareholder value

- 2 Important quantitative measures for making decisions on accepting/rejecting:
o Net Present Value
o Internal Rate of Return
- NPV - Difference between the cost of an asset and PV of FCF ($)
o PV = discounted FCF by appropriate discount rate
 present value = S (1 + i)-n
o Inv Rule: Invest if NPV is positive
- Internal Rate of Return – percentage figure as the rate of return (%)
o The discount rate that results in NPV = 0 when discounting investments FCF
o Inv Rule: Invest if IRR > firm’s required rate of return
o More difficult in real life
o Problems:
 Non-conventional CF – occurs when ongoing CF of investment are not always
positive
  Mutually exclusive projects – when a business can only choose 1 projcet, IRR
does not account for nominal benefit for firm  Use NPV

5.2 The Financing Decision: Equity, Debt and Risk  how to fund purchase of these assets

- Financing decision  capital structure that finances a firm’s assets/activities

- Financial Objective  maximise shareholder return subject to acceptable level of risk
- Risk – probability that actual CF will vary from expected outcomes
o Business risk – exposure to factors that have an impact on firm’s activities/operations
 Eg. Speculative mining company has high risk, but high return
 Depends on type of operations (aggressive competitors, market share,
management competence etc.)
o Financial risk – exposure to factors that have an impact on value of firms assets,
liabilities and associated CF
 Interest rate risk – movements in interest rates that may adversely affect cost of
funds or value of investments
 Forex risk – assets/liabilities/revenues/expenses in foreign currency
 Liquidity risk – having sufficient cash/liquid assets to meet forecast operating
requirements
 Credit risk – debtors do not repay their obligations on time or default on
repayment
 Capital risk – occurs when SH funds are insufficient to meet K growth/abnormal
loss write offs
 Country risk – risk of financial losses associated with country specific factors…
regulation, political unrest etc.
- Debt to Equity Ratio
o Indicator of risk being unable to meet interest due and principal repayments associated
with debt
o Is raising debt against interests of shareholders? – no
 Earnings per share (earnings attributable to ordinary shareholders) =
• (Net income – dividends on preferred stock) / (avg. o/s shares)
 A company can borrow at 9% to finance a project with net return of 15%
• Shareholders benefit from this 6%, rather than diluting profits by raising
equity
• However, increased risk  if return is less than 9%
• Higher debt  higher potential shareholder return but higher EPS
variance
- Appropriate Debt to Equity Ratio
o Gearing Ratio – any ratio comparing OE to borrowed funds… lots of ratios
o No magic number. 4 main criteria to determine ideal ratio:
 Industry norm
 Firm’s history of ratios
 Limits imposed by lenders (loan covenants)
 Management’s decision concerning firm’s capacity to service debt
- Too much debt  increased risk  high cost of funding
- Too little debt  may not maximise shareholder value
5.3 Initial Public Offering

- IPO – offer to investors of ordinary shares in a newly listed company on the ASX
o Prospectus – document prepared by company stating terms and conditions
- Flotation of a business – public listing and quotation of a corporation on the ASX
- Promoter – company seeking to list on the ASX
- Underwriting – contractual undertaking to purchase securities that are not subscribed by
investors
- Limited liability company – claims of creditors against shareholders are limited to issue price of
their fully paid shares
- Ordinary shares (limited liability) – principal form of equity issued by corporations
o Residual ownership claim on firm’s assets
o Voting rights
o Liability limited to extent of fully paid share
- Ordinary shares (no liability) – issue ordinary shares to raise equity funds but shares are issued
on a partly paid basis  in Aus, only mining companies are allowed this
o Eg. $2 per share  initial call may be $0.15 for exploration
 If gold discovered  each shareholder can decide to pay the next call or decide
to not pay the call

5.4 Listing a business on a stock exchange

- If a listed company doesn’t comply with listing rules  liable for suspension/delisted
- Listing rules – criteria that must be met by an entity seeking to list on the stock exchange
- Dual listing – shares of an MNC are listed on more than one stock exchange
o Access to wider capital
o Increases liquidity
o Create 2 holding companies and list on 2 stock exchanges  each holding 50% of assets

5.5 Equity funding for listed companies

- Additional ordinary shares

o Rights issue, placements, takeover issues, dividend reinvestment schemes
o Rights issue – issue of ordinary shares to existing shareholders in pro-rata (1:5)
 Factors influencing issuing price:
• Company’s CF requirements – greater necessity for funds  lower the
rights issue offer price
• Projected earnings flows from new investments funded  more
attractive the expected earnings CF the more attractive to shareholders
therefore lower discount required
• Cost of alternative funding sources  cost benefit analysis of various
funding forms
 2 types:
• Renounceable – shareholders may sell their right
• Non-renounceable – shareholders can’t sell their right
 If you don’t take up rights your shares are diluted by other people taking offer
 Purchase plan  offer to purchase fixed $ amount of shares at predetermined
price (eg. $10,000 or $20,000)
o Placements – additional ordinary shares sold to selected institutional investors
 No prospectus, however a memorandum of information required
 • Info required to be provided to institutional investors
 Minimum subscription - $500,000
 Not more than 20 participants
 Price discount cannot be excessively discounted
 Can raise large amount in short time frame
 Dilution of existing shareholders
o Takeover issue
 Equity funded takeover - Acquiring company issues additional ordinary shares to
owners of target company in settlement of transaction
 Alleviates need for owners of acquiring firm to raise additional cash for takeover
o Dividend Reinvestment Scheme
 Shareholders have option to reinvest dividends in additional ordinary shares
 Usually a discount between 0 – 5 %
 No brokerage/stamp duty
 Growth periods  allows companies to pay dividends and pass on tax credits to
SH whilst increasing equity for future funding
 Schemes may be suspended in low growth periods  cost of equity too high for
any projects that have on offer
- Preference shares
o Hybrid security (debt and equity characteristics)
o Fixed dividend rates are set at issue date
o Rank ahead of ordinary shareholders (dividends/liquidations)
o Features:
 Cumulative or non-cumulative  if a company is not able to make fixed
dividend payments, amount due is carried forward to next period
 Redeemable or non-redeemable  holder is able to redeem preference share
on predetermined date and to receive specified value of cash for the preference
shares they hold.
 Convertible or non-convertible  may be converted into ordinary shares in the
issuer company at a future date. Generally at a discounted market price
 Participating or non-participating  holders will receive a higher dividend if
ordinary shares receive a dividend above a specified amount
 Issued at different rankings  1st ranking preference shares have rank over 2nd
o Advantages:
 Optimal for companies that require funds but reached optimal gearing ratio
 Widen equity base  allows further debt to be raised
 Dividends may be deferred on cumulative shares (interest on debt must be paid)
- Quasi-equity and convertible notes
o Convertible notes – hybrid debt instrument, fixed term, stated rate of interest. Holder
has the right to convert the note into ordinary shares at a specified date
 If view of undervalued or growth stock  holder will convert
 Usually have a lower rate of interest due to option on note
 Advantages to company:
• Can obtain financing with lower interest due to option
• Interest repayments are tax deductible
 Notes are generally available on a pro-rata entitlement to shareholders
 Entitlements to convertible notes are generally not renounceable
 Notes are usually issued at a price close to current share price at time of issue
  Holder has the right to convert the note into ordinary shares
o Company issued options
 Bestows a right, but not an obligation, the holder to buy ordinary shares in a
company
• If holder exercises the right  company able to raise additional equity
 Typically offered in conjunction with rights issue/placement
 Issued free or sold at a price
 Option will be exercised if exercise price < market price at date
o Company issued equity warrants
 Holder has conditional option to buy ordinary shares of a company
 Differs to company issued options  attached to debt not equity
 Terms of warrant:
• Detachable – can be sold separately from original debt security
• Non-detachable – cannot be separated from host debt security
 Attractive to investors  lower the cost of borrowing
 No dividend payments  potential for K gains (purchase price < market price)
 Warrants may be detachable and traded separately from the bond issue

Week 4 – Ethics
What is Ethics?

- Ethics
o A set of guiding morale principles or values
- Ethical Behaviour
o Behaviour that conforms to those values

Why do we need Ethics in finance Industry?

A review of history of ethics in finance & investment industry

- Recent significant fines for unlawful/unethical behaviour

o HSBC - $1.9bn (HSBC – money laundering), UBS - $1.5bn (UBS – libor rigging), JPM -
$920m (trading scandal)
- Ethics has been around for centuries. We all know we should behave ethically.
- 1994 – Nick Leeson (Rogue Trader)  brought down Barings bank
- Sept 2013 survey
o Most firms have attempted to improve adherence to ethical standards
 Goldman sachs etc.
o Industry executives champion the importance of ethical conduct
o Executives struggle to see the benefits of greater adherence to ethical standards
 Some see career advancement may be difficult if they are not flexible on ethics
• Ethical dilemma in industry
o Lack of communication and understanding between departments

What are the issues?

- Betrayal of trust
o 48% of institutional/retail investors do not trust financial services investors
 o Attributes that investors value the most = acting in the best interest of the client (35%)
- Restoring trust
o Embrace transparency
 Clearly articulate investment success/missteps
 Disclose conflicts of interest, quickly address problems
 Fully disclose fees and impact
o Demonstrate integrity
 Resolving conflict of interest in favour of clients
 Structure fees to align with clients’ risk/return objectives
o Improve communication
 Communicate with clients early and often throughout investment process
 Fairly represent the investments made, risk, expenses
 Avoid ambiguity in communications

CFA Code of Ethics and Standards of Professional Conduct

- Code of Ethics
o Act with integrity, competence, diligence, respect and in an ethical manner with the
public, clients etc. in the investment profession
o Place the integrity of the investment profession and the interests of clients above my
own personal interests
o Use reasonable care and exercise independent professional judgement when conducting
investment analysis, making investment recommendations, taking investment actions,
and engaging in other professional services
o Practise and encourage others to practise in a professional and ethical manner that will
reflect credit on ourselves and our profession
o Promote the integrity of, and uphold the rules of governing, capital markets
o Maintain and improve my professional competence and strive to maintain and improve
the competence of other investment professionals
- Standards of Professional Conduct (7)
o Professionalism
 Knowledge of the Law
• Responsibility to understand the law (government, regulatory,
professional associations)
• Compliance with the law
o Apply to the stricter of applicable law
o Not knowingly participate/associate in any violation
 Independence and Objectivity
• Avoid situations that could be seen to avoid a loss of independence in
recommending investments
• Ways in which independence/objectivity may be compromised:
o Gifts, tickets, invitations, job referrals…
 Misrepresentation
• Must not knowingly make any misrepresentation relating to investment
analysis, recommendations, actions, or other professional services
• Misrep: Any untrue statement or omission of a fact or any statement
that is otherwise false or misleading
• To avoid misrepresentation:
 o Be honest about professional credentials and performance
o Exercise care and due diligence when relying on 3rd party info
o Disclose use of external managers
o Be forthcoming with risk of investments
 Misconduct
• Avoid dishonest, fraudulent, or deceitful conduct that reflects adversely
on professional reputation, integrity, or competence.
• Trust is the epicentre of operations of the fin market as a whole
o Integrity of Capital Markets
o Duties to Clients
 Loyalty, Prudence, and Care
• Loyalty – carry out investments actions for sole benefit of the client and
their best interest. Placing client interest before employer’s or your own
interest
• Prudence – act with care, skill, and diligence in the circumstances that a
reasonable person in a like capacity would use
• Care – Act in a prudent and judicious manner to avoid harming clients
 Fair Dealing
• Deal with clients fairly with respect to investment recommendations
• Recommend policies and procedures to ensure that all
individual/institutional clients are treated fair and impartial manner
when taking investment actions
• Suggestions for fair dealing compliance:
o Limit the number of people involved
o Shorten timeframe between decision and dissemination
o Disseminate investment recommendations simultaneously
 Suitability
• Responsibility to ensure that your actions/recommendations is suitable
to their needs
o Need to understand client’s objectives (risk + return)
• Document client’s needs, circumstances, and investment objectives in
an investment policy statement
o Investor objectives, constraints, client identification etc.
 Performance Presentation
• Give a fair and complete presentation of performance information by
o Apply Global Investment Performance Standards (GIPS)
• Without GIPS standards:
o Consider knowledge/sophistication of audience to whom
performance presentation is addressed
o Include terminated accounts as part of performance history with
a clear indication of why they were terminated
o Include disclosures that fully explain performance results being
reported
o Maintain data/records used to calculate performance measures
 Preservation of Confidentiality
• Maintain client confidentiality related to info
 o You receive as a result of your ability to conduct a portion of the
client’s business or personal affairs
o That arises from or is relevant to that portion of the client’s
business that is the subject of the special or confidential
relationship
• Disclosure the info when
o Required by law
o Information concerns illegal activities on the part of the clients
o Permission is obtained from the client
• Simplest way for compliance
o Don’t talk about clients information
o Duties to Employers
o Investment Analysis, Recommendations, and Actions
o Conflicts of Interest
o Responsibilities of a CFA Institute Member or CFA Candidate

Week 5 – Forecasting
Evaluate and apply bottom-up and top-down approaches to fundamental analysis

- Fundamental Analysis – identify factors that are likely to influence directional changes in the
value of a company and hence its share price
o Micro: Firm specific factors
o Macro: Market factors
- Top-down approach (Macro factors  determine strong industries to invest in)
o Forecasts that overall global/domestic economic environment in which corporations
operate
o Share price is determined by supply/demand of a company’s shares
o Expectation of bad company performance  sell shares  reduce price
o It considers macro factors:
 Domestic economy
• Growth, BOP, inflation, wage/productivity, Gov response
 Eco growth
• Higher growth in int markets  increase demand for domestic exports
 Exchange rate
• Cost of imports
 Interest rates
• Direct effect on profitability
o Cost of debt finance and return for finance providers
• Indirect effect on profitability
o Rise in interest rates may indicate a future slowing in eco
growth
• Relationship exists between interest rates/exchange rates
 Inflation
• Effects firm’s real profit
• Inflated selling price of inventory  illusion of inventory profits
 Wages Growth
 • Increase in wages growth  increases expenses
o Impact labour intensive firms
 Balance of Payments Current Account
• Financial record of earnings from X of goods and services to the rest of
the world less M, + income earned on investments made overseas less
the cost of overseas borrowings
- Bottom-up approach
o Performance analysis that focuses on accounting ratios and other measures of a firm’s
performance
o Approach focuses on accounting ratios and other measures of a firm’s performance
o Included ratios:
 Capital structure
 Liquidity
 Debt servicing
 Profitability
 Share price and equity
 Risk
o Additional inputs that may help in making decisions:
 Intelligence on changes in key management positions
 Information on the corporate mission, corporate governance and planned
strategic directions
 Examination of the recent history of indicators
 A comparison of the performance indicators with other similar firms in the same
industry
• Stock screens
o Modern Portfolio Theory
 Concepts that enable a portfolio to be constructed with optimal risk/return
relationships
o Systematic risk – exposures that affect the price of the majority of shares
o Unsystematic risk – exposures that specifically impact on the particular share’s price

Describe and apply technical analysis techniques (not examinable)

- Technical Analysis – explains and forecasts price movements based on past price behaviour
o Assumes markets are dominated at certain times by a mass psychology, from which
regular patterns emerge
- Share price patter – graph over time of movements in a share price or a market index
- 2 main forecasting models
o Moving averages (MA)
o Charting

Examine the role of program trading

- Refers to buy and sell strategies generated by computer programs

o Automatically buys/sells orders by rules entered into a computer program
- Programs range between
o Simple buy/sell orders based on moving averages
o Complex monitoring derivative/share markets for the purpose of hedging a portfolio
- Increases the frequency of trading
- High-Frequency Trading
o Supercomputer algorithms analyse data, identify investment opportunities and place
thousands of buy/sell orders in seconds to take advantage of big/offer spreads
- Flash Trading
o Privileged HFT firms receive info on orders split seconds before the info reaches ETS

Explain the theoretical concepts and implications of the random walk and efficient market
hypotheses when forecasting share price movements

- 2 theories on security values and changes in price:

o Random Walk
 Share price is assumed to be performed by investor’s expectations of FCF
 Price will change in response to new information
• Info arrives randomly  stock prices adjust in unpredictable fashion
 Equal probability that the next price will move up, down or remain unchanged
o Efficient Market Hypothesis (EMH). 3 forms of EMH:
 Weak form – stock prices reflect historical price data (no current data or future
info)
 Semi-strong form – all publicly available info is reflected in share price
 Strong form – public and private info is fully reflected in share price
o Alternative models of investors behaviour
 Behavioural Finance
• Attempts to understand investor behaviour
• Based on psychological principles of behaviour
 Explain market volatility and stock market crashes:
• Over-confidence, over-pessimism, herding, noise trading, framing…

Week 6 – Investors in the Share Market

Consider the role of an investor in the share market and appreciate the range of investment choices
available to the investor

- Investors buy returns to receive returns (dividends, K gains)

- Other factors encouraging investment in securities on ASX
o Depth of market
 Overall capitalisation of corporations on ASX
o Liquidity of market
 Volume of trade relative to size of market
o Efficient price discovery
 Speed at which new info is reflected in the current share price
- A range of securities are offered on the stock exchange
- 2 types of risk
o Systematic
 Factors that generally impact on share prices in the market
• Sensitivity to overarching market factors (interest rates etc…)
o Unsystematic/idiosyncratic
 Factors that impact specifically on the share price of a corporation
• CEO etc.
  Can be diversified away  not priced
- Diversified Investment portfolio
o Portfolio containing a wide range of securities
 Diversifies most of unsystematic risk of individual stocks
o Remaining risk = Beta (systematic risk)
o Expected return = weighted average of expected returns of each share
o Portfolio Variance = correlation of pairs of securities within portfolio
- 2 approaches to investment management
o Active Inv approach
 Assume superior ability to pick stocks to outperform the market
• Pick portfolio based on share analysis, new info, risk-return pref.
o Passive Inv approach
 Portfolio structure based on replicating a specified share-market index
• Industrials index, S&P/ASX 200…
- Other considerations with asset allocation within share portfolio
o Risk versus return
o Investment horizon
o Income versus capital growth
o Domestic vs international shares
- GFC
o Large amount of retirement savings is invested in share market
 Investment horizon for those nearing retirement is short
• Market prices fall  capital losses
o Little time to recover these losses before retirement

Understand the process of buying and selling shares, the risks involved, and the importance of
taxation when investing

- Direct Investment in shares

o Buys/sells shares through a broker
 Discount broker (phone, internet)
 Full service broker  more expensive and provide investment advice
o Consideration when investing: liquidity, risk, return, taxation, accessibility etc.
- Indirect investment in shares
o Investor purchases units in a unit trust or managed fund  they invest in shares etc.
 Traded on ASX  easily liquidated
- Taxation
o Pre-Dividend imputation (1987)
 Dividends were taxed twice  company taxation + investors taxation
o Dividend Imputation (1987)
 Removed double taxation of dividends
 ‘franking credit’ for tax company has paid
- Franking credit = franked dividend x (company tax rate / (1 – company tax rate))
o Eg. Above $70 * (30% / (1-30%)) = $30 franking credit
o Note: Calculate example where not fully franked
 If only 50% franked, multiply $70 by 50%  franked credit = $15
- Capital Gains Tax
o Prior to 1985  tax free
o 1985 – 1999  marginal tax rate applied if held less than 12 months, marginal tax rate
applied to index K gain if held over 12 months
o 1991 – Current  50% discounted gain if held at least 12 months, or marginal tax rate
for < 12 months

Describe indicators of financial performance

- Company performance affects profitability of company and variability of CF

- Indicators of financial performance

o K structure
 Proportion of funding obtained through debt and equity
• Debt to Equity ratio – Liabilities : Shareholders Equity
o Higher D/E  higher levels increases financial risk
o Net income / Shareholders Equity
 Raise debt @ 6% to finance a project with return of 12%
 Shareholders Equity doesn’t change (Assets increase,
liabilities increase)
 Net income increases by 6%
 However, increases financial risk
• Proprietorship ratio - SE : Total Assets
o Higher ratio indicates less reliance on debt financing
 LT viability/stability
o Liquidity
 Ability of a company to meet its ST financial obligations
 Current Ratio
• Current Assets (maturity < 1 yr) / Current Liabilities (maturity < 1 yr)
• Doesn’t consider illiquidity of certain current assets (inventory)
• If ratio < 1  company can still obtain ST finance if required (credit)
o Holding excess amounts of cash can be inefficient
 Liquid Ratio (Quick Ratio)
• (Current Assets – Inventory) / (Current Liabilities – bank overdraft)
 • Note: overdraft can be negotiated to be extended – hence removed
o Debt servicing
 Ability to meet debt-related obligations (interest repayments etc)
 Debt to Gross Cash Flow Ratio
• Debt / Operating CF
o Operating CF = NOPL + Depn + Capx – Change in NWC
• # of year’s CF required to repay total firm debt
 Interest Coverage Ratio
• (Earnings before finance lease charges, interest and tax) / (finance lease
charges and interest)
• If profit is negative, ratio is redundant…
o Profitability  higher ratios = more profitable
 (EBIT) Earnings before interest and Tax to total funds ratio
• EBIT / (SE + borrowings)
 EBIT to LT funds ratio
• EBIT / (SE + borrowings – ST debt)
 Return on Equity
• Net income / SE
 Earnings per Share
• (Net income – dividends on preferred stocks) / (Avg. o/s shares)
o Share Price
 Represents on investors view of PV of future net CF
 Indicators:
• Price to Earnings
o Price per share / earnings per share
o How many years it takes to pay back the equity market
capitalisation of the company
o High p/e  pay more for less earnings
 Stock could be overpriced (paying too much), or
 Expectation of future growth, hence the higher price
• Example – tech startup  $10 price with very
little dividends  high price indicates growth
potential
o Low p/e  pay less for more earnings
 Stock could be under-priced, or
 Mature company with less future growth potential
o If low earnings per share for the period, can distort share price
• Share price to net tangible assets
o P/NTA
o Theoretical premium/discount at which firm’s share price is
trading relative to NTA

Demonstrate share pricing methods

- Shares priced according to supply and demand for a share

o PV of future dividend payments to shareholders
o New info that changes expectations about future dividends  change share price
- Dividend Valuation Model
 ∞
D t

P = t=1 t
(1+rs )
0

P = current share price

0

D = expected dividend per share in period t

t

o r = required rate of return

s

o Constant Dividend

D
P=0
0

rs

o Constant Dividend growth

1+g
 
 
 
 

P =D
 
 
0 0


r −g



s




- Cum dividend and ex Dividend

o Dates differ between dividend declaration and payment
o Ex Dividend date  date at which after you are not entitled to the dividend
 Theoretically, share price will fall on the ex-dividend date by size of dividend
 Note: Takes T + 3 to obtain right to purchase
 Ie. If 30/6/14 is the ex div date  have to purchase 3 days in advance to have
right to dividend
- Bonus Share Issue
o If a company accumulates reserves  distribute to shareholders  bonus issue
 Capitalising accumulated reserves
 Downward adjustment when shares go ex-bonus
 No new K is raised, no changes in assets/expected earnings of company
o Example—If a bonus 1:4 issue is made:
 Cum-bonus price $5.00
 Market value of 4 cum-bonus shares $20.00
 Theoretical value of 5 ex-bonus shares $20.00
 Theoretical value of 1 ex-bonus share $4.00
- Share splits
o Division of a number of shares on issue
o No fundamental change in structure/asset value of company
o Example – 5 for 1 split
 Pre-split share price $50
 Theoretical ex-split share price $10
o Microsoft example
- Pro-rata rights issue
o Increase in company’s issued capital
o Typically at a discount to market price
o Theoretically  market price will fall dependent on
 Number of shares/size of discount

o Example—market price cum-rights $1.00, with 1:5 rights issue priced at $0.88:

 Cum-rights share price $1.00

 Market value of 5 cum-rights shares 5.00
 Plus new funds from 1:5 issue 0.88
 Market value of 6 ex-rights shares 5.88
 Theoretical ex-rights share price (5.88/6) 0.98
o Renounceable right
 A right that can be sold before it is exercised
• Value of right = N (cum rights price – subscription price) / (N+1)
o N = number of shares required to obtain rights issue share
• Value of right above = 5 * (1 – 0.88) / 6 = $0.10

Consider the importance of share-market indices and published share information

- Stock Market Indices

o Measure of price performance of share market or industry sector
 Performance benchmark index
• Measures overall share market performance based on
capitalisation/liquidity
 Tradeable benchmark index
• A narrow index used as basis for pricing certain derivatives
 Market indicator index
• Overall share market performance, or the performance of a select group
of stocks that indicate the overall market
o Price weighted: according to share price
 Dow Jones
o Capitalisation weig=hted: according to market capitalisation
  S&P, All ords
 Share price index
• Measures K gains/losses from investing in an index-related portfolio
 Accumulation index
• Recognises change in share prices and reinvestment of dividends

Week 7 – ST Debt
Learning objectives

 Overview of the characteristics of various forms of short-term debt

 Main types

 Trade credit, bank overdraft, commercial and bank-accepted bills, promissory

notes, negotiable certificates of deposit, inventory accounts receivable and
factoring

 Sources

 Reasons and patterns of use

 Advantages and disadvantages for borrowers and lenders

 Calculations relevant to discount securities

- 2 main uses of capital:

o Capital investment in assets for future returns (MT to LT)
o Ensure they stay solvent (ST)

9.1 Trade Credit

- A facility offered by suppliers of goods that provides purchaser of goods with a specific period
before the account must be paid
o Terms usually specified within invoice
o Eg. 2/10, n/30  2% discount if paid within 10 days, full amount due within 30 days
- Advantages for provider
o Increased sales  more attractive for purchaser
- Disadvantage for provider (must balance with benefits)
o Increased discount (lost revenues), increased length of discount period
o Increased AR/risk of bad debts associated with recovery
 Increased discount  increase opp cost of not taking discount
• Effectively increasing the interest rate of borrowing
- Opportunity of not accepting (1/7, n/30)

% discount 365
Opportunit y cost = ×
100 − % discount days difference between
early and late settlement
1.0 365
= ×
99.0 23
= 0.160298 or 16.03% p.a.
 o On a $100 invoice, I would save $1 if paid by day 7, otherwise pay $100 after 23 days
o I am paying $1 extra on the $99 I would have paid. This is a 1.01% cost incurred over a
23 day period. Therefore is an annualised cost of 16.03% p.a.
 If I cannot pay on time, take out ST loan at less than 16.03% in order to pay.
- Attractive for start-up firms who find it difficult to borrow
o Walmart  8x shareholder capital in trade credit

9.2 Bank Overdrafts

- A fluctuating credit facility provided by a bank allowing a business operating account to go into
debit up to an agreed limit
o Interest rates on debit account
o Terms of overdraft negotiated with bank
 Overdraft amount
 Interest rate (reference interest rate + margin)
 Unused limit fee
 Other fees
o Margin – interest charge above a specified reference interest rate that reflects the credit
risk of a borrower
o Reference interest rate – benchmark interest rate published daily and used for pricing
variable-rate loans
o Prime rate – reference interest rate set by a fin institution for purpose of pricing
variable-rate loan
o Fully-fluctuating basis – requirement that an overdraft be brought back into credit from
time-to-time
o Collateral – property/other assets pledged to lender as security to support loan

9.3 Commercial Bills

- A bill of exchange is a discount security with a FV payable at a future date. 2 categories:

o Trade Bills: issued specifically to finance specific trade transactions
o Commercial bills: simple method of borrowing (don’t relate to specific transaction)
 Bank-accepted bills – when a bank puts its name on the face of the bill
• Bank pays FV to bill holder
• Bill issuer pays FV to bank + Fee
• Increases creditworthiness
• Issuer has reduced discount rate but has to pay fee
 Bank-endorsed bills – a bank endorses a bill when selling to an investor in the
money markets
 Non-bank bills
- Features of commercial bills
o Drawer – issuer of the bill
o Acceptor – party to whom the bill is addressed and who undertakes to pay the FV of the
bill to the person presenting the bill at the time of maturity
o Payee – party to whom the bill is specified to be paid
o Discounter – party that discounts the FV and purchases the bill
o Endorser –a party that was previously a holder of the bill but who has subsequently sold
the bill
o Note if A issues to Bank B, who accepts it, and sells it to C. C then onsells it to D
  At maturity, A (drawer) pays D
 If A can’t pay, then Bank B is liable
 If Bank B also can’t pay, C is then liable as they were the endorser
 Note: since Bank B accepted bill, A will pay Bank a fee for this acceptance
o Bank could improve credit worthiness by acting as the drawer
- Advantages of commercial bill financing
o Lower cost than other ST financing (overdrafts etc)
o Borrowing cost determined at issue date
o Bill line – bank agrees to discount bills up to an agreed amount
o Rollover facility – ST bill funding can effectively be rolled over through successful periods
 Discount is adjusted at each rollover
• The shorter the terms  more frequent adjustments
o Good performance in meeting commitments  improves firms credit reputation

9.4 Calculations discount securities

- Calculating price where yield and FV are known

o , or

o
- Calculating FV where issue price and yield are known
yield
365 + ( × days to maturity)
Face value = price[ 100 ]
o 365
o Eg. Need to raise $500,000 through a 60-day bank-accepted bill. Bank has agreed to
discount bill at yield of 8.75%. What FV will the initial bill be drawn?
365 + (0.0875 × 60)
Face value = $500 000[ ]
365
 = $507 191.78
 Note: in formula, could equal 1 + (yield x (60/365))
- Calculating Yield
(sell price - buy price) (days in year × 100)
Yield = ×
o
buy price days to maturity
o Holding period return
 Return obtained from purchase and then resale in secondary market
o Note: yield is expressed in terms of purchase price (current price) whilst discount rate
is expressed in terms of the FV of security. Securities are identical  rates differ!
- Discount Rate
 ( ) ( )
o . =
( ) ( )
o Eg. 100 x (1 – disc rate) = price
o 100 x (1 – 0.025) = 97.5
o However, 97.5 * 1.025 = 99.93 (yield doesn’t equal discount rate)
9.5 Promissory Notes/P-Notes (commercial paper)
- Similar to commercial bill, discount securities issued in the money market.
o No acceptor or endorser  person issued it is liable to pay it
o Unsecured instruments
o Typically, large reputable companies issue these with good credit ratings
o FV is promissory notes is usually at least $100,000
o Members of the tender panel have the first opportunity to buy the notes
o Lead manager – arranger of a syndicated debt facility, who structures the issue, forms
the syndicate and prepares documentation
o Dealer panel – panel members promote and distribute debt issues to clients and
maintain secondary market in the paper
o Underwriting syndicate – promoters of an issue who agree to purchase paper not
purchased by the tender panel
o Sellers are not required to endorse P notes when sold in the market
o Maturity up to 180 days  normally 90 days
o Don’t incur contingent liability as the corporation pays holders directly rather than the
bank
o Only corporations with excellent reputations can issue P-notes
o Underwriting fee is typically 0.1% of commitment

9.6 Negotiable certificate of deposit

- Similar to commercial bills - ST discount security issued in money market by banks

o Maturities up to 180 days
o Issued to institutional investors
o Wholesale money market

9.7 Inventory Finance, accounts receivable, financing and factoring

- Inventory Finance
o Similar to trade credit. Most common form:
o Floor Plan Finance
 Provision of finance for stock on a showroom floor
 Motor vehicle dealers
 Expected that the dealer will promote demand for the financier’s consumer
finance services when people buy the cars
o Bailment common
 Situation where a finance company holds title to a dealership’s stock
• Bailor (finance company) purchases the vehicle from the manufacturer
and possession is granted to the bailee (dealer)
o Dealer then seeks to sell vehicle
- Accounts Receivable Financing
o A loan to a business secured against its accounts receivable
o Mainly supplied by finance companies
 o Lending company controls a company’s AR, however borrower company is still
responsible for debtor book/bad debts
- Factoring
o Company sells AR to a factoring company
o Advantages:
 Removes admin for AR collection
 Provides current CF
o Disadvantages:
 Will receive CF at a discount
 Questions over who bears bad debts

Week 7 – MT to LT Debt
 Identify the main types of medium- to long-term debt instruments in the market

 Term loans or fully drawn advances, mortgage finance, bond markets (debentures,
unsecured notes and subordinated debt) and lease financing

 Describe the main features of these facilities

 Identify the financial institutions and parties involved in the provision of these facilities

 Undertake calculations related to the pricing of these debt instruments

 Discuss the availability and appropriateness of these debt instruments for business

10.1 Term Loan or fully drawn advance

- Term Loan – loan advanced for a specific period, usually for a known purpose
o 3 – 15 year maturity
o Lender may take charge over company assets  recoup losses
- Fully drawn Advance – a term loan where the full amount is provided at the start of the loan
- Provided by:
o Commercial banks and finance companies , sometimes - IB, merchant banks, insurance
offices
- Term Loan Structure
o Interest during term
o Principal repaid on maturity
- Credit Foncier (amortised loans)
o Each repayment incorporates an interest component and principal reduction component
 By end of instalments, loan principal has been repaid in full
- Deferred repayment loan
o Repayment commences are specific period (ie. Usually when project becomes CF+)
- Interest
o Fixed or variable
o Based on:
 Indicator rate (eg. Bank bill swap rate)
 Credit risk (risk of default)
 Term of loan (LT  higher repayments)
 Repayment schedule (frequency of loan repayments)
- Loan covenants
o Restricts business & financial activities of the borrowing firm  reduce agency problems
  Positive covenant – actions specified in a loan contract that must be taken
• Eg. Minimum K required to hold, minimum interest cover
 Negative covenant – conditions that restrict activities and financial structure
• Eg. Maximum level of secured debt, maximum borrows to tangible net
worth
o Interest coverage – (EBIT/interest expense)
 Common covenants. Others include:
• Debt/equity ratio, limits of accumulation of debt, min working K ratio,
periodic CF statements, constraints on disposal of NCA…
o Debt service (Net operating income / Total Debt Service)
 Debt service = repayment of interest and principal for the period
- Commitment fee – a charge on any part of a loan that has not been fully drawn down
- Technical default – when a company breaches its loan covenant
- Interest only loan – interest payments are paid over the term of the loan and principal is repaid
in full at maturity
- Prices of bonds with long term to maturity are more sensitive to movements in yield
- Prices of bonds with higher coupon payments are less sensitive to movements in the yield
- Calculating Loan Instalment – ordinary annuity
A
R=
1− (1+ i )−n
[ ]
i
where :
R = the instalment amount
A = the loan amount (present value)
i = the current nominal interest rate per period expressedas a decimal
n = the number of compounding periods.
o Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the
purchase of a new high-speed CD burner. The bank offers a $150 000 loan, amortised
over five years at 8% per annum, payable monthly. Calculate the monthly loan
instalments.
A = $150 000
0.08
i= = 0.006667
12
n = 5 years × 12 months = 60
$150 000
R=
1− (1+ 0.006667)−60
[ ]
0.006667
 R = $3041.49 per month
- Calculating Loan instalment – annuity due
o Loan instalments payable at the beginning of the month (pre-payment)
A
1− (1+ i )−n
R=
[ ](1+ i )
o i
10.2 Mortgage Finance

- Mortgage – a form of security for a loan

o Mortgagor (borrower) registers an interest an interest over the title of the property to
the mortgagee (lender). The mortgage is discharged once the loan is repaid.
- Right of Foreclosure – if mortgagor fails to meet terms of loan, mortgagee is entitled to take
control of the property and to dispose of it in order to recover outstanding debt
- Use – mainly retail homes (up to 30 years), lesser degree commercial (up to 10 years)
- It is possible to obtain an interest-only mortgage loan, interest only period is normally for only
part of the loan
- Providers
o Commercial banks, building societies, superannuation funds, finance companies…
- Interest rates
o Fixed or variable
o Fixed rate loans  rate resets every 5 years or less
- Mortgage Insurance
o Insurance company contracts that if the mortgagor is in default, the mortgagee will
suffer no loss of interest or principal
 Bank will sell property  any difference is made up by Mortgage Insurer
- Securitisation and mortgage finance
o Mortgage loan market  no secondary market that trades in individual mortgage loans
 Securitisation – sale of a bundle of mortgage loans by the original lender to the
trustee of a special-purpose vehicle
• Trustee obtains funds to purchase these new securities to investors by
issuing bonds in K markets
o Investors like these bonds as they’re supported by the security
of the mortgage loan assets held by trustee
 ‘Asset Backed Securities’
• Rates of securitisation fell by 50% within Australia pre/post GFC

10.3 Debentures, unsecured notes and subordinated debt

- Debenture and unsecured note

o Corporate bonds
o Repayment of FV of bond + coupon payments
o Unsecured note - No underlying security attached
o Debenture – secured by a fixed/floating charge over the issuer’s unpledged assets
 Listed and traded on ASX
 Higher claim than unsecured note holders
 Unpledged assets = assets with no interested conveyed to other parties
o Fixed charge – assets of a borrower cannot be sold until bond holder repaid
 Machinery etc.
o Floating charge – allows certain assets over which security is held to continue to be sold
in normal course of business. If default, this charge is said to crystallise (floating converts
to fixed)
 Inventory etc.
o Issuing debentures/notes
 Public issue – public at large, by prospectus
• Prospectus Requires:
 o Financial statements
o Directors and executive managers
o Intended use of funds gained from issue
o Any material information that may affect
 Family issue – to existing shareholders and investors, by prospectus
 Private placement – issued to institutional investors, by info memorandum
- Subordinated debt
o Quasi-equity
o Claims of debt-holders are subordinated to all other company’s liabilities
o May be regarded as equity  improve company’s credit rating
o May require debt not be redeemed for certain period
o Recorded as equity on the BS
- Kangaroo Bond - $A bond issued in Australia by non-resident borrowers

10.4 Calculations: Fixed Interest Securities

- Price of fixed-interest bond at coupon date  Sum of PV of FV and PV of Coupon Stream

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

o
o If coupon rate > yield  bond will be priced a premium to FV  investor make a loss
 Above, 10% coupon but 8% yield
• 2% Capital loss (Price – FV) when an investor purchases the bond
- Price of fixed-interest bond between coupon date
 1− (1 + i )−n  −n  k
P = C   + A(1 + i ) (1 + i )
o   i  
o Price bond at previous coupon date, then push its value forward at date infront
 o Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+
corporate bond with a face value of $100 000, paying 10% per annum half-yearly
coupons, maturing 31 December 2016, would be sold on 20 May 2011 at what price?
 Price bond at 31 December 2010  push forward value to 20 may 2011
• Hold the risk for those days between coupon and 20 may 2011
o 140 days
o Coupon period is 181
 Therefore, price bond at 31/12/10  multiply by (1.08)^(140/181)

10.5 Leasing

- A contract where the owner of an asset (lessor) grants another party (lessee) the exclusive right
to use the asset, usually for an agreed period, in return for rent
o Instead of borrowing funds to purchase an asset
 Borrow an asset directly and paying lease charges
- Advantages for lessee
o Conserves capital/other unused lines of credit  can use these for other investments
o 100% financing  lessor provides complete asset required. Debt often requires
borrower to contribute a portion of own funds for purchase
o Matches CF  rental payments matched with income generated by asset
o Covenants  existing covenants may restrict further loans but allow leasing
o ST assets  allows a company to acquire an asset for short period and then dispose of it
o Tax  rental payments and depreciation are tax deductible
- Advantages for lessor
o Low risk  can repossess asset if lessee defaults
 Whereas recovering amounts due on loans can take time during liquidation etc.
o Easy  cheaper to provide than loans to clients. Particularly for small $
- Types of leases
o Operating lease
 ST
 Lessee agrees to make periodic payments to lessor for right to use asset
 Minor/no penalties for cancellation of lease
 Full service lease – lessor is responsible for maintenance and insurance of asset
 Obsolescence risk for lessor
o Finance lease
 LT
 Lessor primary role is to finance the asset
 Lessee makes regular rental payments + residual value of asset at the end of the
lease period
• If lessor sells asset at end of period, lessee pays any difference between
balance
 Net lease – lessee responsible for insurance/maintenance
 The cost of ownership and operation is borne by the lessee
 Lessee needs to pay for residual value of asset at the end of the contract
• Incentive to take good care of it during its use
 Non-cancellable
 The asset remains with the lessee at the end of the lease contract
o Sale and lease back
 Existing assets owned by a company are sold to raise cash
  Assets are leased back to owner
- Lease Structures
o Direct finance lease
 Lessor purchases an asset with its own funds and lease it to the lessee
 Asset is security in case a lease repayment is not made by lessee
 Security of lessor provided by:
• Lease agreement – commitment by 3rd party to meet commitments of
lessee in event of default
o Leveraged finance lease (usually larger purchases)
 Lessor purchases equipment partially form equity and mainly from debt
• Generally $m of assets
• Leased to lessee
 Lease manager – arranger and ongoing manager of leveraged lease that brings
together lessor, debt parties and lessee
 Sometimes lease repayments are only sufficient to repay borrowing costs for the
lessor
• Therefore, lessor may make return from tax deductions of interest
repayments and depreciation
o Equity leasing (usually smaller purchases)
 Similar to leveraged, however funds for asset purchase provided by lessor

Week 8 – Foreign Exchange Markets

15.1 Exchange rate regimes

- Exchange rate = value of one currency relative to that of another currency

- Major currencies (USD, EURO, AUD etc) adopt floating rate - rate is determined by s/d
- Other types of regimes
o Managed float
 Exchange rate is held within a defined band relative to another currency
 Limited fluctuations are allowed
• Fluctuations are allowed assuming it doesn’t adversely impact country’s
eco objectives
 Chines, Singapore, Malaysia, Indonesia
• China – adopts managed float regime which limits exchange rate
movements within band set by CB against a basket of currencies
 Maintain competitive trade equilibrium
o Crawling Peg
 A managed float where exchange rate is allowed to appreciate in controlled
steps over time (ie. Band in which it is allowed to move shifts over time)
 Commentators that contend China operates a managed float regime
• Chinese Yuan has appreciated slowly relative to USD overtime
o Linked exchange rate
 Value of currency is tied to one or a basket of currencies
 Hong Kong $ w/ USD
th
- AUD is 5 largest trader in the world
o Speculators like to use AUD to speculate on commodities as Australia is dependent on
commodities
15.2 FX market participants

- Largest financial market in the world (10x larger than stock market turnover)
- Not a physical market
- Participants:
o FX dealers
 Financial institutions that quote 2 way prices and act as principles in markets
 Usually licensed or authorised by CB of countries in which they operate
 Commercial/investment banks
o FX brokers
 Transact almost exclusively with FX dealers
 Act in FX market in role very similar to that performed by stockbrokers in share
market
 Seek out best exchange rates in international markets and match buy/sell orders
received from FX dealing rooms
 FX dealers provide fee/brokerage for brokers services
o Central banks
 Government’s bank
• Purchase forex to pay for government M’s or pay interest on gov debt
 Change composition of holdings of forex in managing official reserve assets
 Influence exchange rates if CB believes rapid appreciated/depreciation that is
occurring does not reflect economic fundamentals
• Clean float – CB doesn’t intervene in FX market
• Dirty float – CB intervenes in FX market
o Firms conducting international trade transactions
 X/M’rs require forex to conduct real foreign exchange transactions
o Investors/borrowers in international money markets
 Investors/borrowers need forex market to convert investment amounts
o Speculative Transactions (largest portion of forex trade)
 Business/individual has a view on potential movements of forex and takes
position that will ‘profit’ from view
 If, today:
Spot rate: USD1= AUD0.9725
Exchange rate expected today + n days: USD1= AUD1.0225
Then, today:
Buy USD1 at a cost of AUD0.9725
Then, at today + n days:
Sell USD1 and obtain AUD1.0225
 Long position – occurs when underlying asset has been bought
 Short position – entering into a forward contract to sell an assets that’s not held
at the time
o Arbitrage transactions
 Arbitrage – abnormal risk-free profit possible within the fx markets
 Types of arbitrage
• Geographic – 2 dealers in different locations quote different rates on the
same currency
• Triangular – occurs when exchange rates between 3 or more currencies
are out of perfect alignment
 o Triangular arbitrage
 USD1 = AUD1.3525
 USD1 = SGD1.3525
 AUD1 = SGD 0.9870
o Arbitrage strategy
 Sell AUD1.3525 and receive USD1
 Sell USD1 to receive SGD1.3525
 Sell SGD1.3525 to receive AUD1.3703

15.3 Operation of the FX market

- Global market (24 hours a day)

- Larger FX dealers (inv, commercial, merchant banks) have FX function as part of their treasury
operations
o FX dealing room – physical location of FX dealers usually within an institutions treasury
operation
 Info within dealing rooms must be the same throughout the world at each point
in time
• Typically FX dealer rate quotes will be identical around the globe

15.4 Spot and forward transactions

- Spot Transaction
o Maturity date 2 business days after the FX contract is entered into
- Forward Transaction
o Have maturity date more than 2 days after FX contract is entered into
o Exchange rate locked in today

15.5 Spot market quotations

- USD/AUD
o Base Currency (or unit of quotation) - USD
 1st named currency
 Currency being sought
 Eg. Price of 1USD in terms of AUD
o Terms currency - AUD
 2nd name currency
 Used to express value of base currency
- 2 way quotations
o From the dealers perspective
o Australian dollar/euro may be expressed as EUR/AUD1.3755–1.3765, usually
abbreviated to EUR/AUD1.3755–65
 The two numbers indicate the dealer’s buy (bid) and sell (offer/ask) price
 Price Maker: A dealer quoting both bid and offer prices
 The dealer will buy EUR1 for AUD1.3755
 The dealer will sell EUR1 for AUD1.3765
 Dealer ‘buys low’ and ‘sells high’ – takes the spread
- Spread

o
 o More volatile  higher risk  higher spread
o More illiquid  higher risk  higher spread
- Transposing spot quotations
o Inverse the bid/offer prices to get the quote for the term currency
o Ensure that sell price > buy price
- Calculating Cross Rates
o Direct quote – USD is the base currency in an FX quotation
 USD/JPY
o Indirect quote – a currency other than USD is the base currency in an FX quotation
 JPY/USD
o If importer wants to know JPY/EUR, need to calculate cross rates
o 3 different calculations needed:
 Cross 2 direct quotations
• USD/EUR0.7250–55
• USD/JPY81.40–50
• To determine the EUR/JPY cross-rate:
• 81.40/0.7255 = 112.20
• 81.50/0.7250 = 112.41
• EUR/JPY 112.20-41
 Cross a direct and indirect FX quotation
• GBP/USD1.6270-75
• USD/NZD1.3292-97
• To determine the GBP/NZD cross-rate:
• 1.6270 x 1.3292 = 2.1626
• 1.6275 x 1.3297 = 2.1641
• GBP/NZD2.1626-41
 Crossing 2 indirect quotations
• AUD/USD0.9262–69
• GBP/USD1.6270–75
• To determine the AUD/GBP cross-rate:
• 0.9262/1.6275 = 0.5691
• 0.9269/1.6270 = 0.5697
• AUD/GBP0.5691–97

15.6 Forward market quotations

- Forward exchange rate – fx bid/offer rates applicable at a specific date beyond the spot date
o Varies from spot rate owing to interest rate parity
o Interest rate parity – principle that exchange rates will adjust to reflect interest rate
differentials b/w countries
o Quoted the spot rate and forward points to determine the forward exchange rate
 Points will be at either a premium/discount to the spot price
 Points will be added/subtracted from spot rates
 Spread must be larger in the forward market  illiquidity
o AUD/USD
 Spot 0.9630 – 40
 Forward points 32 and 27
• Note: forward points are falling, base currency is at forward discount
  Forward 0.9598 – 0.9613
 AUD buy less USD in the forward market  AUD is at a forward discount
• Can assume interest rates in Aus are higher than in US
- Interest Rate determinant of forward points

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

o
o Points are added to base currency as interest rate of base currency is lower
 Forward rate = USD/CHF 1.1589
o Problems with above interest rate formula – FX Dealer:
 Will need to adjust formula to account for different borrowing/lending interest
rates
 A margin may be applied for additional costs of borne by FX dealer
o Dealer will carry out FX transaction TODAY even though delivery is in the future:
 Borrow funds in one market and purchase forex required for the future date
 Invest purchased forex in that market until delivery is due
 Difference between cost of borrowed funds and return received on invested
currency will be adjusted against the spot rate today
 Eg. Borrow AUD, convert at spot to USD, invest in US market, provide USD to
customer and receive AUD at future date
- Real world complications
o Two-way FX quotations
 Calculating forward points – FX dealer must determine how to apply these to
bid/offer rates. Ie. Equation above = 29 points  does this apply to bid, offer or
both? Add or subtract? Must be careful.
o Different interest rate year conventions
 Some interest rates are quoted on a 360 day year while others quote on 365
• 360 – USA, Japan, Europe
• 365 – Commonwealth countries
• Must convert the 360 day rates to 365 day equivalents or vv.
o Borrowing and lending interest rates
 FX dealer must recognise borrowing and lending interest rate margins when
calculating interest rate differential which forms basis of forward points
calculation

 Bid forward points = S [ −1

( )
 Offer forward points = S [ −1
( )
 o Compound interest period
 Interest compounding period varies between countries
 Effective rate of interest on borrowed funds should be used in calculation of
forward points
• Must take into account effect of reinvesting interest earned

Week 8 – Exchange Rate Determinants

16.1 FX Markets and an equilibrium exchange rate

- Regimes
o Floating Exchange rate regime
 Currency is determined by demand and supply conditions with NO cb
intervention
o Pegged exchange rate regime
 Domestic currency is locked into a specific multiple of another currency such as
the USD
- Below only really applies to floating exchange rates

- Demand for Currency

o Downward Sloping Demand Curve
 Devaluation of $A  will result in an increase in D of $A by foreigners
• Aus goods will be cheaper  foreigners will buy more Aus goods
o Increase demand for $A
o Purchase of AUD  appreciation of $A
 Foreigners buy Australia X/M’s
- Supply of Currency
o Upward Sloping Supply Curve
 Quantity of AUD supplied to the market increases as $A appreciates
• $A appreciation  foreign goods/services are cheaper for Australians
o Australians sell $A and buy foreign currency
 Increases S of $A and D of Foreign currency
- Equilibrium Exchange Rate
o Rate at which Quantity of $A D = S
 Any price other than equib rate is unsustainable
• Eg. If Equib rate was AUD/USD0.98 but actual rate = AUD/USD0.9500
o Underpriced
 o D>S
o People trying to buy $A would offer higher prices
 Qs relative to Qs at 0.95 would increase as selling is now
more attractive
 Qd relative to Qd at 0.95 would decrease as purchasing
is now less attractive
 This would reduce the excess demand in the market
until equilibrium is reached

16.2 Factors that influence exchange rate movements

- Relative Inflation Rates

o Purchasing Power Parity – exchange rates should move in such a way to equalise foreign
currencies around the world. Prices will adjust to ensure prices of the same goods are
equal between countries
 Ie. If $2 can buy a can of coke in Aus, converting it to USD should also buy a coke
in US
 Taxes, transaction costs etc.
o If USA experienced substantial/prolonged increase in inflation  price of goods in US
would increase in USD terms
 Aus demand for US g/s would decrease
• Reduction in forex demand = reduction in Supply of $A
 US demand for Aus g/s would increase
• Increase in $A demand = increase in Demand of $A
 S curve shifts to the left, D curve shifts to the right
• Appreciation of the $A
• Assumes no offsetting US government intervention
 $A will appreciate
- Relative National Income Growth Rates (GDP Growth)
o Domestic growth increases relative to international growth
 AUS D M’s increases  increase S of $A  Depreciation of $A
• Shift of S curve to the right
 Increase foreign investment in Aus  increase D of $A  Appreciation of $A
• Shift of D curve to the right
 Unknown what $A will do
- Relative Interest Rates
o Rise in AUS interest rates relative to the US
 US companies  redirect cash into AUS interest bearing instruments
• Increase Demand for $A
o Shift of D curve to the right
 AUS companies are more likely to keep $A invested in Aus
• Decrease Demand of $A
o Shift of S curve to the Left
 $A will appreciate
o Example
 
 Scenario 1: AUD would depreciate
• The 3% benefit obtained from placing funds in the Australian money
market would be more than offset by the 5% depreciation of the AUD
 Scenario 2: AUD would appreciate
• The 3% benefit obtained from placing funds in the Australian money
market would be offset only partly by the 2% depreciation of the AUD
o From above, a change in interest rate differentials is not all that matters
 Expectation of FX rates are critical
o Nominal Rate of Interest = real rate of return + anticipated inflation component
 Inom = r + pe
• Higher nominal rates as a result of increase in inflation (r constant)
o Probably won’t appreciate  more likely to depreciate
 1. PPP argument
o In periods with expected inflationary increases  businesses
will seek to economise their cash as they know it’ll lose value
 Surplus cash  converted into financial instruments
who’s return will keep pace with inflation
• Some of these are offshore
• Incentive to invest offshore
o Currency expected to depreciate
 FX gain when converted back
after the depreciation occurs
• Higher nominal rates as a result of increase in real return (inflation
constant)
o Currency expected to appreciate
 Inflow of funds from the rest of the world
• Decrease supply as domestic residents invest
locally
• Increase in demand as foreign residents invest
locally
• Summary
o Increase in inflation, all else constant, currency will depreciate
o Increase in real rate, all else constant, currency will appreciate
- Exchange Rate Expectations
o Significant portion of turnover is motivated by changes in exchange rates
o Forex expectations based on expectations on:
 Relative inflation, relative economic growth, relative interest rates
o AUD expected to depreciate
 Aus Residents
• Seek to buy forex before $A falls
o Increase S of $A
 Foreign Residents
• Seek to defer purchase of $A
 o Reduce D for $A
 Net Effect
• AUD depreciates as expected
o Australia is a major commodity exporter  AUD is related to commodity prices
- Government or Central Bank Intervention
o 3 ways of intervention:
 Intervening in international trade flows
• Aimed at increasing X’s or decreasing M’s
• Subsidies, tariffs, quotas, embargo
o Tariff – charge levied by a government on M’s into the country
o Quota – government restriction on the amount of goods M’d
into the country
o Embargo – prohibition on the M of a specific good
• Subsidies make X’s cheaper
o Increasing demand for that currency
 Intervening in foreign investment flows
• Includes: prohibitions on outflow of funds from home country,
imposition of taxes on residents who earn interest offshore or non-
residents who earn interest in the home country
 Directly intervening in the FX market
• 2 motivations:
o Reduce volatility in the currency (FX Smoothing)
 Sometimes, undertaken when CB perceives speculators
are dominating market
• Causing unwarranted volatility
 Eg. If speculators are dominating the market with sell
orders  CB will buy domestic currency. Vv.
o Achieve an exchange rate target value that is different from
market’s perception of the appropriate level
 If CB believes overvalued, will come in and sell currency
• Note: CB’s supply of $A is infinite  refer to
diagram below with flat Supply curve
 If CB believes undervalued, will come in and buy
currency
• Note: strategy is limited as they require forex to
buy the local currency and are therefore limited
to their forex reserves
 o

Week 9 – Interest Rate Determination

 Describe the macroeconomic context of interest rate determination

 Explain the loanable funds approach to interest rate determination, including supply and
demand variables for loanable funds, equilibrium and the effect of changes in variables on
interest rates

 Understand yields, yield curves and term structures of interest rates, and apply the
expectations theory, segmented markets theory and liquidity premium theory

 Explain the risk structure of interest rates and the impact of default risk on interest rates

13.1 The Macroeconomic context of interest rate determination

- Most advanced economies CB’s use monetary policy to influence interest rates in order to
achieve macroeconomic objectives and stabilise the business cycle. Stabilising the business cycle
is important as it provides certainty. Objectives cover:
o Inflation – main CB objective is to contain inflation within target range
 Through maintaining this range, can achieve other economic objectives
 Business Cycle – change in economic activity over time through
expansion/contraction
o Economic growth (GDP)
 GDP = Aggregate value of g/s produced within an economy
o Balance of Payments
 A record of a country’s transactions with the rest of the world
o Credit/debt levels
o Foreign Exchange
- May increase interest rates if:
o Inflation is above target
o GDP growth is excessive
o A large deficit in the BOP
  Increase rates  decrease M expenditure
o Rapid credit/debt growth
o Excessive ‘downward’ pressure on FX markets
- Monetary Policy: Liquidity effect  income effect  inflation effect
o Liquidity effect on interest rates – effect on the money supply and system liquidity of a
CB’s open market operations
 3 main market operation strategies:
• Direct buying/selling of government securities
• Repurchase agreements (repos)
• Foreign currency swaps
o Income effect on interest rates – flow on effect from initial liquidity (above) impact. An
increase in interest rates will reduce spending, therefore reducing incomes, which will
allow rates to ease
o Inflation effect on interest rates – as economy slows, the upward pressure on prices will
ease, allowing interest rates to fall
- Difficult to forecast extend of above effects on changes in interest rates
o Economic indicators provide insight into future economic growth
- Economic indicators
o Leading indicators
 Eco variables that change before a change in the business cycle
 Useful in anticipating changes
 Example: consumer confidence, housing loan approvals
o Coincident indicators
 Eco variables that change at the same time as the business cycle
 Provide same-time tracking of eco-activity
 Example: Non-farm payroll data…  difficult to differentiate b/w lagging
o Lagging indicators
 Eco variables that change after the business cycle changes
 Useful in confirming an increase/decrease in eco growth
 Example: Unemployment
o Difficulties of indicators:
 Knowing the extent of timing/lag
 Do indicators consistently perform?

13.2 Loanable funds approach to interest rate determination

- Loanable funds – amount of funds available for lending within FS

- LF approach is preferred way to explain/forecast interest rates
 Conceptually simplistic
 Preferred by financial market analysts
o Focuses on lending  interest rates are determined by supply of and demand for LF
 Alternatively, macroeconomics use d/s of money to determine rates
- Downward sloping D curve
o As interest rates decrease, demand increases
- Upwards slowing S curve
o As interest rates increase, supply increases
- Demand for Loanable Funds
o Assumes 2 sectors
 Businesses demand for LF
 o ST working K
o LT K investment
• Downward sloping curve
o Any factors causing increase in business demand for funds
would shift the B curve right
 Government demand for LF
o Financing budget deficits
o Financing intra-year liquidity
• Public sector borrowing requirement – total borrowing requirements of
various levels of government and their instrumentalities
• Assumed Gov demand for LF is independent of interest rates due to
their fixed commitments  therefore, vertical d curve (inelastic)
o Change in government sector borrowing would move the G
curve to the left/right
o If government deficit  government surplus
 D curve would disappear
 Surplus would be represented in supply curve

- Supply of loanable funds

o Assumes 3 components:
 Savings of household sector (S)
• Slope upwards
 Changes in Money Supply (M)
• Note: Change in M shifts the supply curve
o If CB increases Money supply  shift S curve to RHS
 Dishoarding (D)
• As interest rates increase, normal cash holdings are reduce and invested
in financial instruments
o Ie. As interest rates rise  more costly to hold cash
o As interest rates rise  more LF supply available in the FS
• Has the effect of steepening the S slope
- Rate of equilibrium (point E below) is only temporary because interest rates will continue to
move as the dynamic variables move. Ie.
o Dishoarding (below: a-b) cannot continue
 Once dishoarding has taken place (ie. Cash has been moved to securities) the
dishoarding process will cease
• Supply curve will adjust
o Money supply is unlikely to increase proportionally in subsequent periods
 If M increases by same amount as last period, curve will remain the same
o Demand is likely to change
 Dishoarding process  decreased interest rate from prior periods
• Business will invest more than in previous periods
o Growth  government demand may decrease as they will have
greater tax revenues

- Expected increase in level of economic activity

o Will increase business D for LF  shift curve to RHS
- Increased interest rates
o Appreciate $A
• Increase M spending
• Decreased X’s
 Will result in X’ing businesses cutting back their investments
 • Help to ease interest rate pressure
- Inflationary expectations in LF approach (Fisher Effect)
o An increase in inflationary expectations  increase in required rate of interest to
achieve same real interest rate
 Supply curve will shift upwards to extent of inflationary expectation
• Require a greater interest rate to achieve their real rate of return
 Demand curve will shift right to extent of inflationary expectations
• Businesses recognise they need greater funds to meet their pre-inflation
investment plans
 Net effect
• i1 = i 0 + P e
- Inflationary expectations in LF approach (Non-Fisher Effect)
o Shift in Demand curve less than in the Fisher effect approach
 Higher inflation  higher wages and $ value of g/s sold
• Increase tax revenues
o Likely to increase faster than inflation
o Shift of supply curve downwards (rather than upwards)
 Higher inflation
• Savers dishoard their funds
• Uncertainty may result in increased savings
o Voluntary or contractual
 Superannuation  will increase with wage increases

13.3 Term Structure of Interest Rates

- Term Structure of Interest Rates

o Relationship b/w interest rates and TTM for debt instruments in the same risk class
- Yield curve
o A graph, at a point in time, of yields on a particular security with a range of TTM
- Shaped yield curves
o Normal or positive yield curves
 LT interest rates > ST interest rates
o Inverse/negative yield curves
 ST interest rates > LT interest rates
o Humped yield curve
 Shape of yield curve changes overtime
- Understanding the shape of these curves. 3 Theories
o Expectations Theory – A theory that explains the shape of a yield curve through current
and future ST interest rates
 Ie. Current ST interest rates and expectations about future ST interest rates are
used to explain the shape of the yield curve
 Assumptions:
• Large number of investors have homogenous expectations
• No transaction costs/impediments to interest rates moving to their
equib
• Investors aim to maximise returns and view all bonds as perfect
substitutions regardless of TTM
  Example: The rate on a one-year instrument is 7% per annum. The investor
expects to obtain 9% per annum on a one-year investment starting in one year’s
time. What is the current two-year rate?

•
 Explanation for yield curve shapes
• Normal – market expects future ST rates > current ST rates
• Inverse – market expects future ST rates < current ST rates
• Humped – Investors expect future ST rates to rise/fall in the future
o Segmented Markets Theory – A theory that all bonds are not perfect substitutes;
investors have different preferences when investing in either ST or LT bonds
 Rejects 2 Expectation theory assumptions:
• All bonds are perfect substitutes
• Investors are indifferent b/w holding ST and LT bonds
 Preferences of participants are motivated by reducing risk of portfolios
• Ie. Minimising exposure to fluctuations in prices/yields

 Shape/slope of yield curve is determined by relative D/S of securities along

maturity spectrum
 Example: CB increases avg. maturity of bonds by purchasing ST bonds and selling
LT bonds
• Note: FS liquidity is unchanged, only eco activity is effected
• SMT suggests
o ST price increases and yields decrease
o LT price decreases and yields increase
• Expectation theory suggests
o No effect on expectations about future ST interest rates
 No effect on economy
 Example: Government funds deficit with bond issue
• SMT suggests
o If bonds issued are spread evenly with the same TTM  curve
will shift upwards
o If bonds have long TTM  ST yield curve will stay the same, LT
yield curve will lift up
 Supply increase in LT  decrease price  increase yield
• Expectations theory
 o Bond issue won’t affect yield curve
o Impact of budget deficit on interest rate expectations will
impact yield curve
 Problems with SMT
• Assumes investors are motivated by reducing risk
o Ignores arbitrage traders
o Ignores those speculators trading on expectations
o Liquidity Premium Theory – a theory that investors prefer ST securities, therefore they
require compensation to invest LT. Similar to expectations theory.
 Less exposure to:
• Interest rate risk – risk that interest rates will change and negatively
impact their investment
• Default risk – risk that the borrower may not meet financial
commitments (coupon and principal repayments)
 Can incorporate liquidity premium into expectations theory:
 i +E i + L 
i =  0 1 11 
02 2

13.4 Risk Structure of Interest Rates

- Risk Free rate of return

o Yield on a security issued by the government (zero default risk assumed)
- Default risk
o Risk that a borrower will fail to meet its payment obligations
- Investors will require compensation for bearing securities with greater default risk
Week 10 – Futures Contracts and Forward Rate Agreements
 Consider the nature and purpose of derivative products

 Outline features of a futures transaction

 Review the types of futures contracts available through a futures exchange

 Identify why participants use derivative markets and how futures are used to hedge price
risk

 Identify risks associated with using a futures contract hedging strategy

 Explain and illustrate the use of an FRA for hedging interest rate risk

 Describe the use of a forward rate agreement for hedging interest rate risk

19.1 Hedging using futures contracts

- Futures contract
o Legally binding exchange traded agreement between 2 parties to buy, or sell, a specified
commodity or financial instrument at a specified date in the future at a price determined
today
o A change in the market price of a commodity/instrument is offset by a profit/loss on the
futures contracts
- Long position
o Underlying asset has been bought forward
- Short position
o Underlying asset has been sold forward
- Derivatives risk management product that derives its value from an underlying physical
commodity/instrument. 2 main types:
 Commodity (gold, wheat…)
 Financial (shares, government securities, money market instruments)
o Allow participants to manage risks associated with assets
o Physical Market – market in which commodity/instrument is issued/traded
- Basic Decision Rule for hedging strategy
o What you want to do with the asset in the future, do in the futures market now
o Conduct an initial transaction in the futures market today that corresponds with what is
planned to be done in the physical markets at a later date
o If going to sell wheat in the future, sell wheat futures today
 If wheat price goes down, lose in the physical markets but gain in the futures
- Buy futures (long position)
o Agreement to buy an asset in the future
- Sell futures (short position)
o Agreement to sell an asset in the future
- Example
Futures Physical
Today (1 Jan): Short 10 3 month contracts @ Today (1 Jan): Wheat selling @ $300/tonne
$300/tonne of wheat
Future (10 March): Long 10 contracts @ Future (10 March): Wheat selling @
$250/tonne of wheat $250/tonne
Futures Gain = $50 x 10 contracts = $500 Physical loss= $50 x 10 tonnes = $500
- Note: no actual physical settlement of futures contract  just given gain/loss at settlement
when the contract has been reversed out (ie. Above  took a long position on short position)
o If contract isn’t closed out, have to physically deliver the underlying instrument
 Above example, someone will probably want to close out an opposite position
- Closing out contract on exchange
- Market perceptions
o Futures prices tell market perception of future commodity/instrument prices

19.2 Main features of a futures transaction

- Exchange traded
o Standardised financial contracts traded on a formal exchange
- Clean price
o PV of a bond less accrued interest
- Orders and agreement to trade
o Trading pit – recessed area on floor of an exchange where transactions are conducted by
open outcry  not used anymore
o Contracts are highly standardised (exchange traded):
 Buy or sell order
 Type of contract (wheat, 10-year Treasury bond…)
 Expiration (delivery month)
 Price restrictions (if any). Example, market order or limit order:
• Market Order – instruction to a broker to buy/sell at current market
price
• Limit order – instruction to a broker to buy/sell to a specified price
within a certain time
o Buy at lowest price up to specified limit or vv.
 Time limits of order (if any)
• Complete before certain date or withdraw order
o Bond futures contract
 Quote as 100 minus yield
 Based on bonds traded on physical market
• Calculate price on the pricing of the actual bond
o Bid – buy price offered for a financial asset
o Offer – sell price offered for a financial asset
o Clearing house – records transactions conducted on exchange and facilitates value
settlement and transfer
- Margins
o Initial margin – deposit lodged with the clearing house to cover adverse price
movements
 Minimum % (2 – 10%) of the contract
 Participants aren’t required to deposit full contract price
o Marked-to-Market
 Periodic re-pricing of an existing contract to reflect current market valuations
 Helps to manage default risk
o Maintenance margin call
 Additional margin that is required to be posted by contract holder to top up
initial margin to cover adverse price movements
 o ASX requires margin as determined by SPAN
 If 10,000 margin required and price movement results in a contract loss of 2,000
• Margin call of 2,000 will be made to ‘top up’ margin account to 10,000
- Closing out agreements
o Close out
 Futures strategy
• Buy/sell futures contract before maturity date that is opposite to initial
futures contract position
o If taken short position, must take a long position to close out
 Broker facilitates this (intermediary)
o A shorts  Exchange shorts  B
o A  Exchange long  B Long
 Net position of broker is 0
• Counterparty risk born by exchange
o Ie. If B wants to close out position before maturity, A is not
affected
 If A longs to close out their short position, their position
will close
 C will come in and short the buy close out from B 
overall nothing changes (Novation)
 Novation
• Process by which one party to a contract is replaced with another
- Contract delivery
o Parties involved in futures
• Hedge risk
• Speculate
 Don’t wish to deliver underlying asset
o ASX24 settlement of contracts
 Cash
 Standard – delivery of underlying physical asset

19.3 Future market instruments

- Futures markets can be established by any commodity/instrument that:

o Freely traded (supply/demand)
o Experiences large price fluctuations
 Encourages risk hedging
 Encourages speculators
o Can be graded on a universally accepted scale in terms of its quality
 ie. Wheat, iron ore etc.
• Eg. Couldn’t grade Sydney houses futures…
o Plentiful supply, or cash settlement possible
- Commodities
o Mineral (silver, gold…), agriculture (wool, coffee…)
- Financial
o Currencies, Interest rates (ST, LT), share price index futures

19.4 Future Market Participants

- Hedgers
o Reduce price risk from exposures in rates/prices
 Take the opposite of the underlying exposed transaction
o Example (exporter) – USD receivable in 90 days
 Enter into futures contract to sell USD in 90 days-time
• Protects against a fall in USD
- Speculators
o Expose to risk in order to make profit
 Enter market in expectation the market will move in a certain direction
o Allows shorting futures, harder to short in the physical market sense
o No holding costs of participating in the physical market
 Eg. Don’t have to hold wheat
o Straddle – buying/selling of contracts with different delivery dates to benefit from price
variance
o Spread position – buying/selling of a related, same-delivery-date contracts to benefit
from price variances
 Eg. Long 90 day T bills but short 3 year treasury bonds
• Expectation that ST yields will fall and LT yields will rise
o Provide volume to the market
 Opposite side to the transaction that hedgers take
- Traders
o Buy/sell contracts, typically S, on their own account
o Similar to speculators
 Trade in high volumes (Small %, large absolute returns)
 Trade timeframe is ST
o Provide liquidity
- Arbitrageurs
o A party that simultaneously conducts buy/sell transactions in two or more markets in
order to take advantage of price differentials between markets
o Make risk free profit

19.5 Hedging Risk Management using futures

Only need to know commodity, interest rate risk and a bit of share portfolio risk

- Hedging the cost of funds (borrowing hedge) – interest rate futures

o Futures price = 100 – yield
 Eg. Price of 95 = yield of 5%
o Borrowing money = selling debt security
o Remember rule: Do what you will do in the physical market in the future, in the futures
market today
 o Profit earned on futures market offsets the cost of the higher interest rates
 Essentially borrowing at futures interest rate of 8.5%
- Hedging the yield of funds (investment hedge) – not required to know
- Hedging a foreign currency transaction – not required to know
- Hedging the value of a share portfolio
o Used to hedge the risk on a diversified share portfolio
o Can be used in a variety of ways
o Note: Loss/gain don’t directly offset in below example as can’t perfectly match contracts
with underlying asset
 Standard Contract Size Risk

19.6 Risks in using future markets for hedge

- Standard Contract Size Risk

o Owing to contract size, the physical market exposure may not exactly match the futures
market exposure, making a perfect hedge impossible
o Examples of contract sizes on ASX
 90 day bank accepted bills - $1,000,000 in FV of bills
 3 year treasury bonds - $100,000 in FV of bonds (6% coupon)
 10 year treasury bonds - $100,000 in FV of bonds (6% coupon)
 S&P/ASX 200 Index – Share price index x $25
 Listed company shares – 1000 shares
o If a company only needed to borrow $600,000 in the bank bill market, a match in the
physical/future market wouldn’t be possible
 Can only partially hedge  still exposed to risk
- Margin Payments risk
o Initial margin ranges between 2 – 10% of contract FV
 Margin calls: Marked-to-market
• Additional funding requirements
o Opportunity cost associated with paying margins
- Basis Risk
o A situation where pricing differentials are evidence between the physical and futures
markets
o Occurs where futures are used to hedge a position where period doesn’t on an actual
futures date
 Uncertainty
o Initial basis risk – pricing differential between physical/futures market at
commencement of hedging strategy
 For example, if hedging because belief that interest rates will decrease. Likely
that most market participants will think that. Therefore, likely that spot interest
rate > futures interest rate at commencement
o Final basis risk – pricing differential between physical/futures markets at completion of
hedging strategy
o Perfect hedge = 0 initial/final basis risk
- Cross-Commodity Hedging risk
o Using a futures contract to hedge risk associated with a different underlying asset
 Often futures are only available for a few commodities
• Participants will pick an asset that is highly correlated
o Eg. Using AUS index if a NZ index isn’t available
o Extent to which correlation isn’t perfect = risk

19.7 Forward Rate Agreements (FRA)

- An over the counter product used to manage interest rate risk exposures
o Over the counter – non-standardised contracts negotiated between a writer/buyer
o Contractual agreement between 2 parties
o Allows parties to lock in a rate of interest that will apply at a specified future date
o Based on a notional principal amount
 No exchange of principal occurs
o Payment of settlement
 Difference between actual and agreed interest rate
- Disadvantages of FRA
o Credit risk (risk of non-settlement)
o No formal market exists
- Advantages of FRA
o Tailor made  greater flexibility and removes some risks discussed in 19.6
o No margin payments
- FRA specifies at start
o FRA agreed rate; fixed rate agreed at start of FRA
o Principal amount
o FRA settlement date; When compensation is paid
o Contract period – term on which FRA interest rate cover is applied
o Reference rate to be applied at settlement date
- Settlement amount = FRA settlement rate - FRA agreed rate,

365 × P 365 × P
= −
365 + (D × i s ) 365 + (D × ic )

o where, is = reference rate at the FRA settlement rate, expressed as a decimal

o ic = the fixed FRA agreed rate, expressed as a decimal
o D = the number of days in the contract period
o P = the FRA notional principal amount
- Using an FRA for a borrowing hedge
- Example: On 19 September this year a company wishes to lock in the interest rate on a
prospective borrowing of $5 000 000 for a six-month period from 19 April next year to 19
October of the same year. An FRA dealer quotes ‘7Mv13M (19) 13.25 to 20’. On 19 April the
BBSW on 190-day money is 13.95% per annum.

365 × P 365 × P
−
365 + (D × is ) 365 + (D × ic )

is = 0.1325 (on 19 April)

ic = 0.1395 (on 19 September)
D= 183 days (from 19 April to 19 October)
P= $5 000 000
365 × 5 000 000 365 × 5 000 000
Settlement = −
365 + (183 × 0.1395) 365 + (183 × 0.1325)
= $4 673 154.46 - $4 688 533.65
= - $15 379.19
o As interest rates have risen over the period, the settlement of $15 379.19 is paid by the
FRA dealer to the company

Week 11 – Options Markets

 Understand the structure and operation of option contracts and the types available
  Explain the profit and loss payoff profiles of call and put option contracts

 Describe the structure and organisation of international and Australian options markets

 Explain the factors affecting the price of options

 Develop options strategies for hedging price risk

 Discuss the advantages and disadvantages of option contracts in managing risk

20.1 The nature of options

- Option – gives the buyer the right, but not the obligation, to buy or sell a specified number of a
specified commodity or financial instrument at a predetermined price, on or before a specified
date
o Exercise/strike price (k)
 The price specified in the option contract at which the buyer can buy/sell
o Expiration date
- Physical market
o A market in which a commodity/financial instrument is issued/traded
 Options based off physical market
• Ie. If stock in physical market increased above strike price exercise call
- Difference from futures
o Payoff profile differs
 Futures – obligation vs. Options – right
• Futures – symmetric
o Futures–profit/loss in futures market offsets that in the physical
• Options – Asymmetric
o Options limit the adverse price movements
o Options don’t reduce profits from favourable price movements

o Premium
 Amount paid by buyer of contracts to the writer (seller of an option)
 Paid at commencement of contract
 All else being equal, call options premium > put option premiums
• Call options have unlimited benefit for purchaser
- Types of options
 o Call Option
 Contract for an option to buy at a specified price at some point in the future
• Long call party – buyer of a call option
• Short call party – writer of a call option
o Put option
 Contract for an option to sell at a specified price at some point in the future
- Exercise differences of options
o European – can only be exercised on specified contract expiration due date
o American – can be exercised any time up to the expiry date

20.2 Option profit and loss payoff profiles

- Profit and Loss Payoff profiles = potential gains/losses available to buyer/writer of an option
- Call option – Profit and Loss Payoff Profiles
o Example: a call option for shares in a listed company at a strike or exercise price (X) of
$12, and a premium (P) of $1.50
o Figure 20.1 indicates the profit and loss profiles of a call option for (a) the buyer or
holder (long call) and (b) the writer or seller (short call)
o The critical break points of the market price of the share (S) at expiration date are <$12,
$12 to $13.50 and >$13.50
o If S (market price of asset) > X (i.e. > $12) , option is ‘in the money’
o Note: Linear increase is at a rate of 1:1 with the stock price
 45 degree – gradient = 1

Payoff Profile (P/L Profile without premium) - Call

Profit/Loss Profile – Call

- Call Option – Profit Profiles – Formula
o The value of the option to the buyer or holder (long call party) is:
 V = max(S - X, 0) - P
o The value of the option to the writer (short call party) is:
 V = P - max(S - X, 0)
- Put option – Profit and Loss Payoff Profiles
o Example: a put option for shares in a listed company at a strike or exercise price (X) of
$12, and premium (P) of $1.50
o Figure 20.2 indicates the profit and loss profiles of a put option for (a) the buyer or
holder (long put) and (b) the writer or seller (short put)
o The critical break points of the market price of the share (S) at expiration date are
<$10.50, $10.50 to $12 and >$12
o Buyer exercises option if S < X (i.e. < $12)

Payoff Profile (P/L Profile without premium) - Put

Profit/Loss Profile – Call

- Put Option – Profit Profiles – Formula

o The value of the option to the buyer or holder (long put party) is:
 V = max(X - S, 0) - P
o The value of the option to the writer (or short put party) is:
 V = P - max(X - S, 0)
- Covered and Naked Options
o Covered call option – Option writer holds underlying asset or provides a financial
guarantee that it can complete the contract if the option is exercised
 Can cover in 2 ways:
 • Buy underlying stock
o Increasing profit on stock covers losses on written call
 Hedges risk
• Buy another call option on the same asset but with lower exercise price
o Refer to diagram below for these 2 ways to cover
o Naked call option – a call option writer without the underlying asset
 Will need to post margins unless they write a covered means it has unlimited
risk
o Covered short sales – practise of selling a financial product with a securities lending
arrangement in place
 Can cover in 2 ways:
• Sold the underlying stock short
• Purchase a put with a higher exercise price
o Naked short selling – practise of selling a financial product without a securities lending
arrangement (an arrangement that gives the short seller an exercisable and
unconditional right to confer ownership of the product to the buyer)

20.3 Organisation of the market

- 2 types of option contracts

o Over the counter
 Non-standardised contracts negotiated b/w writer and buyer
o Exchange traded
 Similar market structure to that of futures market
• Long call  exchange  long call
• Short call  exchange  short call
 Clearing house – counterparty to buyer and seller
• Acts as a seller to the buyer of a call option, acts as a buyer to the seller
of a call option  novation
o Process by which one party to a contract is replaced with
another party
- International options market
 o An exchange in a particular country usually specialise in option contracts directly related
to physical or futures market products traded in that country
 The largest exchanges = Chicago Board of Trade (CBOT) and Chicago Mercantile
Exchange (CME)
• Open-outcry trading on the floor involving 4000 to 5000 people
o International links between exchanges allow 24-hour trading
- Australian options markets
o Range of option contracts
 Options on future contracts
• Sometimes options aren’t available on asset  trade on futures
• Right to buy (call) or sell (put) a futures contracts
• Available for:
o 90-day bank bill accepted, SPI200 index, 3/10 year treasury
bonds…
• Traded on ASX
 Share options  main
• Traded on ASX
• Based on ordinary shares of listed companies
• In order to meet obligations under options contract – clearing house:
 System of deposits
 Maintenance margins
 Share scrip depository
o Writer therefore must be covered (deposit or margin)
• American type options
• Index based options are normally Europe type contracts
 Low-exercise-price options (LEPO)
• Highly leveraged option on individual stocks
o Exercise price of 1c
o Premium comparable to price of underlying stock
• ASX requires margin call system
• European type expiry
• Premium typically lower than share price
o Reason: LEPO isn’t entitled to receive dividend payments
 LEPO attractive to foreign investors as they can’t take
advantage of franking credit
 Warrants
• A financial instruments that conveys a right in the form of an option
o The option to convert the warrant into ordinary shares in the
issuing company at a specified date and a predetermined price
• Can’t sell warrants, can only buy them off financial institutions
• 2 types of warrants:
o Company issued warrants as part of debt issues
 Not concerned in this chapter
o Market traded warrants
 Manage risk exposure to price movements in the market
• Warrants offers in the market include:
 o Fractional warrants – cover part of a listed share. To buy one
share, warrant holder may be required to exercise multiple
fractional warrants
o Fully covered warrants- call warrants that require issuer to lodge
underlying shares in a trust or comparable arrangement. Shares
held as a guarantee of issuer’s capacity to deliver upon exercise.
o Index warrants – issued over a specified share price index
o Basket warrants – contain a group of shares from different
companies.
o Capped warrants – low exercise price warrants set at 1%. Cap is
applied to the warrant holder.
o Instalment warrants – right to buy shares by payment in
instalments. Non-payment is allowed but lapses the contract.
o Capital plus warrants – based on a basket of listed shares. Issued
for approx. $1000. Over 5 years. European. Issuer guarantees
that at expiration at least the initial issue value will be returned
to holder.
o Endowment warrants – no fixed exercise price, but it has an
outstanding amount. LT = 10 years expiry. Reference interest
rate is applied to outstanding amount of warrant.
 Over-the-counter options
• Used for options not traded on exchanges as highly negotiable
o Example – money market securities…
• Flexibility – amount, term, interest rate, price
• Used for:
o Interest rate caps
o Interest rate floors
o Interest rate collars

20.4 Factors affecting an option contract premium

- Model most often used = Black-Scholes model

- Factors that influence
o Intrinsic Value
 Market price relative to exercise price
 Greater intrinsic value  greater the premium

o Time Value
 As time to expiry increases  greater the premium
• Increased chance to be in the money (profit)
 o Cash in on upside of option
• Increased chance to be out of the money
o Don’t care – downside is the same regardless
o Price Volatility
 Greater the volatility of the spot price greater the premium
• Greater chance option will be in the money!
o Same as Time Value explanation
 Don’t care about downside
o Interest Rates
 Positive relationship with interest rates and call premiums
 Negative relationship with interest rates and put premiums
 Explanation: 2 ways that interest rates affect call option value
• 1. A call option offers the opportunity to conserve capital
o If investor is optimistic about asset, they could buy the asset in
the physical market or they could buy the option.
 Funds conserved from option strategy could be invested
in money market  positive interest returns
• Higher the rates  higher the benefits from
conserving capital
o Therefore, value of call option increases
with interest rates
• 2. Higher interest rates reduce value of the option through impact on
time value of money
o Profit obtained from exercising the option is in the future
 Higher the interest rate  lower the PV of profit
• Impact of 1 > 2
 Explanation: 2 ways that interest rates affect put option value
• 1. Opportunity cost of holding the asset
o Holding a put during high interest rates increases opportunity
cost
 Could be investing what they invested in put options in
other assets within the money market
• This would make them a greater return
• Therefore this would reduce the value of put
options
o Don’t understand how this isn’t a 3rd
reason for call options
• 2. Time value of money as above – reduce value
- Cap, Floor, Collar: Options cost-minimisation strategy
o Cap – option contract that places an upper limit on an interest rate
o Floor – an option contract that places a lower limit on an interest rate
o Collar – a combo of cap/floor options that set upper and lower interest rates
 Buy a cap, sell a floor  income received on floor offsets cap theoretically
• If market participants expect interest rates to rise over the period, cost
of the cap will be higher than premium received from equivalent floor
option contract

20.5 Option risk management strategies

 Single-Option Strategies
- When calculating overall P/L Diagram, split it out into tables for individual components then +
- Long asset + bearish about the future asset price
o Option risk management strategies to limit downside exposure to price falls:
 Bearish
• An investor has a negative view of price movements
 Long put
• Pay for premium
• Protect fall in stock
 Short call (example below)
• No immediate cost – receive premium income
• Not as much protection – unlimited loss potential

Combine the above 2 profit profiles to get the below profit profile of the strategy

o Assume:
 Call premium = $1.50
 Strike price = $12
 Current market price = $13
 o Advantages
 Don’t pay anything for hedge upfront
o Disadvantage
 Give up all upside  maximum profit = $0.50
- Short asset + bullish about the future asset price
o Bullish – investor has a positive view of future price movements
o In order to manage risk  buy call option in underlying asset
 Price increases  offset each other
• Loss is limited to premium
o This assumes exercise price = asset price

Combined Option Strategies

- Very bullish about the future price of an asset

- Quite bullish, but with some risk of a price fall
- Expectation of increased price volatility, with no trend (Long straddle)
o Buy a call at exercise price = X
o Buy a put at exercise price = X
o Provides positive payoff for large upward and downward price swings
o If price remains at X, combined loss = P of Call + P of Put

- Expectation of asset price stability

o Strategy 1 = Short straddle
 Short call at exercise price = X
 Short put at exercise price = X
 Provides a positive payoff for stable activity
• Maximum profit = P of C + P of P

o Strategy 2 = Short strangle

 Short call out of the money
 Short put out of the money
 Note: Both call and put should be equally out of the money
• Due to being out of the money, premium will be cheaper than that for
short straddle  less profit
o However, it provides a greater range that prices can move
before a loss is sustained