3

Financial Markets
& Institutions

Editor

Asst.Prof.Dr. Özlem SAYILIR

Authors

CHAPTER1 Asst.Prof.Dr. Gülşah KULALI

CHAPTER 2
Asst.Prof.Dr. Serap KAMIŞLI

CHAPTER 3
Asst.Prof.Dr. Melik KAMIŞLI

CHAPTER 4
Prof.Dr. Abdullah YALAMAN

CHAPTER 5
Asst.Prof.Dr. Özlem SAYILIR

CHAPTER 6
Assoc.Prof.Dr. Murat ERTUĞRUL

CHAPTER 7 Asst.Prof.Dr. İbrahim KARAASLAN

 T.C. ANADOLU UNIVERSITY PUBLICATION NO: 3994
OPEN EDUCATION FACULTY PUBLICATION NO: 2777

Copyright © 2020 by Anadolu University

All rights reserved.
This publication is designed and produced based on “Distance Teaching” techniques. No part of this
book may be reproduced or stored in a retrieval system, or transmitted in any form or by any means
of mechanical, electronic, photocopy, magnetic tape, or otherwise, without the written permission of
Anadolu University.

Instructional Designer
Lecturer Orkun Şen

Graphic and Cover Design

Prof.Dr. Halit Turgay Ünalan

Proof Readings
Asst.Prof.Dr. Gonca Subaşı
Lecturer Neslihan Aydemir

Assessment Editor
Lecturer Dilek Polat

Graphic Designers
Ayşegül Dibek
Gülşah Karabulut

Typesetting and Composition

Kader Abpak Arul
Yasin Özkır
Yasin Narin
Gülşah Sokum
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Zülfiye Çevir
Gül Kaya

FINANCIAL MARKETS & INSTITUTIONS

E-ISBN
978-975-06-3740-7

All rights reserved to Anadolu University.

Eskişehir, Republic of Turkey, February 2020
3322-0-0-0-2002-V01
 Contents

Introduction to
CHAPTER 1 Financial Markets CHAPTER 2 Bond Markets
and Institutions

Introduction.................................................... 3
An Overview of the Financial System.......... 3
Components of the Financial System . 4
Financial Markets ......................................... 9
Informational Efficiency in Financial
Markets................................................... 11
Risk and Return in Financial Markets.. 11
Interest Rates.................................................. 12
Theory of Portfolio Choice.................... 13
Financial Instruments .................................. 15
Main Characteristics of Financial
Instruments............................................ 16
Debt Instruments and Equity
Instruments............................................ 16
Financial Intermediaries .............................. 18
Introduction ................................................... 31
Characteristics and Types of Bonds ............. 31
Characteristics of Bonds ....................... 31
Types of Bonds  ..................................... 32
Bond Valuation .............................................. 36
Time Value of Money  .......................... 36
Bond Yields ............................................ 39
Risks of Bond Investments ........................... 40
Types of Risks Associated With
Bond Investments ................................. 40
Duration and Convexity  ...................... 42
Bond Ratings ......................................... 45

CHAPTER 3 Stock Markets

Introduction ................................................... 57 Constant Growth (Gordon) Dividend

Definition and Properties of Stocks ............. 57 Discount Model ..................................... 65
Rights and Liabilities of Stockholders . 58 Price-Earnings Ratio Model ................. 66
Right to Dividend .................................. 58 Market to Book Value Model .............. 66
Right to Preemption ............................. 58 Regression Model .................................. 67
Right to Liquidation Surplus ................ 59 Stock Indices .................................................. 68
Right to Vote and Right to Participate Major Stock Markets ..................................... 69
in Management ..................................... 59 Volatility and Volatility Spillover ........ 71
Right to Demand Information ............. 60
Secrecy Liability .................................... 60
Capital Liability ..................................... 60
Stock Value Definitions ........................ 60
Types of Stocks .............................................. 62
Common Stocks ..................................... 62
Preferred Stocks .................................... 62
Non-Voting Stocks ................................ 63
Stock Valuation ............................................. 63
The Discounted Dividend Model ......... 64
The Constant Dividend Model ............. 64

iii
 Derivative
CHAPTER 4
Markets
Introduction ................................................... 87
Derivatives and Derivative Markets ............ 87
Types of Derivatives: Forward, Future,
Swap and Options .......................................... 89
Forward Commitments  ....................... 89
Forward Contracts ................................ 89
Futures Contracts ................................. 90
Swaps ..................................................... 91
Contingent Claims ................................. 95
Options .................................................. 95
Basics of Derivative Pricing and Valuation . 98
Pricing and Valuation of Forward
Contracts ................................................ 98
Pricing and Valuation of Futures
Contracts ................................................ 100
Pricing and Valuation of Swap
Contracts ................................................ 100
Pricing and Valuation of Option
Contracts ................................................ 101
Binomial Option Pricing Model ........... 102
Black-Scholes Option Pricing Model ... 102
Investment
CHAPTER 6
Banking
Introduction.................................................... 129
Overview of Investment Banking................. 129
Bringing New Securities to the Market....... 131
Preparation for Public Offerings........... 131
Types of Offerings.................................. 132
Public Offerings Practices...................... 133
Variations in the Offering Process........ 135
Deal Making in Mergers and
Acquisitions..................................................... 136
Categories of M&A................................ 137
Advising Corporations.................................... 138
iv
Commercial
CHAPTER 5
Banking
Introduction ................................................... 109
Functions of Commercial Banking  .............. 109
Sources of Funds and Uses of Funds in
Commercial Banking ..................................... 112
Liabilities and Equity Capital of
Commercial Banks  ................................ 112
Assets of Commercial Banks  ............... 113
Revenues and Expenses of Commercial
Banks .............................................................. 115
Risk Management in Commercial
Banking  ......................................................... 117
Interest Rate Risk .................................. 117
Liquidity Risk ......................................... 118
Credit Risk .............................................. 119
Operational Risk .................................... 119
Financial Crises
CHAPTER 7
and Regulations
Introduction.................................................... 147
Global Crises.................................................... 147
Crises Prior to 1980................................ 148
Crises After 1980.................................... 151
Crises in Turkey............................................... 156
Crises Prior to 1990................................ 156
Crises After 1990.................................... 158
Regulations in the Financial Industry........... 160
Financial Regulations............................ 160
International Financial Regulations..... 160
Preface

In the 21st century, business managers are dealing with a complex financial environment with
complicated financial instruments. They struggle to make efficient investment, financing and
operating decisions in order to improve the performance of the businesses and eventually to
create value for the shareholders and other stakeholders. Thus, understanding the logic behind
the practices of financial markets and institutions has become vital for managers to achieve the
goals of the business. In this respect, this book aims to provide the students with the fundamental
financial concepts and tools to strengthen their comprehension in this field.

Editor
Asst.Prof.Dr. Özlem SAYILIR

v
 Introduction to Financial
Chapter 1 Markets and Institutions
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Describe the financial system Explain the functions of financial markets

3 Explain how interest rates are determined 4 Identify the main characteristics of financial
instruments

5 Distinguish between financial intermediaries

Chapter Outline Key Terms

Introduction Financial System
An Overview of the Financial System Financial Markets
Interest Rate
Financial Markets
Financial Instrument
Interest Rates Financial İntermediary
Financial Instruments Risk
Financial Intermediaries Return

2

Financial Markets & Institutions
INTRODUCTION
Being one of the subject areas of finance,
“financial markets and institutions” covers the
ways and processes of how funds are transferred
at individual level, at corporate level, and at
macroeconomic level in an economy. Financial
environment, financial system, financial markets,
market participants, and regulatory system are
considered to be the key elements of these ways
and processes.
From the point of view of the Business
Administration Department, in finance courses we
generally evaluate financial decisions from different
perspectives such as inside of firms to outside of
the firms. We try to put ourselves in the shoes
of financial managers and try to see what is best
for the business. In the “financial markets and
institutions” course, we start getting to know other
parties besides companies, which also try to find
what is best for them or their business. We also
start to understand how interest rate changes can
affect the way the financial system works, and how
different parties in the financial system are affected
favorably or adversely from these changes.
Throughout this first chapter of this book,
you will be introduced to the basic terms and key
concepts about financial markets and institutions.
You will see briefly how the financial system
works with its key participants. You will grasp
how financial markets are segmented, and what
the reflections of this segmentation are. You will
understand how money is created, and how interest
rates are determined in the financial markets.
You will be introduced to the main financial
instruments, their fundamental properties, and
financial intermediaries. The purpose of this
chapter is to provide basic information about
the financial environment and its key parties. In
this way, our aim is to help you establish the link
between the information about financial markets
and institutions and the decisions of financial
managers about business finance.
1
AN OVERVIEW OF THE
FINANCIAL SYSTEM
Financial system is an open system in an
economy, which enables the main actors of the
economy, namely households, firms, and the
government to have acceptable returns for their
savings, and at the same time to borrow funds at
an acceptable cost when needed. The input of the
financial system is the inclusion of excess funds to
the process of matching the quantity, maturity, and
cost/return of borrowings/savings. The output of
a financial system is the realization of transfer of
funds from those who have excess funds to those
who have shortage of funds. The most crucial role
of a financial system in an economy is making
agricultural, manufacturing, services, and trade
activities easier, and sometimes-even possible. The
balance between investing, production, saving,
and consumption is highly influenced by how
efficient and effective the financial system works.
In order to link firms and the financial system, we
shall remember the three decision areas in business
finance, briefly explained in Exhibit 1, and pick up
on the components of the financial system. People,
organizations, and regulations, as the components
of the financial system together determine the way
financial managers act and decide. Similarly, acts
and decisions of financial managers affect people,
organizations, and regulations in the components
of the financial system.
3
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Introduction to Financial Markets and Institutions

Exhibit 1.1 Decisions Areas in Business Finance.

In business finance, there are three groups of decisions to make for financial managers. First group
involves investing decisions. In order to produce goods and services, companies have to invest in assets,
of real and financial, or tangible and intangible types. Investing decisions include distributing limited
resources of the company to the best short-term and long-term investment alternatives. Investing de-
cisions also include strategic decisions such as mergers and acquisitions and foreign direct investments.
Second group covers financing decisions. It is important to know that companies cannot make all
of their investments with the money they have generated in the past years, or they already have. They
are always in search for funds at a minimum cost in order to partly or fully finance their investments
in the short, medium, and long term. They have two alternatives for financing: (1) debt financing, (2)
equity financing.
Third group consists of dividend decisions. Financial managers should decide on how much of their
earnings will be paid out to shareholders in the form of dividends, and how much will be retained to finan-
ce a company’s future investments and growth. It is a strategic decision involving a trade-off between the
payment of dividends to shareholders and retention of earnings to finance investments. To shareholders,
dividends (together with the capital gain from market value increases of shares) are a kind of return for
their long-term investment in the company. To managers, dividends are strategic decisions to be made in
order to serve maximization of shareholder wealth. However, it is not always clear whether or not there
is an optimal condition for all companies. There is a debate in the financial literature about the effects
of dividend policy on the market value of company shares. Some theories suggest that dividend policy is
relevant to share value; while the other ones suggest that it is not relevant.

Components of the Financial System

In very broad terms, the financial system is a system of transferring funds from those who have excess
funds to those who need to obtain extra funds in an economy. At the same time, it is convenient to
remember that financial decisions include both the present
and the future. It consists of decisions about taking some
actions/positions today, and getting the results at some The financial system refers to a system of
future date. Those who have excess funds lend their savings transferring funds from those who have
today, with the expectation to earn some return in the excess funds to those who need to obtain
future for compensating their inconvenience resulting from extra funds in an economy.
absence of their money. They are the first component of the
financial system, and they are called “ultimate lenders”.
On the other hand, those who need to obtain extra funds to borrow today, with an acceptance of bearing
some cost in the future for utilizing funds when they need. They are the second component of the financial
system, and they are called “ultimate borrowers”. Ultimate lenders and ultimate borrowers are households,
firms, and the government. For example, a firm may borrow some money from the financial system by
issuing short-term bonds, which makes it an ultimate borrower. At the same time, the very same firm may
buy shares of an X Corporation from capital markets in the financial system and hold it in its portfolio of
financial assets, which makes it an ultimate lender. By this example we see that a firm may have two roles as
a borrower and as a lender in the system at the same time. However, we should keep in mind that in general,
firms are in need of raising capital, and they act as net ultimate borrowers in the financial system.
There is one more thing that we should keep in mind. Ultimate borrowers or ultimate lenders do
not always have to be domestic in countries. It is very common that foreign households, firms, and
governments funnel their savings to the domestic markets, while at the same time, domestic households,
firms, and governments funnel their savings to a foreign country. Internationalization of financial
markets is actualized in two forms: The first one of them is foreign direct investments, which is setting

4
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Financial Markets & Institutions

up a manufacturing unit, or making a merger / and enhance the splitability. Splitability

acquisition with existing manufacturing units alone is especially important for individual and
or with other shareholders through expanding small investors. Otherwise, borrowers
manufacturing to other countries. The second of would not use an important quantity of
them is portfolio investments, which is making funds, and at the same time lenders would
investments to securities in other countries, rather not use their small savings for gaining some
than manufacturing units. return.
The fourth component of the financial
system is financial intermediaries. Financial
intermediaries are organizations that enable lenders
Foreign direct investments are for longer terms
and borrowers to find and trust each other in the
with the aim of building a long-lasting financial
financial system. There are two types of financing,
relationships in a foreign country, whereas
regarding the existence of these organizations:
portfolio investments are considered for shorter
(1) direct financing, which takes place when
terms with the aim of gaining the highest possible
borrowers directly find lenders without a need for
return for assumed financial risks.
an intermediary organization. For example, if an
investor individually buys and holds bonds and/or
stocks, it is a case of direct financing.
The third component of the financial system
(2) Indirect financing, which takes place when
is financial instruments. It is not surprising that
borrowers and lenders use financial intermediary
cash is sufficient to make all the fund transfers in
organizations to find each other, to match the
an economy. There is a need for other “means”
quantity/maturity, and to make transactions in
of exchange. Financial instruments are securities,
trust.
providing holders some kind of financial rights
or financial claims against issuers in terms of (1)
receiving part of their cash flows (e.g. bonds), (2)
being their shareholder (e.g. stocks). The value of Financial intermediaries are organizations
financial instruments stems from this right, rather that collect the savings and funnel them to
than its characteristics as a paper. parties in need.
Financial instruments are needed besides
money in the financial system due to the following
reasons: important

1. the quantity of funds is not always matched

among lenders and borrowers in the case
of using just money. Financial instruments
offer various alternatives to investors in this
manner.
2. The maturity is not always matched among
lenders and borrowers in the case of using
just money. Using financial instruments
fulfills the demand for and supply of short-
term and long-term investment/funding
needs.
3. Splitability is a problem in the case of using
just money. The minimum amount of funds
in order to take place in the financial system
as a lender (investor) is very important for
inclusion of small amounts of funds in
the system. Financial instruments provide
means to represent small amounts of funds,
In Turkey, the most dominant financial
intermediaries are commercial banks. Some
of the other financial intermediaries can be
exemplified as development and investment
banks, insurance companies, pension
investment funds, and mutual funds.
important
There are five key components of a
financial system: ultimate lenders, ultimate
borrowers, financial instruments, financial
intermediaries, and legal- administrative
regulations.

5
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Introduction to Financial Markets and Institutions

The last component of the financial system is legal and administrative rules and regulations together
with regulatory institutions. It would be nearly impossible for a financial system to work smoothly if there
were no rules. Because the number of participants in a financial system trying to maximize their financial
benefits is huge, things would get complicated very quickly and the system would become collapsed. The
participants of financial systems make transactions only if
important
they trust the system that their money and information
are safe when they are borrowing or lending funds. In
every economy, there are some organizations that set the In Turkey, primary regulatory organizations are
rules in the financial system. These organizations involve as follows: The Central Bank, Capital Markets
regulating the financial system by written laws, standing Board, Undersecretaries of Turkey, and
rules, codes, and guidelines. Banking Regulation and Supervision Agency.

Table 1.1 Regulatory Bodies of the Financial Sector in Turkey.

Source: Banks in 2017 Report.

6
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Financial Markets & Institutions

Further Reading

The Central Bank of The Republic of Turkey

7
1
Introduction to Financial Markets and Institutions

Source: https://www.tcmb.gov.tr/wps/wcm/connect/en/tcmb+en

The key for the financial system to function efficiently with all its components is the interest rate.
Interest rate is a number, expressed in percentages. It reflects the cost of borrowing for borrowers, whereas
it reflects the reward of lending for lenders. In other words, it represents the price of raising capital.
Loanable funds theory explains the movements in the
general level of market interest rate in a particular country.
Loanable funds here, refers to all kinds of borrowings of Market interest rates are highly influenced
households, firms, and the government. Usually, firms and by the supply of and the demand for loanable
governments are net demanders of loanable funds, whereas funds.
households are net suppliers.

8
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Financial Markets & Institutions

Let us think of supply and demand curves. Shifts (upwards or downwards) in the demand and supply
curves result in a change in the market interest rate. Sometimes interest rates cause changes in the demand
for or supply of loanable funds.
Madura (2015) explains some of the factors that commonly affect the demand for and supply of
loanable funds as follows:
• The demand for loanable funds by households is increased when the purchase of housing,
automobiles, and household items with credit; or when aggregate level of household income rises
(as it increases the purchases by credit).
• The demand for loanable funds by businesses is increased when the number of investment projects
implemented rises. It is generally observed when the interest rates are decreased.
• The demand for loanable funds by the government is increased when incoming revenues from taxes
and other sources cannot cover government’s planned expenditures.
• The demand for loanable funds by foreign governments important
or corporations is increased when their interest rate is
higher than a particular country’s interest rates.
When the demand for loanable funds
• The supply of loanable funds is increased when interest
increases (decreases), the equilibrium interest
rate is higher, (the other things being constant) as the
rate increases (decreases). When the supply
interest rate is the reward of lenders for supplying
of loanable funds increases (decreases), the
funds.
equilibrium interest rate decreases (increases).

Learning Outcomes

1 Describe the financial system

Self Review 1 Relate Tell/Share

What is the role of “decision

makers’ attitude towards
risk” in the relationship
between ultimate lenders
and ultimate borrowers in
the financial system?
How do changes in interest
rates influence the demand Why is trust important in
for and supply of loanable financial markets?
funds?

FINANCIAL MARKETS
Markets are places where buyers and sellers of goods and services come together to make transactions.
A market can be in any contextual form: physical, virtual, or hybrid. Financial markets are places where
financial goods and services (mainly financial instruments) are traded.
We can define different kinds of financial markets according to different criteria. The most common
classifications are as follows:
1. Based on maturity of financial instruments that are traded: Financial markets where transactions
are made with financial instruments with a maturity of up to one year are called money markets.
On the other hand, financial markets where transactions are made with financial instruments with
a maturity of one year and longer are called capital markets.

9
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Introduction to Financial Markets and Institutions
The most common financial instruments
of money markets are deposit accounts and
short-term bonds (issued by government or
firms).
The most common financial instruments of
capital markets are long-term bonds (issued
by government or firms) and stocks.
2. Based on the structure of financial
instruments that are traded: Financial
markets where financial instruments that
represent a situation of borrowing (lending)
some amount of money for a specified
time period for a specified amount of cost
(return) are traded are classified as debt
markets. Financial markets where financial
instruments that represent a situation of
issuing and selling (buying) of some shares
of a company are classified as equity markets.
3. Based on whether financial instruments
are bought and sold before: If financial
instruments are sold for the first time in the
market after the issue, then it is a primary
financial market. However, if financial
instruments that are sold before in the
primary market are sold for consecutive
times, then it is a secondary market. Let
us think of stocks of a company. After the
issuance of stocks, the company sells them
in the primary market, and raises capital.
After that, at some point of time, if buyers
of stocks do not want to hold these stocks
in their portfolio any more, they sell them
to new buyers in the secondary market.
Trading volume of secondary market
transactions and market price of stocks
are very important for companies because
volume and price in the secondary markets
are determinants of volume and price in the
primary markets for the forthcoming issues.
10
important
Companies raise capital in the primary
market, but not in the secondary market. The
ownership of stocks are transferred, and the
liquidity is provided in the secondary markets.
4. Based on the organization status: If
a financial market has its specific land,
building, managers, and written rules and
regulations, then it is an organized financial
market. However, if a financial market
does not have its specific land, building,
managers, and written rules and regulations,
then it is an unorganized, or, an over-the-
counter financial market. Because terms
and conditions are not standard in over-the-
counter financial markets, individuals in
general feel less safe compared to organized
markets.
Stock exchanges such as Borsa İstanbul are
organized financial markets.
Tahtakale foreign exchange market is an
over-the-counter financial market.
5. Based on the timing of payment and
shipment: Financial markets where buyers
make payment and sellers make shipment
immediately are called spot markets. For
example, if you sell some shares of stock
from your portfolio for cash, and take your
cash at the same time, it is a spot market
transaction. Financial markets where
payment and/or shipment are made at a
future point of time (under conditions
set in the first place) take place in futures
markets.

Financial Markets & Institutions
Informational Efficiency in
Financial Markets
Financial markets are considered efficient when
no one participant alone has the power to change
the price of a financial instrument. It is theoretically
not possible in full terms, but partial efficiency may
be possible in some markets. For efficiency, there
needs to be the number of buyers and sellers who
can access important information fast and at a low
cost. The key is the speed and cost of important
information to reach buyers and sellers. Here
in this context, the information that may affect
buying/selling decisions of market participants is
considered as important. Important information
might be about (1) financial instruments, (2) market
forces, or (3) issuers of financial instruments.
Informational efficiency is the degree of speed
and cost of important information to reach
market participants in the financial markets.
In an extreme case of a financial market, which
is perfectly efficient, all of the buyers and sellers
would have access to the information at the same
time and at a very low cost. Therefore, the demand
and supply forces would work perfectly, and the
price of financial instruments would be very close
to their real or economic values. Then, it would
be impossible to beat the market forces and have
excess returns because no one would be able to find
underpriced or overpriced financial instruments.
An asset is underpriced when its market price
is below its real or economic value. An asset
is overpriced when its market price is over its
real or economic value.
However, in real cases, most financial markets
are at a point between being semi-efficient and
inefficient, if we think of efficiency level as a scale
from the most inefficient to the most efficient. In
those levels of efficiency, it is possible to find an
underpriced financial instrument and buy it, hold
it until its price increases, and sell it in order to have
capital gain which is above the market average.
1
Capital gain or loss stems from the
difference between the buying and selling
prices of financial assets. When the market
prices appreciate, investors have capital gain
as they liquidate their investment. When
the market prices appreciate, investors have
capital loss as they liquidate their investment.
Risk and Return in Financial
Markets
All participants in financial markets need to
consider risk and return. “The concept of risk
refers in general to the magnitude and likelihood
of unanticipated changes that have an impact on a
firm’s cash flows, value or profitability. Uncertainty
is a somewhat broader concept, closely related to
risk and often used synonymously.” (Oxelheim and
Wihlborg, 2008). We can consider risk as a form of
uncertainty in a sense that the actual outcomes of
an action are not known, but probabilities can be
assigned to each of the possible outcomes. 
Risk refers in general to the magnitude and
likelihood of unanticipated changes that
have an impact on a firm’s cash flows, value
or profitability.
Uncertainty refers to a prerequisite condition
for risk to exist, but uncertainty can also refer
to the possibility that something completely
unforeseen can happen.
“In finance, risk refers to the likelihood that we
will receive a return on an investment that is different
from the return we expect to make. Thus, risk includes
not only the bad outcomes (returns that are lower than
expected “downside risk”), but also good outcomes
(returns that are higher than expected “upside risk”).
We consider both when measuring risk.” (Damodaran,
2012).
11
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Introduction to Financial Markets and Institutions

attitude), and those who neither like nor dislike

taking risk (people with a risk-neutral attitude).
Researchers have a consensus that most people
have a risk-averse attitude towards risk. They
dislike assuming risk unless they expect to have a
greater benefit in return. In this regard, we can say
that risk-averse investors are those who purchase
assets with high risk only if they expect a premium
return. Perceived risk and expected return tend to
be related: the greater the perceived risk, the greater
the return required by decision-makers (Pike and
Neale, 1996).
Figure 1.1 When we measure risk in finance, we consider
both downside risk and upside risk. important

Academic research studies have classified
individuals according to their attitudes towards
risk in three categories: Those who like to take
risk (people with a risk-seeking attitude), those
who dislike taking risk (people with a risk-averse
Risk-return trade-off addresses that the
greater the perceived risk, the greater the
return required by decision-makers.

Learning Outcomes

2 Explain the functions of financial markets

Self Review 2 Relate Tell/Share

What is the relationship

between the equilibrium
What is the relation
market prices of shares in Describe downside risk and
between risk and expected
secondary financial markets upside risk.
return?
and prices of shares in
primary financial markets?

INTEREST RATES
Interest rate is an analytical tool that is used in important
borrowing and lending funds in financial markets. Interest
rate is closely related with the time value of money. By using
Interest is a cost item in the form of interest
interest rate, lenders compensate for risks and opportunity
expense for the borrower, whereas it is a
costs, resulting from trade off reinvesting opportunities.
return item in the form of interest earnings
They transfer the right of use of their money for a certain
for the lender.
period of time and require an amount of interest from
borrowers as a reward.

12

Financial Markets & Institutions
Using interest rate, we can find the value of
money at any particular past or future date in
time. The future worth of a particular quantity of
money received today is called “future value of
money”. The present worth of a particular quantity
of money which will be received at a future date
is called “present value of money”. If the interest
rate is positive, the future value of a certain amount
of money will be higher than its present value.
Conversely, if the interest rate is negative, the
future value of a certain amount of money will be
lower than its present value.
Calculating future value is called
“compounding”.
Calculating present value is called
“discounting”.
Let us briefly remember how we can find the
future value and present value using compound
interest.
Finding Future Value by Using Compound
Interest (Compounding)
FV= PV * (1+i)n
FV= future value
PV= present value
i= interest rate of the period
n= number of periods
Finding Present Value by Using Compound
Interest (Discounting)
PV = FV / (1+i)n
PV = present value
FV= future value
i= interest rate of the period
n= number of periods
1
Example 1: A person invests 20 000 TL for a
period of 3 years and earns interest semiannually.
The nominal interest rate is 12%. How much will
the value of this person’s money be in 3 years?
Solution : The interest rate of the period is
12%/2= 6% and the number of periods is 5*2=10
FV= PV * (1+i)n
FV= 20,000 * (1+0.06)10
FV= TL 35,816.95
Example 2: A person invested in a bank account
for a period of 5 years and earned interest every
quarter. The nominal interest rate is 12 %. After
4 years, the value of that person’s money reached
TL 100,000. How much must the person have
invested in the bank?
Solution : The interest rate of the period is
12%/4= 3% and the number of periods is 2*4=8
PV = FV / (1+i)n
PV = 100,000 / (1+0.03)8
PV=TL 78,940.92
Theory of Portfolio Choice
In order to understand the behavior of interest
rates in the economy, we should know how demand
and supply in the bond market and in the market
for money works. For any decision-making about
buying/holding a financial asset or selecting a
financial asset over asset groups; investors take these
4 factors into account: (1) wealth, (2) expected
return, (3) risk, and (4) liquidity (Mishkin, 2016:
132). The theory of portfolio choice provides
insights about factors influential on the demand for
an asset to be bought/to be held in the portfolios.
Wealth tells us how much resource an individual
has that is available to buy an asset. Assuming that
everything else is constant, the quantity demanded
of an asset will increase with an increase in wealth.
Vice versa, the quantity demanded of an asset will
decrease with a decrease in wealth.
Expected return is the return that an individual
expects to have from an asset over a period of time.
Investors’ expected return is influenced from the
past experiences related to that particular asset. In
other words, expected return of an asset is formed
13
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Introduction to Financial Markets and Institutions
based on historical actualized returns of the asset.
If the expected return from an asset is high (relative
to the asset’s past returns or relative to alternative
assets’ past and expected returns), then the investor
wants to buy/hold the asset.
Assuming that everything else is constant,
an increase in the expected return of an
asset (relative to alternative assets) results in
an increase in the quantity demanded of an
asset. Vice versa, a decrease in the expected
return of an asset results in a decrease in the
quantity demanded of an asset.
Risk of an asset tells us the calculated degree
of uncertainty about the expected return of an
asset. Considering two financial assets with the
same level of expected returns, the degree of risk
associated to that asset will be the influential factor
for the demand for the asset. We remember that
people are grouped into three according to their
attitude towards risk: risk-seekers, risk-neutrals,
and risk-averse people. In general, most people are
risk-averse. That means that they do not tend to
take risk unless it is necessary, or unless they expect
to have a return that will at least compensate the
bearded risk.
Assuming that everything else is constant, an
increase in the liquidity of an asset results in
an increase in the quantity demanded of an
asset. Vice versa, a decrease in the liquidity of
an asset results in a decrease in the quantity
demanded of an asset.
Liquidity is the ease and quickness of an asset
to be bought and sold at an acceptable value, or
price that is not below the actual value, or price.
Liquidity is a required factor for assets because it
gives investors some degree of flexibility to change
their minds quickly and at a low cost. Liquidity
of an asset depends on two factors: the structure
of the market that the asset is traded, and the
asset’s character itself. In a market with a number
of buyers and sellers and with an acceptable level
14
of informational efficiency, it will be easier for
investors to find an asset to match their preferences.
At the same time, the equilibrium market price for
assets will be much closer to their actual value,
which increases the liquidity of assets in the market.
Besides market structure, properties of assets such
as price, transaction costs, and maturity influence
the liquidity. For example, a financial asset with
a longer maturity and a higher price would be
less liquid than an alternative asset with a shorter
maturity and a lower price.
Assuming that everything else is constant, an
increase in the liquidity of an asset results in
an increase in the quantity demanded of an
asset. Vice versa, a decrease in the liquidity of
an asset results in a decrease in the quantity
demanded of an asset.
Grounding in the theory of portfolio choice, we
can think that the results of changes in supply and
demand forces in: (1) the bond market, and (2) the
market for money. Bond market and the market for
money are important because they are the key term
in the formation of interest rates, which is the price
of the capital. Equilibrium interest rates in these
markets are set according to shifts in the demand
curve and the supply curve. Market equilibrium
occurs where demand and supply become equal.
Therefore, a change in the interest rates reflects a
shift in the curves of supply of and/or demand for
bonds or money.
Assuming that everything else is constant,
an increase in demand makes equilibrium
interest rate to increase; on the other hand,
an increase in supply makes equilibrium
interest rate to decrease.
Assumption of the theory of portfolio choice
is that people store their wealth only with: (1)
money, and (2) bonds. In other words, wealth in
the economy equals supply of bonds plus supply
of money; which is also equal to demand of bonds
plus demand of money. Either the bond market or
 1
Financial Markets & Institutions

the market for money explains the determination

of equilibrium interest rates for money. The
determination of equilibrium interest rates with
the supply of and/or demand for money rather than
supply of and/or demand for bonds is explained
with the Liquidity Preference Framework, a
framework developed by J. M. Keynes. According
to this framework, an increase (decrease) in the
demand for money would result in an increase
(decrease) in the equilibrium interest rate. Further,
a decrease (increase) in supply of money would
result in an increase (decrease) in the equilibrium
interest rate.
important
Economics literature emphasizes the income
effect and the price-level effect. A higher level
of income results in an increase in the demand
of money, and an increase in the equilibrium
interest rate and vice versa. An increase in the
general price levels results in an increase in
the demand for money, and an increase in the
equilibrium interest rate and vice versa.

Learning Outcomes

3 Explain how interest rates are determined

Self Review 3 Relate Tell/Share

Assume that you are in

What is the relation
a hypothetical situation Explain the effect of income
between the demand for
of zero inflation in the levels and price levels on the
bonds/ supply of bonds and
economy. Would there be interest rates.
interest rates?
any interest rate?

FINANCIAL INSTRUMENTS
In the financial system, ultimate lenders lend their money to ultimate borrowers for a period of time
in order to gain some return from their investment. On the operational side, borrowers issue financial
instruments to sell to lenders in order to obtain financing.
Lenders on the other hand, compare financial instruments
that are in the market and try to find the best ones in terms A security is a financial instrument, which
of risk/return profile and in terms of market price in order is a kind of negotiable paper, showing claims
to include these securities to their portfolio and hold them. on future cash flows of the issuer of the
security.
Their aim is to gain some return.

important

Cash flows refer to inflows or outflows of

By buying securities, lenders have a claim
cash related to operating activities, investing
on future cash flows of the issuer of the
activities, or financing activities of issuers.
securities. Therefore, we can say that financial
instruments represent a liability for the issuer,
whereas they represent an asset for the buyer.

15
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Introduction to Financial Markets and Institutions
Main Characteristics of Financial
Instruments
Lenders (investors) in the financial system
compare securities according to some characteristics
that affect risk, return, and therefore the market
price of securities.
1. Estimability of risk: Risk refers in
general to the magnitude and likelihood
of unanticipated upside and downside
changes that have an impact on a firm’s
cash flows, value, or profitability. Risk of
a security can be defined as the probability
of not being able to get all or part of the
returns associated with that security. Risk
is calculated using standard deviation and
it is also called “volatility”. Volatility and
its effects are explained in detail in the
forthcoming chapters of this book. Just for
now, it would be enough to know that when
the probability of actualization of returns
from a financial instrument increases,
(1) the risk of that financial instrument
decreases, and (2) the expected return from
that financial instrument increases.
important
The issuer of a security is an important factor
for its risk. Government bonds are accepted
to have zero default risk as the government
has the prerogative of coining money and
pays all of its debt.
The interest rate of government bonds is
referred to as the “risk-free interest rate”.
2. Maturity: Maturity of a security tells how
long the claim on future cash flows of the
issuer of a security stands. As the maturity
gets longer, the probability of unforeseen
events is increased, so does the risk of a
security for an investor.
3. Liquidity: In broad terms, liquidity refers to
convenience of assets. Liquidity of an asset
tells how easy and how quick an asset can
16
be converted to cash without a significant
loss from its value. Liquid securities are
considered less risky, and their expected
returns are a bit lower than more illiquid
securities. Vice versa, risk is considered to
be one of the factors that affects liquidity.
At the same time, maturity is considered to
be one of the factors that affects liquidity.
important
Riskier securities tend to have lower liquidity.
Securities with longer maturities also tend
have lower liquidity.
4. Splitability: Splitability is a term describing
how much minimum amount of money is
needed in order to buy a security. Securities
high in splitability are more liquid than
securities low in splitability.
Splitability is a term describing how much
minimum amount of money is needed in
order to buy a security.
important
Securities high in splitability are more liquid
than securities low in splitability.
Debt Instruments and Equity
Instruments
The fundamental classification of financial
instruments is based on the type of claims on
future cash flows of the issuer of the security. There
are two main groups: debt instruments and equity
instruments.
Debt instruments represent a claim on future
cash flows of the issuer of the security in the form of
interest return. Issuer of a debt instrument borrows
some amount of funds from an investor (lender),
and in return, pays back the principal amount plus
interest. The interest may be subject to execution
if the issuer company does not pay all or part of
 1
Financial Markets & Institutions

it. Issuers of debt securities are either government their shares to third parties in secondary financial
or private companies. Short-term bonds (treasury markets, and have capital gain or capital loss. Stock
bonds) and long-term bonds (government bonds) investors may also enjoy some dividend gain if the
issued by the government are considered as less company distributes some of the net income to the
risky than short-term and long-term private bonds. shareholders in the form of dividends.
Short-term bonds are more liquid than long-
term bonds. The most liquid debt instrument is important
a treasury bond in most of the financial markets
around the world.
Unlike debt instruments, the expected
return is not certain for equity instruments.
The issuer company may or may not pay
Debt instruments are also called fixed- dividends to shareholders.
income securities by investors because the
interest conditions (interest rate, amortization
schedule, etc.) are fixed at the beginning of
If we want to compare private debt instruments
the period. The interest rate is determined as
with equity instruments, we should primarily look
fixed or variable in the issuance.
at their risk and maturity:
• Issuer companies are responsible to
pay interest and principal amount to
Equity instruments represent a claim on
bondholders. On the other hand, they may
future cash flows of the issuer of the security in
or may not pay dividends to shareholders.
the form of dividends. The most common equity
This makes equity instruments riskier than
instrument is a private company share of stock.
debt instruments in general.
Holders of shares become a “shareholder” to a
• Maturity of debt instruments are definite
company, which is a very long-lasting relationship
(short or long). However, maturity of a
with no maturity date in theory (if we assume
company share is not definite (very very
that shareholders will not sell the share(s) of the
long). This makes equity instruments riskier
company). Of course, shareholders may always sell
than debt instruments in general.

Learning Outcomes

4 Identify the main characteristics of financial instruments

Self Review 4 Relate Tell/Share

Why, most of the time,

What are the main
risk and expected return of What is the relationship
differences between debt
stocks are greater than the between maturity and
instruments and equity
risk and expected return of liquidity?
instruments?
private bonds?

17
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Introduction to Financial Markets and Institutions
FINANCIAL INTERMEDIARIES
Financial intermediaries are organizations
that collect savings and channel them to parties
in need in financial markets. These intermediary
organizations provide ease and efficiency in
transferring funds between two parties. Less
time and less resources are required to collect
and distribute important information in order to
make these transactions as these organizations are
specialized entities that benefit economies of scale.
The variety and functions of financial intermediary
organizations change from country to country.
Transaction costs and costs of obtaining
information associated with the transfer of
funds become lower thanks to intermediary
organizations.
We may broadly classify financial intermediaries
in two groups as (1) depository financial institutions,
and (2) non-depository financial institutions.
Main non-depository institutions are portfolio
management companies, insurance companies,
unemployment insurance funds, and pension
investment funds.
Portfolio management company is a capital
market institution founded in the form of a joint-
stock company, the main activity field of which is
to establish and manage funds. Foreign collective
investment schemes established abroad which are
their equivalents are also the parts of the main field
of activity of the Company. (http://www.cmb.gov.tr)
internet
http://www.cmb.gov.tr
18
Insurance companies are businesses that
provide coverage, in the form of compensation
resulting from loss, damages, injury, treatment or
hardship in exchange for premium payments. The
company calculates the risk of occurrence, then
determines the cost to replace (pay for) the loss to
define the premium amount.
Unemployment insurance fund is a
government created fund which is used to assist
individuals who have lost their jobs.
Pension investment fund is a mutual fund
which is created to invest the contributions
collected by the pension company under the
pension contract. The type of the pension mutual
funds is determined based on the investment
instruments they contain; e.g. government bonds
and bills, stocks, deposits, and so on.
These funds are managed with long-term
investment strategies, and they are considered as
long-term investment instruments. (https://www.
egm.org.tr)
internet
https://www.egm.org.tr
Pension funds are created by pension
companies. They do not have a legal
entity and they are managed by portfolio
management companies.
 1
Financial Markets & Institutions

In Practice

Transformation of the Asset and Wealth Management (A&WM) Industry In Turkey

19
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Introduction to Financial Markets and Institutions

Source: Transformation of the Asset Management Industry in Turkey, PwC

20
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Financial Markets & Institutions

Main depository institutions are deposit banks. In Turkey, the dominant financial institution in the
financial system is banks. It is obviously seen from Table 1.2 that banks have 82 percent of the total assets
held by the financial sector in 2017.

Table 1.2 Total Assets of the Financial Sector in Turkey.

Source: Banks in Turkey 2017 Report

“Banks play critical roles in every economy. They operate the payments system, are the major source of credit
for large swathes of the economy, and (usually) act as a safe haven for depositors’ funds. The banking system aids
in allocating resources from those in surplus to those in deficit by transforming relatively small liquid deposits into
larger illiquid loans. This intermediation process helps match deposit and loan supply and provides liquidity to
an economy. If intermediation is undertaken in an efficient manner, then deposit and credit demands can be met
at low cost, benefiting the parties concerned as well as the economy overall” (Berger et al., 2010).

The main function of Deposit Banks is to meet deposit and credit needs of households and businesses.
Traditional banking involves accepting money from those who have it (depositors) and loaning it to those
who need it (borrowers). The difference between the interest that banks earn from loans and the interest
they pay for deposits is the income they use to fund their operations and generate a profit (ABA, 2010:12).
Legally, deposit banks should be incorporated as a joint stock company in Turkey. From the ownership
point of view, deposit banks may be (1) state owned, (2) private owned, (3) foreign owned, and (4) under
the Deposit Insurance Fund.
“In 2017, the share of assets of deposit banks in Turkish banking sector was 90 percent, while the
shares of development and investment banks and participation banks were 5 percent each. Fifty one
percent of total loans extended to large scale companies and project financing, 24 percent to SMEs and
25 percent to consumers. The distribution of corporate loans among manufacturing industry, commercial
sector, construction industry and energy sector, transportation and real estate brokerage was 18 percent, 15
percent, 9 percent and 7 percent, 5 percent each, respectively.” (Banks in Turkey 2017 Report).
Development and Investment Banks are organizations, which function mainly to provide credit and/
or execute tasks assigned to them through specific codes and similar branches of these organizations in
Turkey that are established abroad. “In broader terms, investment banking covers all transactions and
organizations which comprise capital formations, including the transfer of existing assets and circulation
of shares and debenture bonds” (Celik et al., 2012).

21
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Introduction to Financial Markets and Institutions

Participation Banks can be defined as banks, which collect funds participation accounts and provide
loans. Article 3 of the Banking Law defines participation accounts as “accounts constituted by funds
collected by participation banks that yield the result of participation in the loss or profit to arise from their
use by these institutions, that do not require the payment of a predetermined return to their owners and
that do not guarantee the payment of the principal sum”.

Learning Outcomes

5 Distinguish between financial intermediaries

Self Review 5 Relate Tell/Share

How do financial interme-

Tell the differences between
diaries reduce the costs of
How many banks are there deposit banks, development
obtaining information as-
in Turkish banking system? and investment banks and
sociated with the transfer of
participation banks
funds?

22
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Financial Markets & Institutions

LO 1 Describe the financial system

There are five key components of a financial system:

1. Ultimate lenders: They are individuals or organizations with an over saving. And, they are ready to
lend all or some of their over savings to the other parties for a specified time period, and in return of
a specified or no specified amount of return. Return may be in cash and/or noncash forms.
2. Ultimate borrowers: They are individuals or organizations with a funding gap. They are ready to bear

Summary
a specified or no specified amount of cost in return of using lenders’ over savings for a specified time
period. Bearded costs may be in cash and/or noncash forms.
3. Financial instruments: A financial instrument is a means to transfer funds from ultimate lenders to
ultimate borrowers, and back. They represent the rights and liabilities of lenders and borrowers. These
instruments are bought and sold through financial markets.
4. Financial intermediaries: Organizations which bring lenders and borrowers together and at the same
time contribute to matching the amounts of funds to transfer among them. Otherwise, funds would
not be able to be used effectively. Financial intermediaries earn some amount of commission as an
income for playing such an important role in the financial system.
5. Legal and administrative regulations: Organizations, which assure that the transactions are made in
an easy and orderly manner, and in a secure way. By this, confidence of lenders and borrowers to the
financial system is provided, and this results in circulation of funds effectively.

Explain the functions of financial

LO 2 markets

Financial instruments are traded / bought and sold in financial markets. We can categorize financial
markets by different criteria: (1) money markets, in which financial instruments with maximum one year
maturity are bought and sold and capital markets, in which financial instruments with longer than one
year maturity are bought and sold (2) organized markets, which work with specific places, buildings,
managers, rules, etc. and over the counter markets, which do not have specific places, buildings, managers,
rules, etc. (3) primary markets, in which financial instruments are bought and sold at issuance and for
the first time and secondary markets, in which financial instruments, which are before bought and sold
at primary markets are bought and sold (4) spot markets, which payment and exchange between buyers
and sellers occurs immediately and futures markets, which payment and exchange between buyers and
sellers occur at a later specified date.
Like any other market, the level of competition in the market and the size and depth of the market are the
key factors determining the risks and returns associated with financial instruments. The more competitive
the financial market becomes, the harder it gets to gain excess returns in the market. Moreover, the
bigger and the deeper the financial market becomes, it gets easier to match returns and risks for financial
instruments. At the same time, the level of competition in the market and the size and depth of the market
determine how the equilibrium prices for financial instruments are formed.

23
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Introduction to Financial Markets and Institutions

Explain how interest rates are

LO 3 determined

In the financial system, interest rate represents a cost for the borrowing party, and a return for the lending
party. Determination of equilibrium interest rates with the supply of and/or demand for money rather
than supply of and/or demand for bonds is explained with Liquidity Preference Framework, a framework
developed by J. M. Keynes. According to this framework, an increase (decrease) in the demand for money
would result in an increase (decrease) in the equilibrium interest rate. Moreover, a decrease (increase) in
supply of money would result in an increase (decrease) in the equilibrium interest rate.
Summary

Identify the main characteristics

LO 4 of financial instruments

Financial instruments are means to provide transfer of funds from lenders to borrowers in the financial
system. We can classify financial instruments in some ways. The first classification is termed as debt
financial instruments and equity financial instruments. Debt instruments provide holders (lending party)
a right to receive a specified amount of interest and principle at a specified date for their lending to
the issuer company. Equity instruments provide the holder a right to be a shareholder of the issuing
company. The second classification is as money market financial instruments and capital market financial
instruments. Money market financial instruments have maturity of one year or less. Capital market
financial instruments have maturity longer than a year. The third class consists of spot or derivative financial
instruments. Derivative instruments are futures/forward/option/swap agreements. They represent a future
claim on an underlying asset, which can be either a real asset, or a financial asset.

Distinguish between financial

LO5 intermediaries

Financial intermediaries are organizations, which bring lenders and borrowers together and at the same
time contribute to matching the amounts of funds to transfer among them. Otherwise, funds would
not be able to be used effectively. Financial intermediaries earn some amount of commission as an
income for playing such an important role in the financial system. Financial intermediaries are broadly
classified in two: Depository financial intermediaries and non-depository financial intermediaries. Main
non-depository institutions are portfolio management companies, insurance companies, unemployment
insurance funds, and pension investment funds. Main depository institutions are deposit banks.

24

Financial Markets & Institutions
1 Which one of the following is an over-the-
counter market?
A. Borsa İstanbul
B. New York Stock Exchange
C. Chicago Board of Options Exchange
D. İstanbul Altın Borsası
E. Kapalıçarşı gold market
2 Which one is the main aim of the Central
Bank of Turkish Republic?
A. Transparency of interbank transactions
B. Sustainable supervision of banks
C. Effectiveness of the issue policy
D. Price stability
E. Statistical data availability
3 Which of the following terms refers to
“information that may affect buying/selling
decisions of market participants”?
A. Vulnerable information
B. Important information
C. External information
D. Timely information
E. Excess information
4 A person invests 90 000 TL in a bank for
5 months. If the interest rate is 22%, then how
much will be the value of this person’s money after
5 months?
A. 96.650 B. 97.350
C. 98.250 D. 99.450
E. 100.550
5 A person invested a bank account for a period
of 6 years. The frequency of interest is 3 months,
and the 3-month interest rate is 2%. After 6 years,
the value of that person’s money was 700, 000 TL.
How much must the person have invested in the
bank?
A. 475.105 B. 465.805
C. 455.705 D. 445.405
E. 435.205
1
6 According to “The Theory of Portfolio
Choice”, which of the following is not a factor
that investors take into account when they make
decisions about financial instruments?
A. Historical prices B. Risk
Test Yourself
C. Liquidity D. Wealth
E. Expected return
7 I. Riskier securities are in general lower in
liquidity, compared to less risky securities.
II. Riskier securities associated with lower
expected returns, compared to less risky
securities.
III. Securities, which are high in splitability,
are more liquid than securities, which are
lower in splitability.
IV. Longer-maturity securities are riskier than
shorter-maturity securities for investors.
Which of the above statements (I to IV) about the
main characteristics of financial instruments are
true?
A. I and II B. I andIII
C. II andIV D. I,III and IV
E. I,II,III and IV
8 Which of the following financial instruments’s
interest rate is called “risk-free interest rate”?
A. Stocks B. Treasury bonds
C. Private bonds D. Savings account
E. Warrant
9 Which one of the following is a depository
financial institution?
A. Pension investment fund
B. Portfolio management companies
C. Commercial banks
D. Unemployment insurance fund
E. Insurance companies
10 Which of the following can collect deposits?
A. Insurance companies
B. Portfolio management companies
C. Pension investment fund
D. Unemployment insurance fund
E. Development and Investment bank
25
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Introduction to Financial Markets and Institutions

If your answer is wrong, please review the

1. E 6. A If your answer is wrong, please review the
“Components of the Financial System”
“The Theory of Portfolio Choice” section.
section.
Answer Key for “Test Yourself”

If your answer is wrong, please review the If your answer is wrong, please review
2. D 7. D
“Components of the Financial System” the “Main Characteristics of Financial
section. Instruments” section.

If your answer is wrong, please review If your answer is wrong, please review
3. B 8. B
the “Informational Efficiency in Financial the “Main Characteristics of Financial
Markets” section. Instruments” section.

4. C If your answer is wrong, please review the 9. C If your answer is wrong, please review the
“Interest Rates” section. “Financial Intermediaries” section.

5. E If your answer is wrong, please review the 10. E If your answer is wrong, please review the
“Interest Rates” section. “Financial Intermediaries” section.

What is the role of “decision makers’ attitude towards

risk” in the relationship between ultimate lenders and
ultimate borrowers in the financial system?
Suggested answers for “Self Review”

The key to a working financial system is the interest rate. Interest is a cost
item for borrowers, and a return item for lenders in the economy. Interest
rate is a numerical expression of cost and return. Basically it reflects the price
of loanable funds, regardless of how and with which financial instrument
funds are transferred. Therefore, the relationship between ultimate borrowers
and ultimate lenders is facilitated by the interest rate, which is specifically a
required rate of return by lenders for their lending.
self review 1 Like all decision makers, ultimate lenders are risk seekers, risk averse, or risk
neutral. And, their attitude towards risk is reflected in their required rate of
return for a given risk in a given situation of lending. As we all know, rational
financial behavior requires an increase in the required rate of return for an
increase in risk. It leads us to assume and expect that a risk-seeking lender
may require a lower rate of return from a borrower than a risk averse lender
requires from the same borrower. Vice versa, we can expect that a risk averse
lender may require a higher rate of return from a borrower than a risk-seeking
lender requires from the same borrower.

26
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Financial Markets & Institutions

What is the relationship between the equilibrium market

prices of shares in secondary financial markets and
prices of shares in primary financial markets?

Suggested answers for “Self Review”

Prices of shares in secondary markets are determined by the market forces,
which are demand and supply. Equilibrium prices in secondary markets
are results of shifts in demand and supply curves. For a particular share in
the market, when the demand curve shifts upward and supply curve shifts
downward, equilibrium price goes up. When the demand curve shifts
downward and supply curve shifts upward, equilibrium price goes down.
self review 2
Issuer companies set prices of shares in primary markets. However, prices in
primary markets are not unrelated to prices of shares in secondary markets.
Prices of shares in secondary markets show the expectations of existing and
potential buyers of shares so that it constitutes a reference point for following
share issuances. If the price is in an increased trend in the secondary market,
we can assume that expectations over the issuer company is good, and the
issue price for the next issue may be set high.

Assume that you are in a hypothetical situation of zero

inflation in the economy. Would there be any interest
rate?

For a borrowing-lending relationship, interest is a cost item for borrowers, and

a return item for lenders. Interest rate is a numerical expression of cost and
return. Inflation, in its simplest definition of an increase in the general price
levels, is one of the factors that has an effect on interest rates. Interest rate
should be greater than the expected inflation rate because borrowers would
demand protecting their buying power at least. Otherwise, it would make no
sense to lend money instead of spending it.
self review 3
However, inflation is just one factor that has an effect on the interest rate.
It is not the only reason for lenders to require an interest from borrowers.
Even if there were no inflation, lenders would demand interest in order to
compensate for the risk they bear because of the absence of their money. They
give the right of using their money to borrowers for a period of time. Interest
would exist regardless of the existence of inflation.

27
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Introduction to Financial Markets and Institutions

Why, most of the time, risk and expected return of stocks

are greater than the risk and expected return of private
bonds?
Suggested answers for “Self Review”

Private shares are considered to have a higher risk than private bonds. Private
bonds are debt instruments. Bondholders expect to have specified periodic
interest payments in specified dates and principal amount at the maturity.
Amounts and the time intervals are set in the beginning. However, shares are
equity instruments. There is no specified amount of return for shareholders.
self review 4 Because of higher level of uncertainty, risk and return for shares are generally
higher. At the same time, the maturity of shares is indefinite. Well, theoretically
it is infinite. In reality it is very long. On the other hand, the maturity of
bonds is shorter. The idea of increasing uncertainties and risks with longer
maturities is the second reason behind why risk and expected return are
higher for private shares than as of private bonds.

How many banks are there in Turkish banking system?

The number of banks operating in the banking sector in 2017 was 52. The
following table shows the number of different kinds of banks in Turkey.

Number of Banks in Turkey

self review 5

Source: Banks in Turkey 2017

28

Financial Markets & Institutions
References
American Bankers Association. (2010). Principles of
Banking, 10th ed., USA.
Berger, A. N., Molyneux, P. and Wilson, J. O. S.
(2010). The Oxford Handbook of Banking, Oxford
University Press, UK.
Celik, İ. E., Dincer, H. and Hacioglu, U. (2012).
Investment and Development Banking and Its
Development in Turkey, International Journal of
Finance and Banking Studies, Vol.1 No.1, p.39-45.
Damodaran, A. (2012). Investment Valuation: Tools
and Techniques for Determining the Value of Any
Asset, 3rd ed., John Wiley & Sons, Inc., USA.
Grinbblatt, M. and Titman, S. (2002). Financial
Markets and Corporate Strategy, 2nd International
ed., McGraw-Hill Higher education, USA.
Madura J. (2015). Financial Markets and Institutions,
11th ed., Cengage Learning, USA.
1
Mishkin, F. S. (2016). The Economics of Money,
Banking, and Financial Markets, 11 th Global ed.,
Pearson Education Limited, England.
Oxelheim, L. and Wihlborg, C. (2008). Corporate
Decision-Making with Macroeconomic Uncertainty:
Performance and Risk Management, Oxford
University Press, USA.
Pike, R. and Neale, B. (1996). Corporate Finance
& Investment: Decisions and Strategies, 2nd ed.,
Prentice Hall Inc. Europe, Great Britain.
PwC Turkey (2017). Transformation of the Asset
Management Industry in Turkey Project, UK’s
Prosperity Fund 2016-2017, British Embassy,
Ankara.
The Banks Association of Turkey (2018). Banks
in 2017, The Banks Association of Turkey
Publication No:328, Istanbul.
29
 Chapter 2 Bond Markets
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Explain the main characteristics of bond

Describe the logic of bond valuation
investments

3 Identify risks of bond investments

Chapter Outline Key Terms

Introduction Yield to Maturity
Eurobond
Characteristics and Types of Bonds Duration
Bond Valuation Convexity
Default Risk
Risks of Bond Investments Rating

30
Financial Markets & Institutions
INTRODUCTION
Companies need funds to finance their
investment and operations, and they have different
choices to satisfy their financing requirements:
by debt, equity or hybrid financing. Each of
these alternatives has its own advantages and
disadvantages, and companies may choose one
of them or a combination of them. Market
conditions and company specific conditions affect
the financing decision of the company. If the
company prefers debt financing, and the financing
need is long term, then issuing bonds is a suitable
alternative for the company. Bond is one of the
oldest financial instruments, and it is preferred not
only by companies but also by the governments.
Bond is a less risky investment alternative than
stocks for investors, and it is suitable especially for
risk averse investors. It makes regular payments
and they are paid before the stockholders in the
event of liquidation. Yet, this does not mean
that bond investments are riskless. Besides being
affected by systematic risk factors, bonds may carry
specific risks depending on their types and features.
The most important risk associated with the bond
investments is default risk. Default risk refers to
the possibility that the issuer could lose the coupon
or principal payment ability. Investors evaluate
the default risk and the other risks, and construct
their bond investments. There are many different
types of bonds in the financial markets that may be
attractive for different types of investors, which are
developed depending on the needs of issuers and
demand of the investors.
CHARACTERISTICS AND TYPES
OF BONDS
Bond is a long-term financial instrument issued
by companies or governments, which provides
interest and principal payments to the holders
on specific dates (Brigham and Houston, 2019,
p. 230). It is issued to satisfy long term financing
needs, and is suitable for companies especially
which do not want to lose management of the
company by issuing stocks.
There are two main participants of the
bond markets. The first group is the borrowers.
Borrowers are the bond issuers such as governments,
municipalities, financial and real sector companies.
The second group is the bond investors or holders.
They are the institutions or individuals who want
to evaluate their savings in the bond markets. By
purchasing bonds, they lend their savings to the
borrowers in need of funds (Choudhry, 2006a, p. 3).
Bond is a fixed-income security and a type of
debt instrument.
Although bond is a type of debt financing,
differently from the bank loans, it is traded in
secondary markets. The most traded type of bonds
is the bond that makes regular interest payments
and principal payment on the maturity date, which
is called conventional bond.
Bonds are redeemed on a specified date.
However, based on their type, they can also be
redeemed on a specified date when a predetermined
event occurs or at some time in between two dates.
If it is a callable bond, then it will be redeemed
when the company calls the bonds.
Characteristics of Bonds
There are some elements that determine the
characteristics of the bonds. These are (Williams,
2011, p. 176);
• Par value,
• Form of the bond (Bearer or registered)
• Payment method (Coupon or discount)
• Coupon payment frequency (annually,
semiannually, quarterly or monthly)
• Maturity,
• Call feature if it is callable,
• Sinking fund if it is a sinking fund bond,
• Creditworthiness of the issuer.
Principal or Par Value: The principal, which is
also referred to as par value, redemption value or
maturity value, is the amount that the issuer agrees
to repay on the maturity date. Assume a 10-year
bond with a par value of $1,000, in this case, the
principal of the bond, which will be paid after ten
years, is $1,000.
Coupon Payments: Most of the bonds make
regular payments to the holders, which is called
coupon or interest payment. The amount of
the payments is initially specified as an annual
31

percentage of the principal (fixed-rate bonds) or
as a floating rate, which depends on an external
measure such as LIBOR (London Interbank Offered
Rate), inflation, currency and gold (Brown, 2006,
p. 3). Coupon payments can be made annually,
semi-annually, quarterly or monthly. Most of
the floating-rate bonds pay coupons quarterly or
monthly, while the fixed-rate bonds generally pay
coupons annually or semi-annually.
Maturity: Bonds are issued with a maturity
date. Maturity or term of a bond is the number of
years that the issuer meets the obligations of the
bond, and refers to a specified date on which par
value (principal) of the bond must be repaid to the
holder. Maturity of bond is important, because it
determines the yield on the bond.
important
As the maturity of a bond increases, the price
volatility of the bond will increase due to the
changes in market yields.
Types of Bonds
Bonds are classified in several ways. The type of
a bond that will be issued is determined depending
on the needs of issuer and demand of the investors,
and each type is suitable for different types of
investors based on its features. Some issuers want
to reduce the borrowing costs and issue bonds with
collateral. Some issuers do not want to provide
collateral, so they issue debentures and accept to
pay a higher interest rate.
From the perspective of the bondholders,
in some cases, put provision may be attractive.
Therefore, they accept to receive lower coupon rates.
Alternatively, they may choose to buy convertible
bonds depending on the market conditions.
Bearer and Registered Bonds: Bonds are
divided into two categories in terms of ownership:
bearer bonds and registered bonds. Bearer bond is
a bond type that the owner is the person who holds
it. They have coupons that are presented to a bank
for payment. The issuer of the bearer bonds does
not know the holder of the bond and who receives
the cash flows of the bond. In the United States,
the issuance of bearer bonds is prevented because
investors may escape the tax of interest payments
(Melicher and Norton, 2017, p. 256). As opposed
32
Bond Markets
to bearer bonds, the issuer of the registered bonds
knows the names of the holders and payments are
made directly to the holders.
Straight Coupon Bonds: The most common
type of bonds traded in the markets is straight
coupon bonds, which provide the holder to receive
periodic interest payments and principal on a
specified date. The interest payments of these bonds
are generally made annually or semiannually, and
neither the issuer nor the investor have the right of
demanding early repayment (Brown, 2006, p. 9).
Zero-Coupon (Discounted) Bonds: Holders
of zero-coupon bonds do not receive coupon
payments. They buy the bond at a discounted
price, and they receive the par value at the maturity.
The difference between the discounted price and
the par value becomes the interest payment of the
bondholders.
The reason why companies issue zero coupon
bonds is that they do not have to make payment
until the maturity date, and the reason investors
prefer this type of bond is that there is no risk of
reinvesting at a lower rate. Yet, there is disadvantage
for the holders of the zero-coupon bonds. Although
they are not paid until maturity, they pay the taxes
of interest earned each year (Burton, Nesiba and
Brown, 2015, p. 271).
Return of a zero-coupon bondholder is
the difference between the discounted price
and the par value, which will be paid at the
maturity date.
Government Bonds: This type of bond is
issued by the governments and public sector
bodies, in order to fund the ongoing operations
and the fiscal deficit. Especially, when the tax
revenues are not sufficient, governments prefer to
fund long-term projects through bond issues. On
the other hand, in periods when the economy is
depressed, governments try to provide economic
expansion by increasing government spending. In
order to do this, governments have to find fund
resources. In this case, they have two alternatives:
increasing revenues or borrowing. Borrowing is a
better alternative in depressed periods, since the
main way to increase revenues is to increase tax
Financial Markets & Institutions
revenues, and tax increases in such periods deepen
economic depression (Williams, 2011, p. 174).
Governments mainly have three borrowing
instruments:
• treasury bills which satisfy short-term
financing needs,
• treasury notes that are mid-term debt
instruments,
• government (treasury) bonds which are
issued to satisfy long-term financing needs.
Government bonds can be issued discounted
or with coupons, and their maturity can
range between 1 and 30 years.
important
Coupon rates of government bonds are lower
than the coupon rates of the company bonds,
since the return of the bondholders are
considered as risk-free return.
Corporate Bonds: The bonds issued by
governments and public sector bodies are named
as government bonds, and they are evaluated as
risk-free instruments since they carry implicit
government guarantee. The other bonds are
therefore deemed to be corporate bonds. In this
context, a corporate bond can be defined as the debt
instrument issued by non-government borrowers.
Corporate bonds are accepted as riskier compared
to the government bonds, so the coupon rate of
these instruments is higher than the government
bonds.
The main factor that determines the coupon
rate of the corporate bonds is creditworthiness
of the issuer.
As in government bonds, the issuer pays
coupons and makes the principal payment at the
maturity date for the bonds. If the issuer fails to
make the coupon or principal payment, this is
called default. In this case, the bondholders can
enforce the payments through the legal process
(Choudhry, 2006b, p. 88).
important
The creditworthiness of the issuer reflects
the default risk of the bond. For this reason,
the bond investors should evaluate the
creditworthiness of the corporation in an
investment process.
Coupon rates of corporate bonds are higher
than the coupon rates of government bonds
since the possibility of default in these bonds
is higher compared to government bonds.
Debenture (Unsecured) Bonds, Secured
Bonds and Guaranteed Bonds: Debenture bonds
are unsecured bonds and payments of these bonds
depend on the general credit strength of the issuer.
The holders of these bonds are accepted as general
creditors of the issuer (Melicher and Norton, 2017,
p. 262).
Debenture bonds are typically issued by
companies with high credit ratings and have high
coupon rates since they carry high default risk.
Unlike the holders of debenture bonds, secured
bondholders are protected against the default risk
via the right to sell the pledged asset. Therefore, a
secured bond can be defined as the bond that is
secured by a pledge asset of the issuer. These bonds
also can be secured with the revenue that arises
from the project, for which the bond was issued to
provide finance.
Guaranteed bond is a bond issued by a
company and guaranteed by another corporation
or corporations. The default risk is, therefore,
transferred from the bondholder to the guarantor.
In the event of default, interest and principal
payments of guaranteed bondholders are paid by
the guarantor such as banks, insurance companies
and governmental agencies (Johnson, 2013, p.
284).
Floating-Rate Bonds: The coupon rate of
these bonds change depending on a reference
rate. The coupon rate of each period is the sum of
quoted margin and the current reference rate. The
quoted margin is expressed as “basis point”. The
reference rate or benchmark of a floating-rate bond
is an interest rate or an interest rate index (Fabozzi,
2013, p. 5).
33

One of the most widely used benchmarks
for floating rate is the LIBOR (London
Interbank Offered Rate), which is the
borrowing rate in the London Interbank
Market. Another reference rate is the Prime
Rate, which is the interest rate that banks
charge their most creditworthy customers.
Assume a bond which pays LIBOR plus 100
basis point semiannually. The coupon rate of this
bond will change semi-annually depending on the
LIBOR. For example, if the LIBOR is 4% at the
first coupon payment period, then the coupon
rate will be 5% (4% + 1%). Typically, coupon rate
increases as the reference rate increases. However,
in some cases, coupon rate moves in the opposite
direction of the reference rate. This type of bond is
called inverse floating-rate bonds.
Quoted margin is the rate that the issuer agrees
to pay above the determined reference rate.
Index-Linked Bonds: Index-linked bond is a
bond that the coupon payments and in some issues
principal payments are linked to a specific index
such as Consumer Price Index (CPI). Coupon
payments of index-linked bonds may change in
each period and coupons may be different from
each other due to the changes in the determined
index. In other words, return of these bonds
depends on the developments in the index (Haan,
Oosterloo and Schoenmaker, 2012, p. 142).
Index-linked bonds provide protection
against inflation. Hence, investors prefer
to hold index-linked bonds rather than the
conventional bonds if they are worried about
the unexpected inflation.
Callable and Puttable Bonds: Callable bonds
provide the issuer the opportunity of buying his
debt prior to the scheduled maturity date in case
interest rates fall below the coupon rate of the bond
(Martellini, Priaulet and Priaulet, 2003, p. 460).
Therefore, the issuer can issue new bonds with a
lower coupon rate. If the issuer calls the bond, the
price that the issuer will pay is named as call price.
34
Bond Markets
The call price is specified in the indenture. For
some issues, the call price is the same for all the
time frame. Yet for some issues, there are different
call prices scheduled depending on the timing of
the call.
A callable bond is a type of bond, which can
be redeemed before the maturity date.
There are some disadvantages for the holder of
a callable bond. First of all, the holder is faced by
reinvestment risk. If the bond is called, then the
investor will invest in a bond that gives a lower
coupon rate. Secondly, the callable bonds have
negative convexity (see the last explanations about
convexity in the last section of this chapter). This
means that callable bonds will appreciate less than
the traditional bonds when the interest rates fall.
For these reasons, the buyers of callable bonds are
willing to pay lower prices than the traditional
bonds.
A puttable bond is a bond that provides the
holder to sell the bond back to the issuer at par on
stated dates in the indenture. Put provision provides
advantage to the holder, if the interest rates exceed
the coupon rate. When the interest rates increase,
bond prices will decrease, but the put provision will
protect the holder from the capital loss. In case the
interest rates increase, the holder can sell the bond
back and buy a new bond with a higher rate (Drake
and Fabozzi, 2010, p. 473). On the other hand,
usage of put provision will force the issuer to issue
a new bond with higher coupon rate. Therefore,
puttable bonds are sold at higher prices relative to
traditional bonds or have lower coupon rates.
A puttable bond is a type of bond that gives
the holder the right of selling the bond back
to the issuer on stated dates in the indenture.
Eurobonds and Foreign Bonds (International
Bonds): Eurobond is a bond denominated in a
currency that is different from the currency of the
country where the bond is issued. They are typically
issued by governments, large corporations and
international institutions (Pilbeam, 1998, p. 324).
For example, a bond denominated in US dollars
and sold in London is a Eurobond. Eurobonds
Financial Markets & Institutions

are named with the currency in which the bond is that recently there is a high default risk even for
issued. Therefore, a bond denominated in Japanese foreign bonds issued by governments. The possible
Yen and sold in Germany is called Yen Eurobond. defaults in some of the European countries support
Foreign bond is a type of bond that is issued this statement.
by a foreign company or foreign government. They
are denominated in the currency of the country
where they are sold. Some of the foreign bonds Eurobonds are denominated in a currency
have specific names. For example, bonds issued in that is different from the currency of the
the United States by a foreign company are called country where the bond is issued, whereas
Yankee Bonds, the foreign bonds issued in the foreign bonds are denominated in the
United Kingdom are called Bulldog bonds (Maple currency of the country where they are sold.
bonds – Canada; Panda bonds – China; Samurai
bonds – Japan; Rembrandt bonds - the Netherlands; Besides other risks of bonds, investors are
Kiwi bonds – New Zealand; Matador bonds – also exposed to currency risk, if they buy bonds
Spain; Kangaroo or Matilda bonds Australia). The denominated in a currency other than their home
investor of a foreign bond undertakes default risk currency. They will lose money if the foreign
as in other bond types. Even though the default risk currency decreases against the domestic currency
on foreign bonds issued by governments is lower, when they convert the foreign currency to domestic
all foreign bonds carry default risk. It is even stated currency (Brigham and Houston, 2019, p. 230).
Table 2.1 Comparison of Domestic Bond, Eurobond and Foreign Bond.
Nationality of
Type of Bond Place of Issue Currency of Issue Primary Investors
Issuer
Domestic Bond Domestic Domestic Domestic Domestic
Eurocurrency, Euroyen, Eurodollars,
Eurobond International Any International
Eurosterling, etc.
Foreign Bond Domestic Domestic Foreign Domestic
Source: Arnold, G. (2015), The Financial Times Guide to Bond and Money Markets, p. 206.

Convertible Bonds: Some of the bonds issued by

corporations provide to the holder the right of changing the
bond with another asset. These bonds are called convertible
bonds. For example, holder of a convertible bond can be
granted to receive the face value in cash or a unit of ordinary
stocks of the issuer. This right can be used at maturity or
over a specified period depending on the indenture (Bailey,
2005, p. 283). The investors take the face value or convert
the bonds into the stocks based on their choices.
Learning Outcomes
important
While Eurobonds are denominated in a
currency that is different from the currency of
the country where the bond is issued, foreign
bonds are denominated in the currency of the
country where they are sold.

1 Explain the main characteristics of bond investments

Self Review 1 Relate Tell/Share

What are the elements that Under which conditions Tell the importance of
determine the characteristics should bond investors buy creditworthiness of the bond
of bonds? floating-rate bonds? issuer for bond investors.

35

BOND VALUATION
The concept of time value of money must be
understood to calculate the cost of funds, the value
of the investments and the yield on an investment
such as bonds.
Time Value of Money
Time value of money is a critical concept in
understanding many fields of finance. The value
of financial instruments and future cash flows of
investments is determined by discounting, and
future value of money resulting from an investment
is calculated by compounding (Kettell, 2002, p. 33)
Time value of money in the easiest way can be
defined with the sentence “$1 you have today is
more valuable than the $1 that you will have in
the future”. Today’s $1 is more valuable because
you may make an investment with this money
and obtain interest on it. Therefore, you can have
more than $1 after a while. Yet, this is valid as long
as the interest rate is strictly positive (Martellini,
Priaulet and Priaulet, 2003, p. 43). Another reason
why today’s $1 is more valuable than $1 in future
is the uncertainty of cash flows. In other words,
there is no certainty that those cash flows will be
obtained in the future. We do not know certainly
whether the cash flows will occur or not, when the
cash flows will occur and how much cash flows will
occur in the future.
important
To compare the investment alternatives, we
must know the math of time value of money
because the value of the alternatives must be
on the same timeline in order to choose the
best one.
To compare an investment that present value is
known with an investment that future cash flows
are known can lead to misleading decisions. The
cash flows arising from different investments at
different periods of time can be compared in two
ways. The present money can be compounded to
the future date that the cash flow of the alternative
investment will be received or the future money
can be discounted to the present day (Hiriyappa,
2008, p. 43).
36
Bond Markets
Today’s $1 is more valuable than $1 in the
future because the future carries uncertainty
and today’s $1 can provide return through
the investment.
The formulas of compounding (future value)
and discounting (present value) are as follows;
FV= PV*(1+i)n
FV
PV=
(1+i)n
In the formulas, is future value of cash flow, is
present value of cash flow, is the annual interest
rate (yield) and is the number of years for which
compounding or discounting is done. If the cash
flows occur different than annual frequency, and
must be revised. For example, for semiannual
periods is divided to 2 and is multiplied by 2, since
there are two semiannual payments in a year.
The value of a financial asset is the present
value of future cash flows expected from the
asset. For this reason, determination of price
of an asset requires an estimation of expected
cash flows and an appropriate discount
factor, which refers to the required rate of
return or required yield.
Estimation of expected cash flows of a bond is
easier relative to many of the financial assets, and
it consists of periodic coupon payments and the
principal, which is the par value at the maturity
(Drake and Fabozzi, 2010, p. 514). The discount
factor that is used in bond valuation consists of a
risk-free rate and a risk premium. Risk-free rate
refers to the coupon rate of government bonds, and
the risk premium includes economic, industrial
and firm level risks.
In this context, the factors that affect the
discount rate. Hence the bond value are as follows
(Burton, Nesiba and Brown, 2015, p. 288):
• The economic outlook,
• Monetary policy of the country,
• Government’s borrowing needs,
• Inflationary expectations,
• The level of economic activity,
Financial Markets & Institutions

• The level of capital inflows,

• The credit rating of the bond determined credit rating agencies,
• The capital structure of the company,
• Company conditions.
In general, value of a bond can be estimated by the following formula;

⎛n ⎞
C C C ⎜P C ⎟ P
n ⎜⎜∑
VB = + + ...+ + = +
n t ⎟⎟
1
(1+ i) (1+ i) 2
(1+ i) (1+ i) (1+ i) n
⎝ t=1 (1+ i ) ⎠

Here,
is the value or price of the bond,
C is the coupon payment,
i is the coupon or interest rate,
n is the number of periods until the maturity,
P is the principal or par value of the bond.
If coupon payments are made monthly or quarterly, n and r must be revised according to the payment
frequency. Since coupon payments are regular, the sum of the present value ​​of coupon payments can be
estimated by using the present value of the annuity formula.
Assume a 30-year bond with a par value of $1,000, the coupon rate of the bond is 9%, therefore, the
coupon payments will be $90 ($1,000x0.09), If the discount rate is 11%, the value of the bond is:

⎛ n=30 ⎞
⎜ $90 ⎟ $1,000
VB = ⎜ ∑ ⎟ + = $782.4413+ $43.6828 = $826.1241
⎜ t=1 1+ 0.11 t ⎟ 1+ 0.11 30
⎝ ( )⎠ ( )

Valuing Zero-Coupon Bonds

The estimated value of a bond gives the
economic or intrinsic value of the bond;
hence, it reflects the fair price for the bond.
The investors use this value in investment
decisions.
important
If the bond is sold at the price below the
estimated value, then it means that the
bond is overvalued and it can be purchased.
If the bond is sold at the price above the
estimated value, then it means that the bond
is undervalued and the bondholder can sell
the bond.
A zero-coupon bond provides the investor a cash
flow equal to the par value, which will be obtained
at maturity. Therefore, the value of a zero-coupon
bond is equal to the present value of the bond’s
par value and it can be estimated by the following
formula (Gündoğdu, 2017, p. 363):
VB = P n
(1+i)
Assume a 5-year zero-coupon bond which has
$1,000 par value. If the required return is 8%, the
price of the bond should be:
1,000
VB= =$680,58
(1+0.08)5

37
 Bond Markets

Valuing Bonds with Semiannual Coupons

Coupon payments of bonds can be settled annually or semiannually. If the interest payments will be
made semiannually, then the annual coupon interest payment and discount rate must be divided to 2, and
the maturity should be multiplied by 2. Therefore, the valuation formula can be revised for semiannual
coupon bonds as follows (Brigham and Houston, 2019, p. 246):
⎛ 2n ⎞
⎜ C/2 ⎟ P
V B = ⎜∑ ⎟ +
t
⎜ t=1 1+ i / 2 ⎟ 1+ i / 2 2n
⎝ ( )⎠ ( )
important
Assume a 2-year bond which has $1,000 par value and
makes interest payment semiannually with the coupon rate While valuing the bonds that pay coupons
of 10%. In this case, the nominal rate will be 5% (10% semiannually, the annual coupons and
/ 2), interest payment will be $50 ($1,000*0.10/2). If discount rate must be revised according to
the discount rate is 12% (0.12/2=0.06, since the coupon the period.
payments are semiannual, the value of bond will be:
$50 $50 $50 $50 $1.000
VB = + + + + = $956.3489
1 2 3 4 4
(1+ 0.06) (1+ 0.06) (1+ 0.06) (1+ 0.06) (1+ 0.06)

Accrued Interest, Dirty Price and Clean Price

Except zero-coupon bonds, the bonds accrue interest on a daily basis, and coupons are paid on the
coupon date. The valuation formulas above can be used only for bonds at the very start of a coupon period.
In this case, the dirty price and clean price of the bond are equal.
If the bond price will be calculated at a date between two coupon periods, accrued interest must be
calculated (Bodie, Kane and Marcus, 2018, p. 427). The price of a bond including accrued interest is
called dirty or full price. In other words, dirty price is equal to sum of clean price and accrued interest. The
price without accrued interest is called clean or flat price. The clean price is calculated by subtracting the
accrued interest from the dirty price. The accrued interest (AI) can be calculated by the following formula:

AI=Coupon Payment* Days since last coupon payments
Days separating coupon payments
Dirty price of a bond is the price that includes
the accrued interest at the settlement date.
The price of a bond at a date between two
coupon periods can be calculated by the following
steps (Chisholm, 2002, p. 63);
1. Calculate the number of days in the current
coupon period.
2. Calculate the number of days from
settlement date to next coupon date.
3. Calculate the fraction of the current coupon
period by dividing the result of Step 2 to the
result of Step 1.
4. Calculate the price of the bond by
discounting the cash flows.
Assume a bond with a 10% coupon rate that
matures on 15 May 2021. Par value of the bond is
1,000. It pays the coupons semiannually and the
discount rate is 8%. In this case, the price of the
bond for settlement 10 January 2020 is calculated
as follows:
Number of days in the current coupon period
is 182 (The date that the last coupon is paid: 15
November 2019 - The date that the next coupon
will be paid: 15 May 2020).
1. Number of days from settlement date to
next coupon date is 126 (10 January 2020 -
15 May 2020).

38
Financial Markets & Institutions

2. The fraction of the current coupon period is 0.6923 (126/182). This means that the next coupon
will be paid 0.6923 period later, the one after will be paid 1.6923 period later, and so on.
3. The coupon payment is $50 ($1,000*(0.10/2)) and the discount rate is 4% (0.08/2), since the
coupon payments are made semiannually. The price of the bond is:

$50 $50 $1050

VB = + + = $1,040.229
0.6923 1.6923
(1+ 0.04) (1+ 0.04) (1+ 0.04)2.6923

This price is referred to as“dirty price”. The clean price can be calculated by calculating the accrued
interest. In order to calculate the accrued interest, the number of days since the last coupon payment
should be calculated. The number of days since last coupon payment for the example is 56 (15 November
2019 – 10 January 2020 or 182-126). Therefore, the accrued interest and the clean price of the bond are;
56
AI = $50 * =$15.3846
182
Clean Price = $1,040.229-$15.3845 = $1,024.845

Bond Yields
There are different yield concepts with respect
to bonds. In this context, the concepts of nominal
yield, current yield, yield to maturity and yield to
call are defined below.
Nominal Yield: Nominal yield of a bond is
the coupon rate of the bond, and it does not take
into consideration the bond’s time to maturity or
market price of the bond (Rini, 2003, p. 97). For
example, the nominal yield of a bond with a 10%
coupon rate is 10% (0.10), whether it is sold at par
or not and matures in 2 or 30 years.
Regardless of if the bond is sold at par, at a
premium or discounted, nominal yield of a
bond is the coupon rate of the bond.
Current Yield: Current Yield is the return an
investor expects to earn from an investment or
financial instrument. Therefore, the current yield
of a security is the ratio of investment’s annual
income to the current price of the security. For
bonds, the current yield refers to the ratio of the
annual coupon to the market price of the bond. It
is not the actual return that the investor receives by
holding the bond until the maturity date. (Burton,
Nesiba and Brown, 2015, p. 285). Assume a bond
with par value of $1,000 and is selling for $920.
If the coupon rate is 6%, then the current yield is
approximately 6.5% ($60/$920).
The current yield of a bond is calculated by
dividing the coupon payment to the current
price of the bond
Yield to Maturity (YTM): There are several
measures, which are used to evaluate the return of
bonds. One of these measures is yield to maturity,
which can be also calculated for the callable and
putable bonds.
YTM is the rate of return that the investor
will obtain if he buys the bond at a certain
price and holds until the maturity.
YTM is the rate, which equates the bond price
to the present value of its future cash flows, and it
is a measure of the growth rate of the investment
(Johnson, 2010, p. 45). It is calculated by using
the formula which is used in bond valuation. Yet,
this time, the value of the bond is known, and the
equation is solved for “” that gives the YTM. If the
YTM is equal to or greater than the rate required
by the investor, then the bond should be purchased.
important
YTM of a bond is the internal rate of return
of a bond.

39
 Bond Markets

Yield to Call (YTC): Sometimes, those in need

Differently from the current yield, yield to
maturity includes all of the cash flows of
the bond and takes into account the capital
gain or loss of the investor. Additionally,
timing of the cash flows are considered in the
calculation.
There is a relation between the price and yield
measures of the bonds. If a bond is sold at par value,
then the coupon rate, current yield and YTM are
equal. If the bond is sold at a discounted price,
then the coupon rate will be lower than the current
yield, and the current yield will be lower than the
YTM. Finally, if the bond is sold at a premium
price, then the coupon rate will be greater than the
current yield, and the current yield will be greater
than the YTM.
of funds may issue bonds that give the issuer the
right to call back. In this case, yield to call is an
appropriate measure to evaluate the return of the
bond. YTC is the rate that equals the present value
of the expected cash flows of the bond to the price
plus accrued coupon payments. In general, there is
a call schedule for callable bonds, which shows the
call prices for each call. The bondholders generally
calculate YTC for the first call and for the par call
that gives the issuer the right to call the bond at
par value.
Calculation of YTC is the same as the YTM.
The expected cash flows to be used in the
calculation of YTC for the first call are the
call price and the coupon payments to the
first call date.

For the bonds sold at par value, YTM is
equal to the coupon rate. For the bonds sold
at a discounted price, YTM will be greater
than the coupon rate, and for the bonds sold
at a premium price, YTM will be lower than
the coupon rate.
In the calculation of YTC for the par call, par
value is considered as the call price, and the coupon
payments, which will accrue to the first date at
which the issuer can call the bond at par are taken
into account at maturity (Drake and Fabozzi,
2010, p. 528).

Learning Outcomes

2 Describe the logic of bond valuation

Self Review 2 Relate Tell/Share

Under which circumstances do

we expect the bond prices to Tell why bond prices are
How do we compute the yield
reflect fair values of the bonds? inversely related with changes
to maturity of a bond?
(Remember the Efficient in market interest rates.
Market Hypothesis)

RISKS OF BOND INVESTMENTS

Like other investments, bond investments carry risks. Besides the risks that arise from the economic
conditions, bond investments carry specific risks such as call risk and downgrade risk.

Types of Risks Associated with Bond Investments

The main risk associated with the bond investment is default risk. Default risk refers to the possibility
that the issuer fails to make the payments of the bond. Another risk important for the bondholders is

40
Financial Markets & Institutions
interest rate risk. Changes in the interest rates are
important because they directly affect the price of
the bond. There are also risks such as currency risk,
which depends on the type of bond, undertaken by
the bondholder.
Default Risk (Credit Risk): Default risk is the
risk that the borrower will not meet the obligation
at the agreed time. For bonds, default risk refers
that the issuer will fail to make interest payments
and/or principal at the determined dates. When
the issuers default, the bondholders can sue for
bankruptcy, if the issuers do not file for bankruptcy
(Johnson, 2010, p. 147).
There are credit rating agencies such as
Standard & Poor’s, Moody’s Investment Services
and Fitch Ratings Service that evaluate the default
risk and the credit worthiness of bonds. The ratings
given by these companies affect the decisions on
the investors. To have a rating determined by the
mentioned companies increases the marketability
of the bonds. On the other hand, many of the
large institutional investors establish credit analysis
departments in order to evaluate the issuers’ ability
to meet their obligations arising from the bond.
Downgrade Risk: Downgrade risk can be
defined as the risk that the rating of the issuer or
instrument will be downgraded by a rating agency
or more rating agencies, due to the deterioration in
the creditworthiness of the borrower. Therefore, the
downgrade risk can be considered as a component
of credit risk. However, the origin of the downgrade
risk is generally an event notably default, and it is
estimated depending on the possibility of this event.
Credit risk is also associated with the consequences
of the event. It considers both the possibility of
the event and its potential consequences (Aarons,
Ender and Wilkinson, 2019, p. 34).
An increase in the downgrade risk results in a
decrease in the price of the bond.
Interest Rate Risk or Market Risk: Interest
rate risk refers to potential losses caused by changes
in the interest rates.
important
Typically, prices of fixed income securities
move in the opposite direction of the interest
rate changes. For example, the price of a bond
increases when the interest rates decrease, and
price of a bond decreases when the interest
rates increase.
The interest rate changes are important especially
for the investors who plan to sell the bond before
the maturity date (Fabozzi and Mann, 2005, p.
22). If the interest rates increase, the investor will
sell the bond at a lower price. This risk undertaken
by the investor is called interest rate risk or market
risk, and it is one of the most important risks of
fixed income investments. (The interest rate risk
of bonds is evaluated via some measures such as
duration and convexity which are presented in the
following section) .
Call Risk: Call risk is a type of risk that some
bonds are exposed to. Call risk is the possibility
that the issuer will buy back the bond before the
maturity date. The bondholders undertake this risk
if the bond carries a call provision.
Two factors fundamentally determine the call
risk. First of these factors is the length of the call
provision. The call risk increases as the length of call
provision increases. The second factor is the coupon
rate of the bond. While other things are the same,
call risk of a bond with a lower coupon rate is lower
than call risk of a bond with a higher coupon rate
(Robinson and Wrightsman, 1980, p. 157).
The call risk increases especially when the
interest rates tend to decrease because the issuer
will use the call provision in order to issue new
bonds with a lower coupon rate. Yet, if the coupon
rate of the bond is low and the interest rates are less
volatile, the call risk will be low.
Reinvestment Risk: Investors desire to reinvest
their income generated from their investments. In
this case, they are faced with the reinvestment risk that
arises from the possibility of reinvesting their money
at lower rates. This risk is high when the interest
rates are volatile. Especially for bond investments,
reinvestment risk is higher because the price of the
bond decreases as the interest rates increase, and the
bondholders sell their bonds at lower prices besides
reinvesting their money at lower rates.
41

The reinvestment risk in bond investments
stems from the need to reinvest the coupons of
the bonds (Arnold, 2015, p. 133). The holder may
reinvest money arising from the coupon payments
at lower rates if the interest rates decrease. On the
other hand, if the investor has a callable bond and
the interest rates decrease, the issuer will exercise
the call provision. In this case, the investor will
reinvest the amount higher than the coupons at a
lower rate.
Currency Risk (Foreign Exchange Risk):
In general terms, currency risk can be defined as
the potential loss occurs due to the changes in
the exchange rates. The bondholders undertake
currency risk when they invest in a bond which
pays the coupons and principal in a foreign
currency. When the foreign currency that the
bondholders will receive as the cash flows of the
bond depreciates against the domestic currency, it
will take more foreign currency to buy the same
amount of domestic currency (Wright, 2003, p.
87). In other words, they will receive less amount
of domestic currency when they convert the
foreign currency, since the foreign currency goes
down in value. There is no problem with domestic
currency appreciation, as long as the investor holds
the foreign currency. The problem occurs when the
bondholder wants to convert the foreign currency
to the domestic currency. On the other hand,
the domestic currency can depreciate against the
foreign currency. In this case, the return of the
bondholders will increase, since they will take more
money when they convert the foreign currency to
the domestic currency.
important
If the foreign currency depreciates, the
holders of foreign bonds will receive less
amount of money in domestic currency when
they convert the foreign currency that stems
from the bond investment.
Purchasing Power Risk or Inflation Risk: This
type of risk is associated with the unanticipated
changes in the future value of money. Investors
who want to protect their investment against this
contingency can buy index-linked securities, for
which the payoffs are adjusted according to the
price changes (Bailey, 2005, p. 298).
42
Bond Markets
Duration and Convexity
Duration and convexity are tools that are widely
used to manage the risk exposure of fixed-income
investments like bonds.
Duration
The maturity of a bond provides little
information about how long it takes the bond
to repay the investment. Moreover, it does not
give any idea about the sensitivity of the bond to
changes in interest rates. It is simple to compare two
bonds with the same maturity but with different
coupon rates. As the bond with the higher coupon
rate will repay the investment faster, theoretically,
its value will be less exposed to changes in interest
rates. However, when we want to compare two
bonds with different maturity and coupon rates,
the maturity cannot help us in evaluating two
alternatives (Choudhry, 2006b, p. 40).
Zero-coupon bonds do not make payments
until the maturity, but coupon bonds provide cash
flows before the maturity. The fluctuations in the
price of a bond is related to term structure of the
bond. Current value of the bond changes due to the
changes in the market interest rates and the term.
As the time to maturity increases the coupon rate
increases, and as the market interest rate increases,
coupon payments become more important than the
payment of the principal. Therefore, when we want
to evaluate the bond investments, we should use a
method that considers the time value of money.
Duration is a first order interest rate risk
measure and it reflects the sensitivity of the bond to
changes in interest rate rates. Duration is a method
that gives a weighted average of the time to receive
the investment, which uses the present value of cash
flows gained from the bond. Besides the principal
of the bond, it considers the coupon payments
and the timing of these payments. In this context,
duration can be defined as the average time that
is needed to receive principal and coupons of the
bond, which considers the sensitivity of bond to
interest rate changes. Duration of an n-year zero
coupon bond is n year. In other words, duration
of zero-coupon bond is equal to maturity of bond.
However, duration of an n-year coupon bond is
less than n year because the bondholder receives
coupon payments in certain periods until the
maturity date.
Financial Markets & Institutions

receipt of cash flows with the present value of cash

flows, and then dividing the sum of these values
Duration is a measure of interest rate sensitivity
to the sum of present value of cash flows (PVCF)
of bond and gives the weighted average time to
(Wright, 2003, p. 177).
receive the cash flows of the bond.
For bonds with semi-annual coupons, the
important
cash flows are discounted at half of the discount
rate. Macaulay duration formula can be shown as
follows:
Duration decreases when the interest rates
increase. ⎡n ⎤ n
⎢ CFt CFt
Duration of a bond with higher coupon rate D = ⎢∑ *t ⎥⎥ / ∑
t t
is shorter than the duration of a bond with ⎢⎣t=1 (1+ r ) ⎥⎦ t=1 (1+ r )
lower coupon rate.
Here, represents the cash flows of the bond,
Holding other factors constant, duration of a
r is the discount factor and t is interest period or
bond increases as the term to maturity increases
the time that the investor will receive the payment.
(Arnold, 2015, p. 351).
Assume a 3-year bond which has $1,000 par value
Duration is also known as “Macaulay Duration” and makes interest payment annually with the
since the concept of duration was firstly developed coupon rate of 8%. The bond is sold at par. In this
by Frederick Macaulay. Macaulay duration is case, coupon payment will be $80 ($1,000*0.08),
calculated by multiplying the time (t) until the and the duration of the bond will be:
$80 $80 $80 $1,000
*1+ *2+ *3+ *3
1 2 3 3
D=
(1+ 0.08) (1+ 0.08) (1+ 0.08) (1+ 0.08) = 2.782
$80 $80 $80 $1,000
+ + +
1 2 3 3
(1+ 0.08) (1+ 0.08) (1+ 0.08) (1+ 0.08)
Duration is calculated as 2.7832 years. This means that the average time needed to receive the cash
flows of this bond is 2.7832 years. As expected, the duration of the bond is lower than three years as some
of the income is received before the end of three years.
In the duration formula, the denominator, which is the sum of the present values of the coupons and
the principal, in fact gives us the price of the bond (Choudhry, 2001, p. 159). Therefore, we can calculate
duration for bonds sold at different prices. In this case, the cash flows in the numerator part of the formula
are discounted with the yield and later, the value obtained in the numerator part is divided by the price
of the bond.
Duration can be calculated for bond portfolios. The duration of a portfolio of bonds is calculated as
follows (Johnson, 2010, p. 174):

n
D p = ∑ wi * Di
i=1

Assume a portfolio consists of three bonds. The weights

of bonds in the portfolio are 25%, 35% and 40%. If the The duration of a portfolio of bonds is
durations of the bonds are 0.3472, 2.6596 and 1.2835 equal to the weighted average of durations of
respectively, then the duration of the portfolio is: the bonds in the portfolio.

43
 Bond Markets

Modified Duration
There are many forms of duration focusing on
different properties of bonds, which have been
developed to evaluate different types of bonds.
One of these forms is modified duration.
While duration or Macaulay duration reflects
the sensitivity of a bond to the interest rate
changes, modified duration evaluates the effects
of yield changes on the price of the bond.
Modified duration is calculated under the
assumption that cash flows of the bond do not
change when the yield changes. For this reason,
this measure is not suitable for some types of bonds
such as callable bonds and bonds with embedded
options (Fabozzi and Mann, 2005, p. 204).
Modified duration can be calculated as follows:
Macaulay Duration
M.D.=
1+ yield/k
In the formula, k is the number of coupon
payments per year. For example, k is 1 for bonds
that make annual coupon payments, and k is 2 for
bonds that make coupon payments semi-annually.
The modified duration for the bond that we
calculated the duration will be;
2.7832
M.D.= =2.5770
1+0.08
In case of yield changes, we can calculate
approximate changes in the bond price by using
modified duration (Brentani, 2004, p. 76). The
change in price of a bond given a change in yield
can be calculated by the following formula:

Approximate change in bond price = (− M.D.) * Δy * PVB

In the formula, is the change in the yield and is the present value of the bond. For example, if the yield
increases from 8% to 8.2%, the change in the price of bond will be:

Approximate change in bond price = (–2.5770) * 0.002 * $1,000 = $-5.1542

This means that, if the yield increases from 8% to 8.2%, the price of the bond will fall by about
$5.1542.

Convexity
Duration is a first order interest rate risk measure, which uses first-order derivatives. However, convexity
uses second-order derivatives and represents a second order important
interest rate risk (Choudhry, 2005, p. 41).
Duration does not consider the convexity of bond price If the interest rate changes are large, the
with respect to interest rates and estimates the approximate magnitude of price changes will be different for
percentage of price change regardless of the way of the increases and decreases. In this case, convexity is
change in the interest rate. Yet, for large changes in the a better measure than the duration.
interest rates, the magnitude of price changes is different for
increases and decreases. For this reason, duration is a good
measure to analyze the effects of small interest rate changes
on the bond price, whereas it is not a suitable measure in Convexity measures the nonlinear
cases where interest rate changes are large. For these cases, relationships between bond prices and
convexity is the appropriate measure to evaluate the interest interest rates.
rate risk.
While other conditions are the same, the bonds that have higher convexity should be preferred by the
investors. The logic is as follows: As the interest rates decrease, the price of a bond that has higher convexity

44
Financial Markets & Institutions

increases more than the price of other bonds. The price of a bond that has higher convexity decreases less
than the price of other bonds while the interest rates increase.
Convexity, in fact, shows by how much the duration of a bond will change, when interest rates change
and it measures the volatility of the duration (Wright, 2003, p. 178).
The convexity of a bond can be calculated by the following formula:
⎡m ⎤
⎢ CFt ⎡ 2 ⎤
CX = ⎢∑ *t * (t +1)⎥⎥ / ⎢(1+ r ) * P⎥
t ⎣ ⎦
⎢⎣t=1 (1+ r ) ⎥⎦

For semi-annual coupon bonds, discount factor is divided by 2 (Choudhry, 2001, p. 185).
Assume a 5-year bond which has $1,000 par value and makes interest payment annually with the
coupon rate of 6%. The bond is sold at $985 and the market interest rate is 6.5%. In this case, coupon
payment will be $60 ($1,000*0.06), and the convexity of the bond can be calculated as in the table below:

Interest Period (t) Cash Flows (CFt) PVCF t*(t+1) PVCF* t*(t+1)
1 60 56.3380 2 112.6760
2 60 52.8995 6 317.3970
3 60 49,6709 12 596.0508
4 60 46,6394 20 932.7880
5 1,060 773,6737 30 23,210.2110
25,169.1228
25,169.1228
CX= =22.5285
(1+0.065)2*985

The unit of convexity calculated by the given formula is in years; hence, the coupon payments are
annually. For bonds which make payments on a different frequency, we can convert the convexity to years
using the following formula:

CX
CX years= 2
k

Convexity can be used to find the approximate percentage change that will occur in bond price against
a given yield change (Chisholm, 2002, p. 87). The following formula is used to find the change:

1
Change in Price = * Yield Change2 * CX * 100
2

For example, a 100 basis point (1%) change in the yield will change the price of the bond that we
calculated the convexity for approximately:

1
Change in Price = * 0.012 * 22.5285 * 100 = 0.1126%
2
Bond Ratings
Lenders want to evaluate creditworthiness or repayment ability of the borrowers. They decide if they
will fund the borrower or not depending on the repayment ability. On the other hand, cost or interest rate

45
 Bond Markets

of the debt is fundamentally determined by the repayment ability. As with lenders, investors also consider
the creditworthiness of the issuer. They decide if they purchase the security or not by evaluating the default
risk of the issuer. For bond investors, credit rating is a suitable indicator in order to evaluate the default risk
of the issuer. Issuers also want to have credit ratings in order to increase the marketability of their bonds,
since ratings reflect trustworthiness of issuers and it is an important process for investors.
For short-term debts with maturity less than one year,
credit rating is a forward-looking assessment of default
risk. But for long-term debts, besides reflecting default Besides the default risk, credit rating agencies
risk, credit rating provides a forward-looking assessment provide information about the downgrade
of magnitude of the loss in case of default. The default risk of the bonds.
risk is given as percentage and termed as default rate, and
magnitude of the potential loss in case of default is referred to as default loss rate. On the other hand,
rating transition tables which are provided by the agencies periodically reflect the downgrade risk (Fabozzi
and Mann, 2005, p. 25). Therefore, ratings are suitable indicators for the bond investors to evaluate
default risk and possible losses that stem from the investment.
Several rating agencies such as Standard & Poor’s, Moody’s and Fitch rate corporate and government
bonds with respect to the issuer’s ability to make the regular coupon payments and principal payment at
the maturity date (Rini, 2003, p. 58). The agencies monitor the issuers and change the rating if the credit
quality changes.
If the credit quality of the issuer improves, then the
important
agency upgrades the rating, and if the credit quality of the
issuer deteriorates, then the agency downgrades the rating.
The rating agencies also modify the ratings by additional Bonds with high ratings are considered safer
expressions such positive, developing, stable or negative. than the lower rated bonds. If a bond has a
While positive outlook indicates a possible upgrading in very low rating, then investing in this bond is
the future, the negative outlook gives the signal of a possible considered as speculative.
downgrading in the future.

Further Reading

DEBT SECURITIES MARKET IN TURKEY conducted; the Equity Repo Market where repo-
h t t p s : / / w w w. b o r s a i s t a n b u l . c o m / e n / reverse repo transactions are carried out with the
products-and-markets/markets/debt-securities- shares of the companies that are traded on Borsa
market İstanbul Equity Market and which are included in
BIST 30 Index; and International Bonds Market,
The Debt Securities Market is comprised
where foreign debt instruments issued by the
of the Outright Purchases and Sales Market,
Turkish Undersecretariat of Treasury and listed
where the secondary market transactions of debt
by Borsa İstanbul are conducted. There is also
securities are conducted; the Offering Market
the Committed Transactions Market where same
for Qualified Investors, where the capital market
day or forward value date buy-sell transactions
instruments of the corporations whose equities
are realized between the seller party with a
are traded on Borsa İstanbul Equity Market
commitment to repurchase a predetermined
are issued to “qualified investors” as defined
security and the buyer party with a commitment
in the capital markets legislation; the Repo-
to resell that security and the Watchlist Market
Reverse Repo Market, where repo-reverse repo
where capital market instruments that are
transactions are conducted; the Repo Market
previously traded in the Outright Purchases
for Specified Securities, where repo-reverse repo
and Sales Market and decided to be traded in
transactions with specified debt securities are

46
Financial Markets & Institutions
the Watchlist Market pursuant to the Listing
Regulations.
Debt securities, securitized asset and income
backed debt securities, lease certificates, liquidity
bills issued by the Central Bank of the Republic
of Turkey and other securities which are approved
by Borsa İstanbul Board, which are denominated
in TRY and foreign currency can be traded on
the Debt Securities Market.
Trading is conducted electronically in the
Debt Securities Market via the automated
multiple price-continuous auction system.
Sub-Markets of the Debt Securities Market
were launched on the following dates:
• Outright Purchases and Sales Market; June
17, 1991.
• Repo-Reverse Repo Market; February 17,
1993.
• Offering Market for Qualified Investors;
May 17, 2010.
• Repo Market for Specified Securities;
December 17, 2010.
• Equity Repo Market; December 7, 2012.
• International Bonds Market; April 16, 2007
(conducted under Debt Securities Market
since September 13, 2013)
• Watchlist Market; December 1, 2017
• Committed Transactions Market July 2,
2018
Central Bank of the Republic of Turkey
and the intermediary institutions, which are
members of Borsa İstanbul and Banks can carry
out transactions in the Debt Securities Market.
Settlement operations are realized by İstanbul
Settlement and Custody Bank Inc. (Takasbank).
Transactions are conducted on the following
markets:
Outright Purchases and Sales Market
Fixed income securities are traded on the
Outright Purchases and Sales Market, which is
an organized and transparent secondary market.
Repo- Reverse Repo Market
Fixed income securities are sold with a
repurchase agreement (repo) and are bought with
a resale agreement (reverse repo) in the Repo-
Reverse Repo Market, which is one of the leading
organized repo markets in the world.
Repo Market for Specified Securities
This Market provides the opportunity
to realize repo transactions on specified debt
securities within the organized market and then
to deliver such securities to the buyer. It provides
the means to exchange the security in a specified
period, ensuring the flow of the securities between
the forward and spot markets.
Equity Repo Market
This market provides a means for carrying
out repo transactions on company shares within
an organized market framework. Shares acquired
through repo transactions are delivered to the
buyer for the duration of the contract.
Offering Market for Qualified Investors
The Offering Market for Qualified Investors
is the market where the debt securities of the
issuers defined in the related CMB Communiqué
are issued to “qualified investors” as defined in
the capital markets legislation, in accordance
with the regulations of the Capital Markets
Board of Turkey.
International Bonds Market
Foreign Debt Securities (“Eurobonds”)
issued by the Turkish Undersecretariat of
Treasury and listed by Borsa İstanbul are traded
in the International Bonds Market.
Committed Transactions Market
In Committed Transactions Market, TRY
denominated lease certificates issued by asset
leasing companies founded by the Treasury
and asset leasing companies founded by public
enterprises assigned by the Treasury, as well as
other capital market instruments determined
by the Board of Directors of Borsa İstanbul
can be traded. Same day or forward value date
buy-sell transactions are realized between the
seller party with a commitment to repurchase a
predetermined security and the buyer party with
a commitment to resell that security.
Watchlist Market
Capital market instruments that are
previously traded in the Outright Purchases
and Sales Market and decided to be traded in
the Watchlist Market pursuant to the Listing
Directive are traded in the Watchlist Market.
47

In Practice
Economic worries last year turned out to
be great news for bond investors.
https://www.nytimes.com/2020/01/17/
business/bond-market-investments.html
Interest rates fell sharply and bond prices
rose as recession fears grew through the summer,
resulting in the most profitable calendar year
for bond fund investors since 2002. Core
investments such as the Vanguard Total Bond
Market Index mutual fund and the iShares Core
U.S. Aggregate Bond exchange-traded fund
gained nearly 9 percent in 2019.
Investors playing it safe in high-quality short-
term bonds profited, too. The 3.5 percent gain for
the Schwab Short-Term U.S. Treasury E.T.F. was
more than a percentage point above inflation. The
Baird Short-Term Bond fund gained 4.7 percent.
Yet, the bond party of 2019 is expected to give way
to a bit of a hangover this year.
“You don’t get those kinds of returns two years
in a row unless something really bad happens to the
economy and interest rates take another slice down
“ said John Mousseau, director of fixed income at
Cumberland Advisors, a money manager.
That’s not widely anticipated. Mike Pyle,
global chief investment strategist at BlackRock,
expects that “the big forces” that set off last
year’s bond rally are “going to recede into the
background.”
After three rate reductions last year in
response to concerns about global growth, the
Federal Reserve is now signaling that it intends to
sit tight this year as improving economic data has
apparently reduced the likelihood of a recession.
“The barriers to cutting rates seem pretty high,
and the barriers to raising rates from here are
higher still,” Mr. Pyle said.
A better global economic outlook should also
tamp down demand for United States bonds. Last
year, when global recession chatter was increasing
during the U.S.-China trade war, investors clamored
for the safety of United States Treasuries, which had
the added allure of offering much higher yields than
the negative rates paid on government bonds issued
by Japan and many European economies.
48
Bond Markets
The yield on the 10-year Treasury note fell
from a high of 3.25 percent in late 2018 to a low
of 1.45 percent in early September. That yield
tumble — which played out in corporate and
municipal bonds as well — is what set off the big
2019 gains for bond funds and E.T.F.s.
Mr. Mousseau expects that the 10-year
Treasury could rise from its current 1.9 percent to
2.25 percent this year. “We are back to clipping
coupons,” he said. Without falling rates to
increase prices — interest rates and bond prices
move in opposite directions — returns will be a
simple function of the interest bonds pay. That
suggests core bond returns of around 2 percent.
While bond investors profited as rates fell, the
Fed’s 2019 U-turn was “a big disappointment”
for money-market investors, said Ken Tumin,
editor of DepositAccounts.com.
After seeing cash rates rise throughout 2017
and 2018 — the first signs of life since the
financial crisis for savers seeking safe and liquid
income — rates slumped in 2019 in sync with
the Fed’s rate cuts. For example, in December
2018, the online Ally bank offered a certificate of
deposit that guaranteed a 3.1 annual yield for five
years, which was well above the rate of inflation.
A five-year Ally C.D. bought in December paid a
2.15 percent yield.
Mr. Tumin says high-yield savings accounts
from online banks and credit unions offer the “most
bang for the buck” for savers today. While brick and
mortar banks and credit union savings accounts pay
less than 0.2 percent on average, there are plenty of
online savings accounts with yields ranging from 1.7
percent to above 2 percent.
Despite that risk-free opportunity to bolster
cash performance, Christopher Cordaro, chief
investment officer of Regent Atlantic financial
advisers, says he sees plenty of new clients who are
“earning next to nothing at their brick and mortar.”
He says he has taken on clients who had more
than $1 million in an old-school bank account
with virtually no yield. That inertia works out to
a self-imposed penalty of $17,000 to $20,000,
which is about what $1 million can earn if it is
moved to a high-yield savings account.
Financial Markets & Institutions

Mr. Cordaro also says savers are probably
leaving cash on the table in their brokerage
accounts. “Brokerage firms have gone to charging
zero commission on trades, but they can afford to
do that by basically paying nothing on your sweep
account,” said Mr. Cordaro, referring to the cash
account where proceeds from trades are parked.
According to Crane Money Fund Intelligence,
the average brokerage sweep account had a yield
of 0.13 percent in December. Money-market
mutual funds offered by those same brokerage
firms — but not the default option — paid more
than 1 percent.
For example, making a low-yielding bank
account the default option for cash accounts has
become a major revenue generator for Schwab.
A $100,000 balance in a Schwab sweep account
had a 0.06 percent yield in December. Alert
investors who move their cash into a Schwab
money-market account could earn more than 1.5
percent in December.
“‘Free’ makes people do silly things,” says
Mr. Cordaro. “You would be better off paying
$5 to trade and have a better sweep account.”
Fidelity and Vanguard continue to use money-
market mutual funds, with higher yields than
bank accounts, as the default for their investors.
For longer-term bonds, investors may need
to accept that they need to emphasize either
safety or income. But, no single type of bond is
likely to excel at both.
While Treasury yields are meager, Treasury
bonds are the best ballast when stocks are falling,
and that is worth remembering, more than 10
years after the start of a stock bull market.
Mr. Pyle of BlackRock noted that with low
concern for a sharp pickup in inflation, prices
for Treasury Inflation Protected Securities have
not been bid up as much as those for regular
Treasuries. That makes 2020 a “good entry point”
to build in some long-term protection to rising
prices. Morningstar, the fund research firm,
recommends Vanguard Short-Term Inflation-
Protected Securities and Schwab U.S. TIPS.
For income seekers willing to take on
more risk, Mr. Pyle said, high-yield bonds are a
reasonable way to generate more income, if you
accept BlackRock’s outlook for moderate growth,
without a recession, in the United States this year.
For example, the Vanguard High-Yield
Corporate fund had a current yield of 4.2
percent in December, compared with 1.7 percent
for the Vanguard Intermediate Treasury fund.
BlackRock also recommends emerging-market
bonds, which it says could do well at a time when
the global economic outlook is solidifying. The
TCW Emerging Markets Income fund has a 5
percent current yield.
But, high yield is often called “junk,” because
it comes with a risk. When stocks are falling,
bonds that pay higher yields tend to experience
sharp price declines that lead to negative total
returns. During the last bear market, the
Vanguard High-Yield Corporate fund lost 24
percent. TCW Emerging Markets Income lost 10
percent. Vanguard Intermediate Term Treasury
delivered the ballast, gaining nearly 17 percent.

Learning Outcomes

3 Identify risks of bond investments

Self Review 3 Relate Tell/Share

How can investors use the Associate the duration of a Tell the difference between
concept of convexity in bond bond with changes in the the duration and modified
investments? interest rates. duration.

49
 Bond Markets

Explain the main characteristics

LO 1 of bond investments

Companies satisfy their financing needs by debt or equity. If the companies need long term financing and
decide to fund their investments by debt, bond is a good alternative for financing. Besides companies,
bonds are issued by governments and government corporations too. In this context, bond can be defined
as financial instruments issued by companies or governments in order to finance long term financing
needs. Buyer of bonds receive periodic interest payments and par value of the bond at the maturity date
Summary

that refers to specified date determined with the indenture.

There are different types of bonds issued depending the needs of issuer and demand of the investors.
Fundamentally, bonds can be classified as government bonds and corporate bonds. Government bonds
are the bonds issued by governments and public sector bodies, and other bonds are called as corporate
bonds. In terms of entitlement, bonds are classified as bearer and registered bonds. Bearer bond is a bond
type that the owner is the person who holds it. But, registered bond is the bond which contains the name
of the owner on the bond. Due to the cash flows that the bond provide, bonds types are straight coupon
bonds and zero-coupon bonds. Straight coupon bonds provide the holder to receive periodic coupon
payments and principal. But, zero-coupon bondholders buy the bond at a discounted price, and they
are paid par value at the maturity instead the coupon payments. Based on the guaranteed they carry,
bonds are classified as debenture bonds, secured bonds and guaranteed bonds. While the payments of
debenture bonds depending on the general credit strength of the issuer, the payments of secured bonds
are secured by a pledge asset of the issuer, and the payments of secured bonds guaranteed bonds are
guaranteed by another corporation or corporations. There are also international bonds which are called
as Eurobonds and foreign bonds. Eurobond is a denominated in a currency that is different from the
currency of country where the bond issued and foreign bond is a type of bond that is issued by a foreign
company or foreign government, which are denominated in the currency of the country where they are
sold. Besides these types of bonds, there are floating-rate bonds, callable and puttable bonds, index-linked
bonds and convertible bonds that satisfy different needs of issuers and the investors.

Describe the logic of bond

LO 2 valuation

As in the other financial assets, the value of a bond is present value of the cash flows that will be received
from the bond. Therefore, value of a bond is equal to the sum of present value of coupon payments and the
principal one that will be paid at the maturity date. Bond valuation process is relatively easier than the other
financial assets since the cash flows of the bonds are periodic and principal payment is definitely known.
Especially the valuation of zero-coupon bonds is quite simple. Value of a zero-coupon bond is equal to
the present value of the bond’s par value. In the bond valuation, the important point is to determine the
appropriate discount rate. The discount rate that will be used in the bond valuation consists of a risk-free
rate and a risk premium. Coupon rate of government bonds is used as risk-free rate, and the risk premium
is determined by considering economic, industrial and firm level risks. Therefore, the factors that affect
the discount rate can be sorted as: the economic outlook, monetary policy of the country, government’s
borrowing needs, inflationary expectations, the level of economic activity, the level of capital inflows, the
credit rating of the bond determined credit rating agencies, the capital structure of the company, company
conditions. The effects of these factors may be different depending on the type of bond.

50
Financial Markets & Institutions

LO 3 Identify risks of bond investments

Just like other investments, bond investments carry risks. One of the most important risks for the
bondholders is default risk. Default risk is the risk that the borrower will fail to meet the obligations at the
determined dates. The default risk reflects the invest ability of the bond and the bonds with high default
risks are accepted as speculative investment vehicles. There are credit rating agencies that evaluate the
default risk and give ratings to the bonds. The possibility that the rating of the issuer or instrument to be
downgraded by rating agencies is called downgrade risk. Interest rate risk also crucial for bond investments

Summary
because bond prices move in the opposite direction of the interest rate changes. On the other hand,
interest rates are important for the bondholders who received to the coupon payments. Bondholders
desire to reinvest the coupon payments. Yet, there is possibility that the investor may reinvest the money
at a lower rate and this is called reinvestment risk. Reinvestment risk is high for the callable bonds, since
the issuer has call provision. The call provision creates the call risk for the bondholder. Another risk for
the bond investments is inflation risk. Inflation affects the real return of the investments. For this reason,
bondholders should evaluate the inflation risk in their investment decisions. For bonds denominated in
a foreign currency, currency risk is quite important. Currency risk refers to the potential loss arises from
the changes in the exchange rates.

51
 Bond Markets

1 Which of the following gives the current 5 What is the value of a 3-year zero-coupon
yield of the bond? bond with a $1,000 par value if the required return
A. The ratio of the coupon periods to the call price is 7%?
of the bond A. 802.25 B. 810.70
Test Yourself

B. The ratio of the annual coupon to the market C. 816.30 D. 856.75

price of the bond E. 903.90
C. The ratio of the annual coupon to the put price
of the bond
6 Dirty price of a bond is $972.68. If the
D. The ratio of the coupon periods to the par value accrued interest is $17.44, what is the clean price
of the bond of the bond?
E. The ratio of the annual coupon to the par value
of the bond A. 900.12 B. 918.40
C. 933.96 D. 947.88
2 The rate that equates the bond price to the E. 955.24
present value of its coupon payments and principal
is called ……….. 7 A bond portfolio consists of four bonds. The
weights of bonds in the portfolio are 15%, 20%,
Which of the following is written in the blank?
30% and 35%. If the durations of the bonds are
A. compound yield 4.4290, 0.9512, 3.1856 and 1.8348 respectively,
B. yield to maturity what is the duration of the portfolio?
C. nominal yield A. 2.4524 B. 2.0854
D. real return C. 1.948 D. 1.8764
E. reference rate E. 1.7936

3 ……….. are unsecured bonds, where the 8 What will be the change in the bond price
payments depend on the general credit strength of for a 150-basis point change in the yield, if the
the issuer. convexity of the bond is 18.6489?
Which of the following is written in the blank? A. 18.56% B. 18.97%
A. Corporate bonds C. 19.34% D. 20.98%
B. Straight coupon bonds E. 22.52%
C. Eurobonds
D. Bearer bonds
E. Debenture bonds 9 ……… is the possibility that the issuer will
buy back the bond before the maturity date.
4 Which of the following refers to the rate that Which of the following is written in the blank?
issuer agrees to pay above the determined reference A. Default risk B. Market risk
rate for the floating-rate bonds? C. Call risk D. Reinvestment risk
A. Risk-free rate E. Downgrade risk
B. Conversion margin
C. Reference rate 10 Which of the following is the risk type that is
D. Quoted margin evaluated by the credit rating agencies?
E. Prime rate A. Default risk B. Currency risk
C. Interest rate risk D. Reinvestment risk
E. Inflation risk

52
Financial Markets & Institutions

1. B If your answer is wrong, please review the 6. E If your answer is wrong, please review the

Answer Key for “Test Yourself” Suggested answers for “Self Review”
“Bond Valuation” section. “Bond Valuation” section.

2. B If your answer is wrong, please review the 7. A If your answer is wrong, please review the
“Bond Valuation” section. “Risks of Bond Investments” section.

3. E If your answer is wrong, please review the 8. D If your answer is wrong, please review the
“Characteristics and Types of Bonds” section. “Risks of Bond Investments” section.

4. D If your answer is wrong, please review the 9. C If your answer is wrong, please review the
“Characteristics and Types of Bonds” section. “Risks of Bond Investments” section.

5. C If your answer is wrong, please review the 10. A If your answer is wrong, please review the
“Bond Valuation” section. “Risks of Bond Investments” section.

What are the elements that determine the characteristics

of bonds?

There are elements that determine the characteristics of bonds. One of these
elements is maturity. Bonds are issued with a maturity date, which refers
to a specified date on which principal of the bond must be repaid to the
holder. The second element is par value of the bond. Par value or principal
is the amount that the issuer agrees to pay on the maturity date. Another
cash flow stems from the bond is coupon payment. The frequency of the
coupon payments can be annually, semiannually, quarterly or monthly. But,
there are also bonds that are sold discounted. At this type of bond, the holder
self review 1 receives the par value at the maturity, which is higher than the purchase price.
The difference between the par value and purchase price is the profit of the
investor that can be considered as interest income. Bonds can be issued bearer
or registered. It has to be stated whether the bond was issued in bearer or
registered form. Also, some bonds can have a call feature, and in some bonds,
the payments can be linked to a sinking fund. These features also have to
be stated by the issuer. Finally, creditworthiness of the issuer is one of the
elements that determines the characteristics of a bond. Creditworthiness or
payment ability of the issuer determines marketability and the interest rate
of the bond.

53
 Bond Markets

How do we compute the yield to maturity of a bond?

Suggested answers for “Self Review”

YTM is the rate, which equates the bond price to the present value of its
future cash flows, and it is a measure of the growth rate of the investment. It
self review 2 is calculated by using the formula, which is used in bond valuation. Yet, this
time, the value of the bond is known, and the equation is solved for “” that
gives the YTM.

How can investors use the concept of convexity in bond

investments?

Convexity uses second-order derivatives and represents a second order interest

rate risk. It is a measure of nonlinear relationship between the bond price and
interest rates. Another measure for the relationship between the bond price
and the interest rates is duration. But, the duration estimates the approximate
percentage price change regardless of the way of the change in the interest rate
and is suitable to measure the effects of small interest changes on the bond
price. The magnitude of price changes differs for increases and decreases in the
large interest rate changes. If the interest changes are large, then the convexity
is the appropriate measure to evaluate the interest rate risk. Convexity shows
the changes in the duration of a bond against the interest rate changes. In
self review 3 other words, it measures the volatility of the duration. Investors may use the
convexity in choosing bonds. Investors should prefer the bonds with high
convexity while other conditions are the same because the price of a bond
that with higher convexity increases more than the price of other bonds while
the interest rates decrease, and the price of a bond that has higher convexity
decreases less than the price of other bonds while the interest rates increase.
The convexity also can be used to estimate the approximate percentage change
that will occur in bond price against a given yield change.

54
Financial Markets & Institutions
References
Aarons, M., Ender, V. and Wilkinson, A. (2019).
Securitisation Swaps: A Practitioner’s Handbook,
West Sussex: John Wiley & Sons.
Arnold, G. (2015). The Financial Times Guide to Bond
and Money Markets, Harlow: Pearson Education.
Bailey, R. E. (2005). The Economics of Financial
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Brentani, C. (2004). Portfolio Management in Practice,
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Brigham, E. F. and Houston, J. F. (2019). Fundamentals
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Brown, P. J. (2006). An Introduction to the Bond
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Burton, M., Nesiba, R. and Brown, B. (2015). An
Introduction to Financial Markets and Institutions,
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Chisholm, A. M. (2002). An Introduction to Capital
Markets: Products, Strategies, Participants, London:
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Choudhry, M. (2001). The Bond and Money Markets:
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Heinemann.
Choudhry, M. (2005). Fixed Income Securities and
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Choudhry, M. (2006a). An Introduction to Bond
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Choudhry, M. (2006b). Bonds: A Concise Guide for
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Drake, P. P. and Fabozzi, F. J. (2010). The Basics of
Finance: An Introduction to Financial Markets,
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Jersey: John Wiley and Sons.
Fabozzi F. J. and Mann, S. V. (2005). The Handbook of
Fixed Income Securities, (7th Edition), New York:
McGraw-Hill.
Fabozzi, F. J. (2013). Bond Markets, Analysis, and
Strategies, (8th Edition), New Jersey: Pearson
Education.
Gündoğdu, A. (2017). Finansal Yönetim, Ankara:
Seçkin Yayıncılık.
Haan, J. Oosterloo, S. and Schoenmaker, D. (2012).
Financial Markets and Institutions: A European
Perspective, (2nd Edition), Cambridge: Cambridge
University Press.
Hiriyappa, B. (2008). Investment Management:
Securities and Portfolio Management, New Delhi:
New Age International.
Johnson, R. S. (2010). Bond Evaluation, Selection, and
Management, (2nd Edition), New Jersey: John
Wiley and Sons.
Johnson, R. S. (2013). Debt Markets and Analysis,
New Jersey: John Wiley and Sons.
Kettell, B. (2002). Economics for Financial Markets,
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Loader, D. (2002). Understanding the Markets,
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Martellini, L. Priaulet, P. and Priaulet, S. (2003). Fixed-
Income Securities: Valuation, Risk Management and
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Sons.
Melicher, R. W. and Norton, E. A. (2017). Introduction
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Robinson, R. I. and Wrightsman, D. (1980). Financial
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Williams, R. T. (2011). An Introduction to Trading
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Wright, S. S. (2003). Getting Started in Bonds, (2nd
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55
 Chapter 3 Stock Markets

After completing this chapter, you will be able to:

1 2
Learning Outcomes

Define the concepts of stock and stock value Identify different stock types

3 Explain models that are used in stock valuation

4 Discuss the importance of stock indices in
investment decisions

5 Discuss the importance of stock markets for

economies

Chapter Outline Key Terms

Introduction Dividend
Definition and Properties of Stocks Capital Liability
Intrinsic Value
Types of Stocks
Preferred Stock
Stock Valuation Gordon Dividend Discount Model
Stock Indices Price-Earnings Ratio
Major Stock Markets Stock Index
Volatility Spillover

56
Financial Markets & Institutions
INTRODUCTION
Investors have several options to invest their
money. They may put their money in a bank,
they may purchase a house or invest in financial
securities. One of the securities that the investors
may invest in is stocks. Stock investment is a risky
alternative, but it provides high returns to the
investors. Therefore, it is one of the most popular
financial instruments in the financial markets.
Holding stocks of a company does not make the
investor responsible for the operations of the
company, but it gives the right of voting in the
general assembly and making claims on the profit
and assets of the company (Duncan, 2015, p.3).
Investors may have these rights according to the
type of stocks they purchased. On the other hand,
they can obtain capital gain resulting from the
difference between buying and selling prices.
From the perspective of a company, issuing
stock is a type of equity financing, and it is a good
financing alternative especially when the interest
rates are high for borrowing. Issuing stock provides
permanent financing to the company since there
is no specified maturity date, and companies do
not have to make regular payments as is in debt
financing. Companies choose their financing
method and tool by evaluating the economic
conditions and the company’s conditions. If the
conditions indicate equity financing is favorable,
companies may issue stocks.
This chapter consists of four sections. In the first
section, basic definitions of stocks and the rights
and liabilities of stockholders are given. The second
section focuses on types of stocks and features of
these stocks. In the third section, stock valuation
models and examples regarding these models are
presented. The final section provides an overview
of stock markets. In this section, information
about the stock indices that are used as indicators
in the stock markets are given.
DEFINITION AND PROPERTIES
OF STOCKS
Stock is a financial instrument that companies
issue to raise capital in order to satisfy their
financing needs. Stock represents a share in the
ownership of the company. From the perspective of
the investor, stock is a security that provides rights
such as receiving some share from the profit and
participating in the management of the company
and (Kuen, 1997, p. 52). A certificate given to the
investor shows the ownership of the investor to the
company. This certificate may be a physical copy or
an electronic copy. In the past, physical copies were
needed to prove ownership, but in today’s financial
world electronic copies are preferred due to the
developments in technology.
Motivations of stockholders may be different.
Some of them buy stocks in order to receive
dividends and some of them buy to gain from the
difference between buying and selling prices.
Stock investments provide two types of
return: dividend and capital gain.
Dividend refers to the proportion of net
profit that is paid to the stockholders.
The investors, who buy stocks for dividend
payment, buy stocks and hold them generally for
long periods. They take dividend payments from
the profit of the company with respect to their
shares. The investors seeking for capital gain try to
buy in low prices and sell when the prices go up,
as a result, the difference between the prices is the
profit of the investor.
There are many factors affecting the return
that will be gained from stock investments. One
of these factors is inflation. In fact, financial
specialists consider stock investments as a hedge
against inflation mainly because inflation increases
the value of companies’ assets such as buildings,
factories and land. Moreover, companies raise the
price of goods and services as the inflation rises
and increase their revenues. As the stocks provide
ownership to the company, this revenue increase
is reflected in the return of the stockholder, and
thereby investment is protected against inflation.
Yet, this situation is not true in all cases. Sometimes
rising prices due to the inflation cause decreases in
sales and accordingly in revenues of the company.
On the other hand, in inflationary periods, the
57

prices of materials and supplies increase too, and
borrowing and labor costs are higher than low
inflation periods. Therefore, production costs
increase and this leads to decreases in the profit of
the company (Scott, 2005, p.146).
Another factor that affects stock prices or
returns is interest rates. Interest rates affect the
stock price through two channels:the cost of capital
and demand for alternative financial instruments.
Companies can finance their assets by debt or by
equity. If the company chooses debt financing,
then the interest rates will determine the cost of
capital, and if the interest rates are high the cost
of capital will be high. Especially, if the company
prefers to borrow with a floating rate, the increases
in the interest rates will cause increases in the
borrowing costs, and hence the profitability of the
company will decrease. This situation may result
in decreases in stock prices. On the other hand,
increases in interest rates will make the fixed income
securities attractive for the investors since stocks
and the other financial securities are alternatives to
each other. If the return that will be gained from
the fixed income securities such as bonds and
commercial papers is high, investors may change
their portfolios against stocks, and the decrease in
the demand for stocks causes decreases in the price
of stocks (Apergis and Eleftheriou, 2002, p. 232).
There are also other macroeconomic factors
other than interest rates and inflation that have
effects on stock prices. The most investigated of
these factors in the financial literature are money
supply, economic growth, industrial production,
exchange rates and real activity.
Rights and Liabilities of Stockholders
The investors who buy the shares issued by the
company are considered as shareholders, and this
provides some rights to them as indicated at the
definition. Owing stocks imposes some obligations
on investors too. These rights and liabilities can be
listed as follows:
• Right to dividend,
• Right to preemption,
• Right to liquidation surplus,
• Right to vote and right to participate in
management,
• Right to demand information,
• Secrecy liability,
• Capital liability.
58
Stock Markets
Right to Dividend
One of the most important financial rights of
stockholders is the right to receive share from the
net profit. However, this right can be limited by the
decision of the general assembly. If the company
has profit in the relevant operating period and the
general assembly gives approval, the portion of the
profit that will be paid to the stockholders is called
dividend. Companies generally pay only part of
their profits as dividend. They use the remainder
to fund new investments of the company (White,
2007, p. 30). Each shareholder has the right to
benefit from the profit of the company and to
receive dividend from the portion of the profit to
be distributed. Companies may distribute their
profits as cash or by issuing new shares that will be
added to the capital of the company. By dividing
the amount of the dividend paid to the number of
shares, the dividend per share is calculated.
important
Companies may prefer not to distribute dividends.
They may use this fund to finance the new
investments of the company that is expected to
increase the value of the company.
Right to Preemption
Right to preemption refers to the right of
existing stockholders to purchase new stocks issued
in the event of capital increases in proportion to
their shares in the existing capital. In other words,
in the capital increase the current stockholders
have the right of purchasing newly issued stocks
in proportion to their existing shares before
the stocks are sold to new investors. This right
helps the stockholders to keep the control of the
company, and prevents the transfer of company
management from the existing stockholders to the
new ones (Okka, 2009, p. 469). Companies may
sell new stocks at a lower price than the market
price in order to protect the existing stockholders
who exercise the preemption right. If existing
stockholders do not exercise this right, companies
may sell stocks to new investors.
Financial Markets & Institutions
important
The right to preemption is important for the
stockholders to keep the management of the
company. For this reason, the stockholders of small
companies may be granted preemption rights.
Preemptive rights are important especially for
small companies that have few shareholders since
in case of any capital increase in such companies,
the existing stockholders can lose voting rights and
management power due to selling new shares to
the new investors. However, in large companies, it
is hard for new stockholders to take the control of
the company since the number of the shareholders
is more. In addition, average stockholders of large
companies are not interested in their proportionate
ownership of the company. On the other hand, it
would be difficult in large companies to exercise the
preemption rights. For these reasons, stockholders
of large companies are rarely granted preemption
right (Schneeman, 2010, p. 365).
There are two main purposes of granting
stockholders preemption right. The first reason
is to protect the power of existing shareholders
in the management. Without this protection, the
management of a company criticized by a group
of shareholders will be changed by issuing large
amounts of new shares. In this case, the requests of
existing shareholders will be ignored. The second
reason is to protect the shareholders against price
decreases. The sale of the stocks at a price below
the market price will reduce the price of the stocks
in hand. Thus, there will be wealth transfer from
existing shareholders to the new stockholders. The
right of preemption prevents the occurrence of
these situations.
Right to Liquidation Surplus
One of the rights of stockholders is the right
to liquidation surplus. This means that the portion
of the assets remaining after the debts are paid is
distributed to the stockholders in proportion to
their shares in the capital of the company in case
of liquidation of the company. Yet, the right to
liquidation surplus can be exercised only if there is a
remaining part after the debts are paid. Stockholders
participate into the surplus in proportion to their
shares. If the liquidation surplus is negative, it
creates a debt to the stockholder limited to the
unpaid capital. If the capital obligation is fulfilled,
the debt is not in question.
Right to Vote and Right to Participate
in Management
Each of the stockholders has a minimum one
voting right. Yet, the voting right of a stock may be
increased on condition that granting preference on
voting. However, companies can issue stocks which
do not carry voting rights. The stockholders may
participate in the general assembly through the
right to vote and have a say in many operations
of the company. Some of these operations are
(Varrenti, Cuevas and Hurlock, 2011, p. 191) as
follows:
• Decisions to accept or amend the articles of
association of the company,
• Decisions such as capital increase, bond
issuance, dividend distribution, changing
the type of the company, merger and
liquidation,
• Appointment and replacement of senior
executives such as board members, CEO
and auditors,
• Release of the operations of the board of
directors and auditors,
• Approval of annual reports,
• Alteration of the rights attached to the
securities issued by the company,
Voting and participating rights enable
stockholders to elect and even be elected to the
board of directors. The election of the board of
directors and supervisory board is carried out by
the votes of the shareholders. The members of the
board of directors are elected as the representatives
of the shareholders. The board appoints and audits
the senior staff of the management and acts with
management. In many companies, shareholders
elect the members of the board according to the
majority-vote system. In this case, each member is
voted separately, and the shareholders cast one vote
for each share they hold.
59

important
Voting rights can be transferred to the second
persons by proxy. Therefore, stockholders may try
to change the management through the proxy if
they are dissatisfied with the operations and the
management of the company.
Stockholders may transfer their voting
rights to second persons by “proxy”.
Therefore, the management usually tries to get
the proxy of the shareholders and often accomplishes
this. If stockholders are not satisfied with profitability
and other managerial issues, they may try to form
a group outside the company by “proxy” in order
to change management and take control of the
company (Bodie, Kane and Marcus, 2003, p. 8).
This situation is known as the proxy war.
Right to Demand Information
Right to demand information refers to the
right of the stockholders to receive information
about all types of company operations. This right
cannot be prevented or restricted by the articles
of association or the decision of any unit of the
company. Shareholders may draw the attention
of the auditors to matters that they consider as
suspicious and may ask for explanations if they
deem it necessary.
important
Stockholders have the right to review the profit
and loss situation, annual reports and balance sheet
within the one year following the general assembly
meeting. However, none of the stockholders has
the right to learn the company’s trade secrets.
Secrecy Liability
Under any circumstances, the stockholders are
obligated to keep the company’s business secrets,
even if they leave the partnership. Stockholders
who do not fulfill this obligation are liable to
60
Stock Markets
the company for any losses that may arise. The
mentioned owners may be penalized with the
complaint of the company even if no loss is
expected.
Capital Liability
Stocks impose liabilities to the owners besides
providing some rights. One of the most important
liabilities is to pay the capital that stockholders
committed, both in new establishment and in
capital increase. If the company bankrupts or goes
into liquidation while the stockholders have not
fulfilled their commitments yet, the unpaid portion
of the commitments may be requested from the
stockholders in order to pay the remaining debts
of the company. On the other hand, additional
liabilities may be imposed on the stockholders by
the articles of association (Korkmaz and Ceylan,
2007, p. 183).
Besides providing rights, holding stocks imposes
liabilities to the owners, and these liabilities are
known as secrecy and capital liability.
Stock Value Definitions
Valuation is a process that aims to determine
the worth of an asset or a firm. Valuation can be
conducted for many purposes such as buy and sell
decisions, mergers and company acquisitions. In
this context, the value of a stock can be measured
for different purposes and in different ways.
Par (Face) Value: Par or face value is a legal term
and refers to the minimum amount of money that
the stockholders have to pay per share. The par
value concept was developed to satisfy the need
of lenders to evaluate the company’s solvency. Yet,
in today’s financial world, the lenders generally
consider the operating cash flows as the source of
solvency, and the importance of par value is not as
much as the past. On the other hand, par value of
a stock generally has no relationship to its market
value. In other words, the term of par value has
little economic significance. Therefore, the par
value of the stocks are quite low. Moreover, in some
countries the companies are permitted to issue
stocks without a par value (Werner and Stoner,
2007, p. 363).
Financial Markets & Institutions
Book Value: Book value refers to accounting
value reflected in the financial statements. Book
value is an historical value and it may be quite
different than the market value. It is the sum of
par value, paid in capital and retained earnings,
but firms generally report it on a per share basis.
The book value per share is calculated by dividing
the book value of the shareholders’ equity by the
number of shares outstanding (Baker and Powell,
2005, p. 104).
Going Concern Value: This value is estimated
based on the assumption that the company
will continue its operations into the foreseeable
future. In this context, going concern value can be
defined as the value that result from the company’s
operations, assets, customers and workforce as a
whole. Determination of going concern value is
important especially when a company wants to
acquire another (Carey and Essayyad, 2005, p. 45).
Liquidation Value: Liquidation value is the
value that remains after all the assets of the company
are sold, and the liabilities including preferred
stocks are paid off. Liquidation value per share is
calculated by dividing this amount to the number
of common stocks (Chaturvedi, 2009, p. 94).
Issuance Value: Issuance value refers to the
price at which stocks are issued. Typically, stocks
are issued at a price above the par value. In some
countries, companies are not allowed to issue
stocks below the par value.
Market Value: The market value of a stock is
the price that stock is traded in the market. For
another definition, market value is the price that
the buyer accepted to buy and the seller accepted
to sell the stock. The market value is determined
Learning Outcomes
1 Define the concept of stock and stock value.
Self Review 1 Relate
How does inflation affect In which markets do market
stock returns? values reflect real values?
by supply and demand. Supply and demand to
a stock, hence market value, is affected by many
factors such as earnings, growth potential of the
company and company size. The market value of
stocks listed on stock exchange can be established
easily (Chandra, 2008, p. 436).
Intrinsic (Real) Value: The intrinsic value
is obtained by discounting the cash flows that
the investor expects to get from the investment
in a specified period. Therefore, intrinsic value
of a stock depends on the expected cash flows
received from the stock, riskiness of the stock and
the discount rate which represents the investor’s
required rate of return. This value is important
especially for the investors and typically used
in investment decisions. Investors calculate the
intrinsic value and compare it to the market value
of the stock. If the intrinsic value is greater than the
market value, then it means stock is undervalued.
Under this condition, it is expected that the price
will increase in the future, so that investors may
take a long position in the stock. If the intrinsic
value is lower than the market value, then it means
stock is overvalued and investors may sell the stock
if they hold it or they may short the stock (Stoltz et
al., 2007, p. 156).
important
Investors use intrinsic value as a benchmark in
order to determine if the stock has a fair price
or not. While an intrinsic value greater than the
market price indicates an undervalued stock,
an intrinsic value lower than the market price
indicates an overvalued stock.
Tell/Share
Tell the main reasons of
companies to issue non-voting
stocks.
61

TYPES OF STOCKS
There are different types of stocks in the
financial markets that are attractive for different
investor types. Each of these stocks has its own
advantages and disadvantages, and investors
choose them according to their expectations. Some
of the investors are willing to take high risks for
high returns, while some of them prefer low but
guaranteed return. Some of the investors just
consider the return of the investment and they do
not care about the risks. Therefore, investors invest
in alternative types of stocks based on their attitude
towards risk and return expectation.
Common Stocks
The companies may issue one or more types
of stocks that each has its own rights and features.
One of these stock types is common stock.
Common stock is the basic type and the most
traded one in the financial markets. They are issued
to satisfy the company’s financing needs. This type
of stock gives the right of voting to the holder in
the management decisions (Duncan, 2015, p. 5).
Each of the common stocks typically provides one
voting right to the holder. Yet, the voting right
is significant only if the holder has a majority or
significant share of the company. The holders of
common stocks also have the right of receiving
dividends and right to liquidation surplus.
Ownership of common stock is represented by
a certificate with information such as the name
of issuer, the par value of the stock, the serial
number, the name of the owner of the stock (if
it is a registered stock) and the number of shares
of ownership. In some cases, common stocks
are classified as A type and B type. Differently
from B type, A type of common stocks may give
privilege in dividend distribution and participating
management (Karabıyık and Anbar, 2010, p. 26).
Features of common stocks can be listed as
follows (Faerber, 2008, p. 13):
• Holders of common stocks are the residual
owners of the company since they have
voting rights and take risks associated with
the company.
• In event of liquidation, they can be paid
only if there is a surplus after the debt
holders and preferred stockholders take
their claims.
62
Stock Markets
• The financial liability of common
stockholders are limited to the amount of
share they have.
• Common stockholders can receive
dividends only if all of the obligations of
the company are met and the dividend
distribution is declared by the board of
directors.
Preferred Stocks
All of the stockholders have the right of
receiving income in the form of cash dividends
from the profit. However, differently from
the other stockholders, preferred stock owners
have preference on the after-tax earnings and
assets of the company if the company goes into
liquidation. Another difference that distinguishes
preferred stocks from the common stocks is that
the dividend payments are usually stipulated for
preferred stocks (Kuen, 1997, p. 52). Preferred
stocks typically provide a guarantee of receiving
fixed dividend payments. Yet, the dividends of
common stocks usually depend on profitability of
the company, so that payments may change during
the holding period. Therefore, preferred stocks are
suitable especially for investors who do not want
to undertake a high risk. Since they are less risky
than common stocks, their return is lower to the
common stocks.
Features of preferred stocks can be listed as
follows (Gulati and Singh, 2014, p. 208):
• Preferred stocks provide a priority right
on profit and company’s assets in case
of liquidation in respect to common
stockholders.
• The dividends of preferred stocks are
generally fixed. Due to the first and second
features, preferred stocks are referred to as
hybrid securities. Yet, the company is not
obligated to pay dividends if the earnings
are not adequate.
• As it is in common stocks, the preferred
stocks represent ownership of the company.
• The dividends of preferred stockholders
have to be fully paid before the dividend
payments of common stockholders.
• There are two types of preferred stocks:
cumulative and non-cumulative. If the
Financial Markets & Institutions

dividends are not paid to the owner of the
cumulative stockholder, next period the
dividend of this period and the prior one
are paid totally. There is no such payment
to non-cumulative stockholders. Therefore,
the rate of dividend paid to non-cumulative
stockholders is usually higher than the
dividends paid to cumulative stockholders.
• The ownership status of preferred
stockholders is limited with respect to
common stockholders. Normally they have
not right to vote, they can vote only for
decisions that affect their right attached to
the stock.
• One of the important features of these
stocks is that they generally have lifetime
differently from the common stocks.
Non-Voting Stocks
A non-voting stock is a security that provides its
holder the rights of other stocks with the exception
of voting right. This type of shares are generally
presented with the code A. The holders of non-
voting stocks cannot vote in the company’s strategic
decisions. The reason why the company issues
these stocks is to provide funds without losing the
management of the company. Therefore, non-voting
stocks are suitable especially for family companies.
The reason for the investors to buy these stocks is to
take dividend payments (White, 2007, p. 28). The
holders of the non-voting stocks receive dividends
with the other shareholders in the amount specified
in the articles of association. Additionally, it must
be paid preferred dividends to the non-voting
stockholders at a rate to be specified in the articles
of association. The preferred dividends are paid in
cash. Unless the preferred dividend granted to the
non-voting stockholders are distributed, companies
cannot decide to allocate reserve funds, to transfer
profit to the following year or to distribute
dividends to other stockholders. However, non-
voting stocks are not as popular as other stock types.
Therefore, the price of these stocks are lower than
the others. In order to make them attractive for the
investors, companies can issue non-voting stocks
which carry the right of purchasing common stocks
of the company in a certain period or the right
of replacing non-voting stocks with the common
stocks at a fixed or variable rate. On the other hand,
companies can give privilege to the non-voting
stockholders regarding liquidation balance besides
the privilege of receiving bonus stocks (Karabıyık
and Anbar, 2010, p. 31).
important
Non-voting stocks provide holders the rights,
which are provided by the other stocks with the
exception of voting rights.

Learning Outcomes

2 Identify different stock types

Self Review 2 Relate Tell/Share

What are the differences Identify the advantage of Tell the importance of
between common stocks and preferred stocks in the event of pre-emption rights for the
preferred stocks? liquidation. company and the investor.

STOCK VALUATION
Stock investors follow stock prices to construct their decisions about investing in stocks. The price of a
stock is determined by the supply and demand forces. The supply and demand for a stock are determined
by many macroeconomic and company based factors notably dividend, profitability and capital structure.

63

In many cases, the market price of a stock is
different from the real value of the stock. If the
market price is below the real value, it is thought
that the prices will increase till it reaches the real
value, and if the market price is above the real value
it is considered as a signal that prices will decrease.
The investors, especially seeking capital gain aim
to find undervalued stocks, and to do this they
have to calculate the real value of the stock. In the
valuation process, there are three key elements;
expected cash flows, timing of the cash flows and
the discount rate. There are models in the financial
literature developed to calculate the real value of
stocks. In this section of the chapter stock valuation
models: the discounted dividend model, price-
earnings ratio model, market/book value model
and regression model will be explained.
important
Macroeconomic factors such as inflation, interest
rate, growth and company based factors such as
dividend, profitability and capital structure affect
the supply and demand of stocks.
The Discounted Dividend Model
The discounted dividend model (DDM)
is one of the basic and oldest models used in
stock valuation. In this technique, the present
value of a stock is calculated by discounting the
future dividends or net cash flows obtained from
operations of the company (Korkmaz and Ceylan,
2007, p. 250). In practice, the future dividends are
mostly used to value stocks. Yet the main difficulty
here is to forecast the future dividends. To
overcome this difficulty, growth models such as the
Gordon Model, two-stage and three-stage models
can be utilized or dividends can be calculated by
using pro forma financial statements depending on
a basis point (Pinto et al., 2010, p. 96). Another
problem in applying the discounted dividend
model is to determine the appropriate discount
rate. The mentioned rate may be determined as a
profitability rate that is acceptable for the investor.
In the process of choosing the model to be used in
64
Stock Markets
the valuation the type and dividend policy of the
company should be considered. The discounted
dividend model can be shown as follows:
D1 D2 D3 D∞
P̂o = + 2
+ 3
+ ...+
(1+ ks ) (1+ ks ) (1+ ks ) (1+ ks )∞
This equation can be expressed as follows:
∞
Dt
P̂ = ∑
t=1 (1+ ks )t
Here, P̂o is the price calculated by considering
expected dividend flows and risk of these dividend
flows. However, this price may be different than
the market price (Po). If the price calculated by the
investor (P̂o) is higher than the market price (Po), the
buying decision should be made. In the equation,
D1 represents the expected dividend at the end of
the first year, D2 represents the expected dividend
at the end of the second year, and D3 represents the
expected dividend at the end of the third year. In
other words, Dt’s represent the expected dividend
payments in the future. Since the expected dividend
amount may be different for investors, the calculated
price may be different. Finally, ks expresses the
minimum return expected from the stock.
The Constant Dividend Model
In the constant dividend model, it is assumed
that the growth is provided by internal funds of
the company, and therefore the dividends paid to
the stockholders does not change over the time
(Dt = D) (Kasper, 1997, p. 38). This model is
suitable especially for stable companies and the
companies in the maturity stage. For example, blue
chip stocks can be valued by using the constant
dividend model. The model is also typically used
to value preferred stocks, since they generally pay
a constant dividend. The price of a stock can be
calculated by the following formula:
D
P̂ =
ks
Financial Markets & Institutions

For example, suppose investors expect a 10%

important
In constant dividend model, the price of a stock is
estimated under the assumption that the dividends
paid by the company are fixed.
increase in dividends annually for a stock which
paid $ 5 TL dividend. In this case, the dividend
to be calculated after one year for the mentioned
stock will be:
D1 = 5 (1 + 0,10)1 = $ 5,5

Assume that the company ABC, which is The second year:

thought to show zero growth for a long period,
paid $ 4.5 per share, and it is expected to continue D2 = 5 (1 + 0,10)2 = $ 6,05
indefinitely. If the rate of return on similar stock is
%12, then ABC stock should be sold for: The eighth year:
4.5
P̂o = =$ 37.5 D8 = 5 (1 + 0,10)8 = $ 10,72
0.12
If the growth rate (g) is constant, investor can
The constant dividend model is limited calculate the price of the stock by the following
because companies may have negative growth formula:
values or they may be in the growth phase. On the
other hand, companies have life cycles. They are D (1+ g ) D1
established, grow, mature and decline. Especially P̂o = 0 =
ks − g ks − g
newly established companies display high growth
rates. In this case, the constant dividend model is
not appropriate to value stocks. For the companies Here, ks is the minimum return expected from
in the growth phase two-stage models can be used the stock. In order to use the model, ks > g condition
for valuation (Ehrman, 2006, p.54). is a must. Otherwise, negative stock price will be
calculated. On the other hand, it should be noted
that the growth rate (g) in the model is assumed to
Constant Growth (Gordon) Dividend increase at a constant rate forever.
Discount Model Assume that, DMS Company paid $ 2 dividend
In the dividend discount model, dividends per share, and it is expected that the dividends
must be estimated for each future year. In Gordon will grow 5% rate every year indefinitely. If is it
model, it is assumed that dividends grow forever assumed that the desired minimum return rate is
with a constant rate (g), and the expected return 8% than the price of QWE stock should be:
per share is equal to the sum of dividend return
and the expected growth rate of the dividend 2 (1+ 0.05 )
P̂o = =$ 70
(Bodie, Merton, and Cleeton, 2000, p. 247). 0.08 − 0.05
Expected dividends for constant growing stocks are The formula of constant growth dividend model
calculated by the following formula; can be arranged as follows based on the calculation
of ks ;
D1 = D0 (1 + g)1, D1 = D0 (1 + g)2, D1 = D0 (1 + g)t
⎛D ⎞
ks = ⎜ 1 ⎟+ g
⎝ P̂o ⎠
important For example the expected dividend amount of
XYZ company stock is $ 6 at the end of first year,
In the Gordon dividend discount model, the price and the calculated price for the stock is $ 75 TL. If
of a stock is estimated under the assumption that is it assumed that the expected growth rate for the
the dividends paid by company grow forever with dividends is %20 than the expected return of ABC
a constant rate. stock will be:
⎛6⎞
ks = ⎜ ⎟+0,20=%28.
⎝ 75 ⎠

65

Price-Earnings Ratio Model
Price-earnings (P/E) ratio is one of the most
used and best known models in stock valuation
in the last decades. It gives an idea to the investor
if the stock is fairly valued or not. However, it
should not be forgotten that P/E ratios are affected
by risks, and ratios may be higher or lower than
it should be due to the optimistic or pessimistic
investor behaviors. Nevertheless, using this ratio
may be a starting point for the investors (Brigham
and Houston, 2019, p. 340). If the ratio is low
without a readily apparent reason, it means that
stock is cheap. In this case, stock is an attractive
investment opportunity especially for the patient
investors who can wait until the market revalues
it (Anderson, 2002, p. 16). The ratio is calculated
by dividing the stock market price to earnings per
share and shows how much investors are willing
to pay for the company’s earnings per share before
tax. Investors agree to pay more especially to the
earnings per share of the companies which have
high growth potential. While providing realistic
results in efficient markets, the model gives deviant
results for the developing stock markets. The
price-earnings ratio is calculated differently for
the assumptions that dividends are constant or the
dividends grow with a constant rate. Under the
assumption that the dividends are constant, the
price-earnings ratio is calculated as follows:
important
Price-earnings ratio is affected by risks and investor
behaviors, and therefore may be different than
it should be. For this reason, investors should be
careful particularly in valuing stocks of developing
markets.
⎛D⎞
⎜ ⎟
P ⎝ E ⎠ Payout Ratio
Pr ice− Earnings Ratio= 0 = = stock. If the ratio is high, it means that price will
E k k decrease in the future. In this case, investors should
Here, P0 is the market price, E is the earning
per share and k is the discount rate or required
(expected) return of the stock.
Assume that Company A earned $3.5 per
share and paid a dividend of $2.1 per share. If the
required or expected return of the stock is 15%, in
this case the payout ratio will be 60% (2.1/3.5) and
P/E ratio will be:
66
Stock Markets
0.60
Price−Earnings Ratio= =4
0.15
Under the assumption that dividends grow
with a constant rate, the price-earnings ratio can
be expressed as a function of payout ratio, discount
rate and growth rate. In this case, the price-earnings
ratio is calculated as follows:
⎛ D1 ⎞
⎜ ⎟
P ⎝ E ⎠ Payout Ratio
Price−Earnings Ratio= 0 = t =
Et k − g k−g
If payout ratio of a company is 70%, expected
return of the stock is 20% and expected future growth
rate of the stock is 7%, then the P/E ratio will be:
0.70
Price−Earnings Ratio= =5.38
0.20 − 0.07
As can be seen from the formula, the price-
earnings ratio will increase with the increase
in the payout ratio. In other words, there is a
positive relationship between price-earnings ratio
and payout ratio. Similarly, P/E ratio is positively
related with the growth rate. However, there is a
negative relationship between the ratio and the
discount rate.
Market to Book Value Model
Similar to the price-earnings ratio, market to
book value (MV/BV) ratio can be used in stock
valuation as a starting point. While P/E ratio uses
income statement for per-share earnings in the
formula, market to book value ratio uses balance
sheet for book value. If the market to book value
ratio is low, it means that the stocks of the company
are undervalued and will increase in the future.
Therefore, investors may take a long position in the
sell the stock if they have it or they may short sell
the stock. Yet, it should not be forgotten that the
ratio can be misleading. Investors should analyze
if the company deserves the ratio, and if the ratio
is affected by pessimistic or optimistic behaviors
(Lee and Lee, 2006, p.176). The market to book
value ratio is calculated by dividing market price
per share to the book value per share and can be
shown as follows:
Financial Markets & Institutions

Market Price per share Regression Model

MV / BV=
BookValue per share In regression models one of the two or more
variables is considered as the dependent variable
The market to book value ratio is also calculated and the relationships between the dependent
by the following formula; and various independent variables are given
mathematically. In stock valuation, stock price is
Market Capitalization taken as the dependent variable and the factors
MV / BV=
BookValue such as interest rates, exchange rates, gold and
money supply are considered as the independent
For example, the stock price of Company variables that are thought to affect the stock price.
MAST is $27 and its book value is $3,000,000. If Based on the relationships between the stock price
the number of outstanding stocks is 250,000, then and the selected independent variables, the value
the market-to-book value ratio will be: of a stock is determined. Regression model can be
shown as follows:
27∗250,000
MV / BV= = 2.25
3,000,000 Yt =∞+ β1x1 + β 2 x2 + ...+ β n xn +ut

In the equation, Y represents the stock price as

important
the dependent variable, and x1, x2,..., xn variables are
the independent factors that affect the stock price.
In a fully efficient market, the market price of a
stock should be equal to the real value of the stock.
Therefore, if the MV/BV ratio greater than 1 this By using historical data, analysts create the
indicates that the stock is overvalued, and if the regression equation and then calculate the
MV/BV ratio less than 1 this indicates that the next price based on their forecasts for the
stock is undervalued. dependent variables. The weak point of
this model is the usage of historical data to
determine the regression coefficients and
not to consider that these may change for
different periods.

Learning Outcomes

3 Explain models that are used in stock valuation

Self Review 3 Relate Tell/Share

What are the difficulties

Associate The Constant Tell how Price-Earnings Ratio
encountered when The
Dividend Model with the blue Model can be used in stock
Dividend Discount Model is
chip stock valuation. investment decisions.
used in stock valuation?

67
 Stock Markets

STOCK INDICES
Stock market can be defined as the market Indices are used as measurement tools in many
where the stocks are bought and sold. Yet, this areas and considered as indicators especially in
definition may not be sufficient because different the field of economy and finance.
types of securities are traded in many markets
named as stock markets. In this context, the
In this context, there are too many indices
definition may be extended as the market where
calculated to be used in evaluating different features
different securities issued by companies and
of the stock markets. In the stock exchange, the
governments are bought and sold. Therefore,
indices created to show the price changes of the
they enable investors to channel their savings into
stocks are called stock market index. Prediction of
profitable investments and companies provide the
movement of the stock indices is quite important
funds they need. In other words, they support
(Qiu and Song, 2016, p. 1) because it has effect on
economic growth by creating a safe marketplace
buy and sell decisions of the investors. Stock market
where savings can be channeled.
indices provide information to investors about the
price movements of secondary market securities.

The main function of stock markets is important

to bring the companies and the investors
together. Stock indices also allow the market trend to be
compared with past trends and other markets.

Changes in the stock markets have significant

effects on the economy. For this reason, the stock
The indices provide information about the
markets are closely monitored by the public
structure and volatility of the capital markets, and
authorities, and stock indices are established in
this information has an impact on the decisions of
order to follow changes. Index is an indicator
the market participants. On the other hand, stock
that consists of the movements of one or more
market indices are regarded as leading indicators
variables, and it is used to measure the relative
for the real economy. For example, large declines
changes and differences. In other words, an index
in these indices are considered as the signal of
shows time-dependent changes in the values of ​​ the
economic distress (Cotti, Dunn and Tefft, 2015,
underlying variable such as commodity, product,
p. 804). Especially in developing economies,
income, financial instrument, economic data,
the decline of stock market indices is considered
intelligence, physical changes and social data. The
as one of the crisis indicators. These indices also
main properties of the index are as follows (Medhi,
give investors insight into the price movements
1992, p. 94):
of securities in the market. Although they are
• Shows relative changes, numerical indicators, stock indices also reflect the
• Shows the changes in statistical data, expectations of the society for the future of the
• Usually calculated on a base value such as 100. economy and may provide socio-economic and
Indices can be expressed numerically and refer psychological information. In addition to providing
to a particular situation at a given time. They are the information on mentioned areas, the indices
tools that allow the complex events to be reduced may be used as the benchmark in performance
to numbers and provide approximate information measurement of the fund manager. The gains
about events and their consequences. Indices give below the market index is generally accepted as the
the opportunity of making comparisons between failure of the managers.
the old and new situations, since they show
continuity over time. On the other hand, they
allow to compare two or more variables within the
same or different period of time and can be used as
estimators.

68
Financial Markets & Institutions

important world, there are too many financial instruments

Stock indices are considered as the leading indicators
in evaluating economic and financial activities. The
sharp declines in these indices may indicate a crisis
particularly for developing countries.
The movements of the index contain information
on the investors’ possibility of generating earnings
from their portfolios. Increases in the index are
considered as a signal that stocks’ future dividends
will be better than in the past, while decreasing
trends lead to a pessimistic picture about future
dividends. In other words, indices have an impact
on the expectations of the future direction of the
stock market. As the developments in the economy
affect the companies and the stock market, the
indices reflect the news about both the market as
a whole and the individual companies or sectors.
Besides being used as an indicator, indices can
be used as investment vehicles. In today’s financial
issued on indices. The investor who has a prediction
on the movements of an index can invest in the index
based securities and can make a speculative gain.
Investing in indices protects investors especially from
the bearish trends. The loss of an index will be lower
than the loss of a portfolio constructed of a stock or
group of stock (Wild, 2009, p. 95). In other words,
index investing reduces the risk since indices are
well diversified. Therefore, index investing is a good
alternative especially for risk averse investors, and it
is getting popular in financial markets. Especially in
countries with developed stock markets, the volume
of index-based financial products is quite high.
important
Since the indices are well diversified portfolios,
index investing is quite popular for the investors
especially those who do not have sufficient
information about stock investing.

Learning Outcomes

4 Discuss the importance of stock indices in investment decisions

Self Review 4 Relate Tell/Share

What are the advantages of Associate the stock market Tell the main benefits of stock
stock index investing? volume with economic growth. indices as investment vehicles.

MAJOR STOCK MARKETS

Stock markets are one of the most important parts of the financial markets. They provide a link
between the buyers and sellers of stocks and contribute to price formation. Stock markets are important
for several reasons, and they perform different functions in the economy. First of all, they are marketplaces
for companies. Companies issue stocks to be sold in primary markets and receive capital to finance their
operations and investments. Secondly, stock markets provide an area that the investors can evaluate their
savings. Investors can trade in secondary markets and obtain dividend and capital gain. Thirdly, stock
markets serve as indicators of the overall economy. Stock market movements generally give signals to the
economic units for the future of the economy (O’Connor, 2004, p. 206). As the development of the stock
market increases, the success of performing the mentioned functions also increases. Stock markets can be
classified in several ways. One of these ways is to classify these markets in terms of size and trading volume.

69

Stock markets contribute to price formation
for the financial assets by bringing together a
large number of buyers and sellers. The prices
in the stock markets are references for many
decisions.
The New York Stock Exchange (NYSE) is
one of the oldest and largest stock markets in the
world. NYSE is an American stock exchange which
was founded in 1792. Many securities are traded in
this exchange notably corporate stocks, corporate
bonds and US Treasury securities. The Treasuries are
traded over the counter (OTC), while the stocks are
traded on the floor of the exchange. Not only stocks
of US companies, but also stocks of companies
from the different countries can be traded on this
stock exchange. In order to be listed on NYSE,
companies must register the securities under the
Securities Act 1934 in addition to qualifying under
standards of the exchange. Another US large stock
market is NASDAQ (National Association of
Securities Dealers Automated Quotation) which
was founded in 1971. NASDAQ consists of a
large inter-connected computer system, and there
is no central location as in other stock exchanges
(O’Connor, 2004, p. 62).
Tokyo Stock Exchange (TSE) is another
large exchange in the world in terms of market
capitalization and the number of listed companies.
TSE was established in 1878, and is located
in Japan. The trading volume in this exchange
increased especially after World War II. Despite
the significant declines in 2011, the exchange is
considered as the world’s third largest stock market
(Hafer and Hein, 2007, p. 103). Similar to the TSE,
London Stock Exchange is an old stock market,
70
Stock Markets
which was founded in 1895. LSE is located in
London, which is the financial center of the world,
and it is the largest stock market of Europe. Another
European stock exchange accepted as one of the
largest stock markets is Frankfurt Stock Exchange
(FRA) which is located in Germany. Although
most of the securities traded at the exchange are
German financial products, the exchange has
become more international depending on the
increase in foreign security listings. Remote access
opportunity and cooperation with the other stock
exchanges such as Vienna Stock Exchange, Zurich
Stock Exchange and London Stock Exchange
support the internalization process (Felsenstein,
Schamp and Shachar, 2002, p. 99).
The Hong Kong Stock Exchange (HKG),
which is one of the most important financial
centers of Asia region, is considered one of the
largest stock markets in the world. Hong Kong is
a Special Administrative Region (SAR) of China,
but it has a free market economy. Foreign investors
who have limited allowance to invest in Shanghai
Stock Exchange and Shenzhen Stock Exchange,
which are the main stock markets of China, can
invest in HKG. Therefore, they can invest in China
because the Hong Kong economy is connected to
the Chinese economy (Smith, et al., 2008, p. 96).
important
The Hong Kong Stock Exchange is one of largest
stock markets located in Asia. Although Hong
Kong is a Special Administrative Region (SAR) of
China, it has a free market economy and foreign
investors can invest in HKG.
Financial Markets & Institutions
Table 2.1 Major Stock Markets and Indices
Stock Market - Country
The New York Stock Exchange - USA
NASDAQ - USA
Euronext Amsterdam - Netherlands
Euronext Paris - France
London Stock Exchange - UK
Frankfurt Stock Exchange - Germany
Tokyo Stock Exchange - Japan
Shanghai Stock Exchange - China
Hong Kong Stock Exchange - Hong Kong
Bombay Stock Exchange - India
Toronto Stock Exchange - Canada
BOVESPA - Brazil
Volatility and Volatility Spillover
Volatility is a statistical measure of variability
in price or return of a financial variable. Volatility
of financial instruments or markets is important
because it reflects the risk of the instrument or the
market. Volatility is caused by many factors such
as new public information, changes in investor
behaviors and economic and political developments
(Stoll and Whaley, 1990, p. 4).
In stock markets, the large changes are generally
followed by other large changes whereas small
changes are followed by other small ones. This
tendency causes increases in the volatility of the
stock markets. Another factor that contributes to
the volatility is trading and non-trading days. For
example, on Mondays variability of the prices is
higher due to the new information arriving 72
hours later. Thirdly, recessions and financial crises
are the factors which change the volatility of the
stock markets. In such bad economic conditions,
volatility tends to be higher than the normal
periods. Nominal interest rates is also accepted as
one of the major factors that explain the volatility
changes in stock markets. High levels of nominal
interest rates cause high volatility in stock markets
(Rossi, 1996, p. 3-4).
Volatility is a measure of risk that reflects
the variability in price or return of a financial
variable.
Index
NYSE Composite
NASDAQ Composite
AEX
CAC 40
FTSE 100
DAX
Nikkei 225
SSE Composite
Hang Sang
Sensex
S&P/TSX Composite
IBOVESPA
After the devastating effects of the 1997 Asian
Crisis and the following crises, it is seen that crisis
that occurred in a financial market can spread to
the other financial markets through the financial
and economic linkages. This phenomenon is called
volatility spillover. For stock markets, volatility
spillover can be defined as the effect of a stock
market’s volatility on the volatility of another stock
market (McAleer and Da Veiga, 2008, p. 2). There
are relationships between the volatility of markets.
Therefore, one of the major factors that explains
the volatility changes in a market is the volatility in
other related markets. Especially after the process
of financial liberalization, linkages between the
countries have increased due to the increases in
the financial and economic relationships. This
situation increases the importance of determination
of the volatility spillovers between the markets.
To determine the volatility of the stock market is
important for investors, since it reflects the risk
of the market. It helps investors to realize the
information flows and the risk transfer between
the markets and provides valuable information
for portfolio and risk management strategies (Lee,
Huang and Wu, 2014, p. 328).
Investors should determine the volatility
spillovers between the markets in order to
determine the volatility of the stock market
properly. Volatility spillover is an input in
predicting future volatility in both markets (Zhou,
Dong and Wang, 2014, p. 722).
71
 Stock Markets

important

One of the main reasons for increases in the volatility of a stock market is the volatility
in related markets. Hence, volatility spills over to other markets through financial and
economic channels.

Learning Outcomes

5 Discuss the importance of stock markets for economies

Self Review 5 Relate Tell/Share

Associate volatility spillovers

What are the factors that affect Tell the importance of volatility
with the process of financial
the stock market volatility? for portfolio management.
liberalization.

Further Reading

BIST RISK CONTROL INDICES
Risk Control Indices are ideal instruments
for the investors who want to limit the volatility
of their investment on an equity index and/or
a market. Although index options and warrants
may be good alternatives for hedging purposes,
their costs may increase substantially during the
high volatility periods. Since volatility of a Risk
Control Index is predetermined and limited,
costs of derivatives written on these indices
would decrease accordingly.
With Risk Control Indices, investors have
a chance to invest in an index portfolio which
includes repo and underlying index with one
transaction. Weights in the portfolio are adjusted
daily according to realized volatility of the
underlying index. Weights move toward repo
index during the high volatility periods and move
toward underlying index during the low volatility
periods.
BIST Risk Control Indices are calculated
for the target volatility levels of 10%, 15%,
20%, 25% and %30 for each underlying index.
There are various options of target volatility
level and investors can choose the underlying
index and target volatility level according to
their investment strategy and risk perception.
All BIST Risk Control Indices are calculated in
both total and excess return basis. While Excess
Return Index series reflects the daily return of
the underlying index proportional to its weight
in the index portfolio, Total Return Index series
reflects the return of the index portfolio which
includes both underlying index and repo index.
To take advantage of potential return of
the underlying index during the low volatility
periods, a maximum weight limit of 150% is
applied for the underlying index.
Indices are calculated from the closing values
of underlying index and repo index. Base date
of the indices are December 31, 2003 and base
values are 100.
BIST Risk Control Indices Ground Rules
Risk Control Indices provide investors the

72
Financial Markets & Institutions

opportunity to invest in an asset class or an index at a predetermined level of volatility. These indices
comprise of two components: an underlying asset or index, such as BIST 100, and another asset or
index, which is assumed to be risk-free, such as BIST-KYD Repo Index (Net). By dynamically changing
the weights of the underlying index and the repo index in the index portfolio, it is aimed that the
volatility level of the Risk Control Index is fixed at the predetermined target volatility level. In other
words, the weight of the underlying index decreased during the high volatility periods and increased
during the low volatility periods.
It is possible to limit the volatility of an index portfolio by changing the weight of underlying
index in the index portfolio, according to its realized volatility level. This is the basic principle used to
construct Risk Control Indices. Accordingly, BIST Risk Control Indices have two main components;
underlying index, which is aimed to be invested at a fixed level of volatility, and another index, which
is assumed to represent a risk-free rate of return and used to stabilise the total volatility of the index
portfolio. In order to attain target volatility level of the index, weights of these two components are
rebalanced daily.
Two types of BIST Risk Control Indices are calculated; Excess Return and Total Return. While
Excess Return index series reflects the daily return of the underlying index proportional to its weight
in the index portfolio, Total Return index series includes return of both underlying and repo index
proportional to the weights in the index portfolio.
Weight of the underlying index is calculated by dividing the target volatility level to the realized
volatility level of the underlying index. Target volatility level is determined at the index development
stage and remains unchanged through the index life. In order to limit the leverage of the underlying
index during the high volatility periods, weight of the underlying index is capped in the index portfolio.
Maximum weight of the underlying index is 150% in all BIST Risk Control Indices.
In order to be able to take both short and long term volatility levels into account, the maximum of
21 and 63 day historical volatility values are used in BIST Risk Control Indices.
Trading costs are ignored while calculating the return of BIST Risk Control Indices. Indices are
calculated for the days when both equity and repo/reverse repo markets are open. For the next business
day after one or both of these two markets are closed, the last day, where both markets are open, is taken
as the previous day (t-1) in the calculation of index return.
BIST Risk Control Indices are shown in the table below. Every index on the table is calculated as
both total and excess return.

BIST Risk Control Underlying Index Target Volatility Underlying Index Maximum
Index Level (%) Weight Limit (%)
BIST 30 RK %10 BIST 30 10 150
BIST 30 RK %15 BIST 30 15 150
BIST 30 RK %20 BIST 30 20 150
BIST 30 RK %25 BIST 30 25 150
BIST 30 RK %30 BIST 30 30 150
BIST 100 RK %10 BIST 100 10 150
BIST 100 RK %15 BIST 100 15 150
BIST 100 RK %20 BIST 100 20 150
BIST 100 RK %25 BIST 100 25 150
BIST 100 RK %30 BIST 100 30 150

Source: https://www.borsaistanbul.com/en/indices/bist-risk-control-indices
https://www.borsaistanbul.com/docs/default-source/endeksler/bist-risk-control-
indices-ground-rules.pdf?sfvrsn=8

73

In Practice
A Funny Thing Happened on the Way to
the Stock Market Record
Asset bubbles and the desperate search for
profits amid negative rates aren’t laughing
matters. Be afraid.
By Peter Coy
h t t p s : / / w w w. b l o o m b e r g . c o m / n e w s /
articles/2019-12-19/this-funny-thing-happened-
on-the-way-to-the-stock-market-record
Apologies for being churlish in the holiday
season, but the let-nothing-you-dismay attitude
of the financial markets has me worried. The
exuberance feels irrational. Asset bubbles form,
remember, when greed overwhelms fear. It’s a
truism that bad loans are made in good times
when lenders relax their standards. As the
American economist Hyman Minsky once put
it, stability breeds instability.
Investors get edgy when asset prices are
down, but they should be more concerned at
times like now, when prices have gone up, up,
and up. Through Dec. 17 the S&P 500 index has
gained 27% this year. The market feels as frothy
as the top of a nutmeg cappuccino.
“We enter the next decade with interest
rates at 5,000-year lows, the largest asset bubble
in history, a planet that is heating up, and a
deflationary profile of debt, disruption, and
demographics,” Michael Hartnett, chief equity
strategist for BofA Global Research, wrote in a
recent note.
There’s a bigger issue here than whether stock
and bond prices are too high. The more serious
question is whether the economies of the U.S.
and other wealthy nations can no longer grow
without producing destabilizing bubbles—spikes
in asset prices unjustified by fundamentals. Or,
worse yet, whether the bubbles themselves are
crucial to generating economic growth.
The circumstantial evidence for a
dysfunctional relationship between economies and
bubbles is troubling. The last time the U.S. jobless
rate got down to almost as low as it is now was the
late 1990s and 2000. That boom was fueled by
74
Stock Markets
a mania of investment in telecom infrastructure
and dot-com startups that ended abruptly at the
turn of the century, when glutes formed and prices
got too high. The bubble popped. Growth was
rescued by a surge of overinvestment in housing,
which was pumped up by stupid or fraudulent
subprime mortgage lending. The popping of that
bubble led to the worst economic downturn since
the Great Depression.
Now the funny-money cycle seems to be
happening all over again. Interest rates in Japan
and Western Europe have broken below what
used to be called—naively, we now realize—the
“zero lower bound.” Economic historians say
this appears to be the first time in the history
of the world in which negative interest rates are
widespread. Scholars of ancient Mesopotamia are
invited to say otherwise.
Are Negative Interest Rates Pumping Up
Bubbles?
As rates fell below zero in Europe and Japan,
U.S. stock markets soared
When rates on safe securities go negative—
or ultralow, as they are in the U.S.—investors feel
compelled to take on greater risk to get what they
consider an acceptable return on their money.
They “reach for yield.” Default-prone Argentina
found buyers in 2017 for a 100-year government
bond. Greece’s 10-year bonds have found takers
at yields of just over 1% a year. In the U.S.,
investors are snapping up risky “covenant-lite”
corporate loans that have been stripped of the
protections for lenders that ordinarily discipline
the borrowers.
“I am very worried,” says Mayra Rodríguez
Valladares, managing principal of MRV
Associates, a New York-based consulting and
training firm for the financial sector. Banks’
assertions that they have plenty of capital and
liquidity to withstand the next downturn aren’t
reliable, because “you can’t control fear,” she says.
“When fear takes over, it’s hard to stop.”
Bubbles are not all bad. Sometimes it takes
the prospect of enormous riches to get people
to make investments that end up being good
Financial Markets & Institutions
for society, even if the investors lose their shirts.
That applies to canals and railways in the 19th
century, fiber-optic networks in the 1990s, and
companies in hot areas such as drones, batteries,
solar power, and virtual reality today.
But bubbles also generate waste. The housing
bust left hundreds of unsightly and unsafe
“zombie subdivisions” across the American West,
the Lincoln Institute of Land Policy wrote in a
2014 report, ``Arrested Developments”. The
poor and working class suffer the most from
boom-and-bust cycles, because they’re the last
hired and first fired and are more likely to invest
at the worst time, right before things go bad.
It’s ironic that at a time of low inflation, there’s
been rioting in Chile, Colombia, Ecuador, Iran,
Hong Kong, Lebanon, and Sudan over, among
other issues, the high cost of living. A bubble in
real estate is one of the incitements to protest
in Hong Kong, which has the world’s most
expensive housing.
So it’s natural to ask why this keeps
happening and what, if anything, can be done
to take the bubbles out of economic growth.
Former Federal Reserve Chairman Ben Bernanke
partly explained it in 2005 when he identified a
global savings glut: foreign investors, including
the Chinese, were pouring money into the
U.S. because their savings far exceeded good
investment opportunities at home. Some of
those foreign savings, alas, were wasted on
those arrested housing developments. Lawrence
Summers, a former U.S. Treasury secretary and
Harvard president, has built on Bernanke’s theory
with the notion of secular stagnation: a chronic,
worldwide lack of spending because of the
aging of society and the rise of companies such
as Apple, Airbnb, and Google that don’t need
much physical capital. Summers argues that the
economic expansion would ebb if left alone and
is being sustained by governments using artificial
means: deficit spending and low interest rates.
Minsky, the economist who said stability
breeds instability, may have had the most complete
diagnosis, even though he died in 1996, before serial
bubbles became a thing. Building on the work of
others, including the Briton John Maynard Keynes
and Michal Kalecki of Poland, Minsky focused on
the financial side of the economy—flows of money,
not just goods and services.
“Profits,” Minsky wrote in 1992, are “the
key determinant of system behavior.” He
said financing tends to degenerate from safe
(“hedge”), to risky (“speculative”), to outright
irresponsible (“Ponzi”). The Minsky moment—
not his term—is the collapse of prices when
people abruptly realize that financing has become
reckless and unsustainable.
There’s a troubling new analysis of where
we are today, in the Minsky tradition, called
Bubble or Nothing. The 64-page report was
issued in September by David Levy, chairman
of the Jerome Levy Forecasting Center LLC in
Mount Kisco, N.Y. Levy is a former associate of
Minsky and the third generation of forecasters
in his family. A hedge fund he launched in 2004
to bet on falling short-term interest rates gained
500% for investors before closing in March
2009, shortly after rates bottomed.
When investors reach for yield, as they
are now, it’s because they “see no other way to
obtain financial returns that are anywhere near
their goals,” Levy wrote in Bubble or Nothing.
Pension fund managers, for example, feel they
have to take risks to fulfill promises to retirees. In
1992 public pension plans assumed they would
earn a return of 8%, about what they could get
on 30-year Treasury bonds. Reasonable. In 2012
they were still assuming they could earn almost
8% a year, according to a study by Pew Charitable
Trusts, even though the yield on safe 30-year
Treasuries had fallen to 3%. Unreasonable.
The core problem, Levy says, is that household
and business balance sheets have gotten too big—
top-heavy, you might say. He focuses not only on
debt, on the right side of the balance sheet, but
also on assets, which appear on the left. While
having lots of debt is obviously precarious, he
says, having too much in assets is also problematic
for the economy as a whole. It can indicate
overinvestment (too many houses in the Phoenix
exurbs) or excessively high valuation of whatever
assets exist (so prices are unsustainable).
Americans emerged from World War II with
little debt because consumption was rationed
during the war years. They owned few assets
because private investment had been suppressed
and valuation of assets was pessimistically low,
with a price-earnings ratio in 1949 of less than
6 for the S&P 500 (it’s 21 now). But balance
75

sheets grew. In each successive business cycle, the
ratio of debt to income grew as lenders competed
for market share. By the 1980s it began to be
a problem. Ominously, a growing share of the
debt went to buy existing assets rather than new
ones: It was inflation vs. creation.
With balance sheets getting too big to fail,
the Fed came to the rescue in each recession
with interest-rate cuts to reduce the carrying
cost of all that debt and to prop up the value of
rate-sensitive stocks, bonds, and other assets. It
worked like a ratchet. Rates fell in each successive
cycle because the bigger balance sheets grew, the
lower interest rates needed to be, Levy says.
True, households in the U.S. have paid down
some of their debt since the 2007-09 financial
crisis. But the nonfinancial corporate sector
has gotten even deeper into hock. “Corporate
America’s fragile debt pile has emerged as a key
vulnerability,” Oxford Economics Ltd. senior
economist Lydia Boussour wrote on Oct. 31.
Half of investment-grade corporate bonds are in
the lowest tier by credit rating, vs. 37% in 2011.
And 80% of leveraged loans are covenant-lite, vs.
30% during the financial crisis, she wrote.
Unfortunately for the would-be rescuers—or
enablers—at the world’s central banks, interest
rates are about as low as they can possibly get in
Western Europe and Japan. (The Fed still has a little
room.) The banking system begins to break down
at negative rates because depositors, who supply
banks with funds, refuse to lose money by leaving
it in the banks. At some point they’re better off
keeping it under the mattress. “We are very aware
of the side effects” of negative rates, European
Central Bank President Christine Lagarde said
after her first board meeting on Dec. 12.
Lagarde has a bigger problem than does
Fed Chair Jerome Powell. She’s up against ratios
of private non financial-sector debt to gross
domestic product above that of the U.S. The
ratios in Australia, Canada, China, and South
Korea are, in fact, higher than the ratio was in
the U.S. at its 2009 peak, according to the Bank
for International Settlements. That’s why Levy
predicts the next crisis will begin abroad. “It may
not be as bad for the United States as in 2008-
2009; it is likely to be worse for most of the rest
of the world,” he wrote.
76
Stock Markets
The fix seems simple enough: De-risk
balance sheets by allowing the air to come out
of asset prices and paying off debts. “The best is
to grow out of it gradually and consistently, and
it’s the solution to many but not all episodes of
current indebtedness,” says Mohamed El-Erian,
chief economic adviser to the German insurer
Allianz SE and a Bloomberg Opinion columnist.
But as Keynes taught, what works for a single
household doesn’t work for the economy as a
whole. One person’s savings deprives someone
else of income. The business profits that Minsky
pegged as the key determinant of system behavior
depend on constantly increasing investment
in houses, factories, software, etc. And those
investments are largely financed with debt.
The only way businesses could make a profit
at a time of deleveraging would be if governments
took up the slack with massive public spending,
as they did in World War II. But even that
wouldn’t work if it bolstered the private sector’s
confidence and led households and businesses
to releverage. The war was a special case. In the
U.S., wrote Levy, “that situation included grave
household and business fears, great uncertainty,
government quotas, outright bans on some
kinds of spending, a powerful social force for
the population to comply with the government’s
programs, massive government deficit spending
equal to a quarter of GDP, and hyperdrive
economic growth.”
Levy concluded that the inevitable correction
to balance sheets, whenever it comes, will
produce “serious financial turbulence, systemic
credit problems, and generally unsatisfying
economic conditions.” He wrote that “by far the
trickiest priority” for the government is to rescue
the economy without inducing new risk-taking
by the private sector, which would generate the
problem all over again. A “benign transition,” he
wrote, is “next to impossible.”
Given the ugly alternatives, governments
are keeping the game going through stimulative
fiscal and monetary policy. But for how long?
The late economist Rudiger Dornbusch once
said, “In economics, things take longer to
happen than you think they will, and then they
happen faster than you thought they could.” —
With Enda Curran
Financial Markets & Institutions

Define the concept of stock and

LO 1 stock value.

Investors have many alternatives to channel their savings, and stock investing is one of these alternatives.
Stock is a security that provides holders the right of receiving share from the profit and participating
in management. By investing in stocks, investors aim to receive dividends and obtain a capital gain
by finding undervalued stocks. For this purpose, they try to determine the intrinsic value of the stock.
Intrinsic value of a stock is the amount of discounted the cash flows that the investor expects to get from

Summary
the investment in a specified period. There are also different value measures needed for different purposes.
One of them is going concern value. Going concern value is the value that results from the company’s
operations, assets, customers and workforce as a whole. Par value refers to the minimum amount of
money that the stockholders have to pay per share. Book value of a stock is the accounting value reflected
in the financial statements. Liquidation value is the value that remains after all the assets of the company
are sold and the liabilities are paid off. Issuance value refers to the price at which stocks are issued, and
finally, the market value of a stock is the price that stock is traded in the market.

LO 2 Identify different stock types.

There are different types of stocks that have different features. These types of stocks have emerged as a
result of different company needs, and they may be attractive for different types of investors based on
expectations. One of the stock types is common stock which is the most traded stock in the financial
markets. Common stocks give the right of voting in the management decisions, and each of these stocks
provides one voting right that is generally used by proxy. Common stockholders also take share from the
profit of the company and participate in the liquidation surplus. The second type of stock is preferred
stock which is considered as hybrid securities. Differently from the common stockholders, the preferred
stockholders have priority on the profit and company’s assets in case of liquidation, and they are generally
paid fixed dividend. For this reason, this type of stock is attractive especially for the investors who do not
want to undertake high risk. Another stock type that is traded in the financial market is non-voting stock.
Non-voting stocks provide holders the rights of other stocks with the exception of voting rights. The
companies issue non-voting stocks in order to satisfy financing needs without losing the management,
and the investors purchase them to take dividend payments.

Explain models that are used in

LO 3 stock valuation.

There are several models developed to determine the real value of stocks. The most commonly known
of them are: the discounted dividend model, price-earnings ratio model, market/book value model and
regression model. The discounted dividend model, which is one of the widely used practical models,
uses a determined discount rate and future dividends or net cash flows obtained from operations of the
company in valuing stocks. Another model used in stock valuation is price-earnings (P/E) ratio model.
Price-earnings ratio may be misleading because it is affected by the behaviors of the investors. But, it may
be a starting point in valuation. If the ratio is low, it may mean that stock is cheap, and vice versa. Market
value/book value model also can be used as a starting point just like price-earnings ratio model. If the
market value/book value ratio is low, it may mean that the price of the stock will increase and it may be
bought. If the ratio is high, it may mean that the stock is overvalued. Finally, in regression model, stock
price is considered as the independent variable, and the relationships between stock price and the selected
dependent variables are determined. Based on the determined relationships stock price is calculated.

77
 Stock Markets

Discuss the importance of stock

LO 4 indices in investment decisions.

Financial authorities establish stock indices in order to observe the different characteristics of stock
markets. These indices give information to the investors about the structure and the future behavior of the
stock market. Changes in the indices are considered as the signals of future movements. While increasing
trends reflect a positive atmosphere, decreasing trends indicate a pessimistic picture for the future of the
market. Investors also may use the indices as the benchmark in evaluating performance of their portfolios.
Summary

If the return gained from the constructed portfolio is below the index return, then this means that the
portfolio failed. On the other hand, indices are considered as financial instruments. There many index
based securities traded in the financial markets. These assets are suitable especially for the investors who
do not have sufficient knowledge about the financial markets. Also, investing in index based securities
reduces the risk of the investor undertakes since they are well diversified.

Discuss the importance of stock

LO 5 markets for economies.

Stock markets are the most important component of the capital markets and the main source of long-term
financing. Stock markets perform several functions in the economy. First of all, companies can satisfy their
financing needs through these markets, and the investors find the opportunity of evaluating their savings.
In other words, stock markets build a bridge between the buyer and seller and provide a marketplace that
contributes to price formation. The existence and development of stock markets are quite important for
economies. In an economy without a stock market, it is difficult for companies to receive fund sources,
and the cost of funding is high due to the limited access opportunities. On the other hand, the existence
of the stock market allows investors to evaluate their savings in a safe way. Another reason why the stock
markets are important is that they give information about the state of the economy. Changes in the stock
markets give signals to the economic units for the future possible developments in the economy.

78
Financial Markets & Institutions

1 Which of the following is not one of the 5 TED Company paid $ 3.75 per share, and it
rights of stockholders? is expected to grow yearly at a constant rate of 7%.
A. Right to demand information If the rate of return of similar companies is 13%,
B. Right to preemption what should be the price of TED stocks?

Test Yourself
C. Right to dividend A. $ 62.125
D. Right to interest B. $ 63.925
E. Right to vote C. $ 66.875
D. $ 69.250
2 Which of the following items are required to E. $ 72.500
estimate the intrinsic value of a stock?
A. Total liabilities of the company, the discount 6 Earnings per share of Company KAR is
rate and riskiness of the stock $5.4, and $4.2 per share dividend is paid to the
B. Expected cash flows, riskiness of the stock and stockholders. If the expected return of the stock
the discount rate is 18%, what is the price-earnings ratio of the
C. Total assets of the company, expected cash company?
flows, the discount rate A. 3.21
D. The discount rate, riskiness of the stock and B. 4.32
total assets of the company C. 5.44
E. Total liabilities of the company, total assets of D. 6.12
the company and expected cash flows E. 7.14

3 Which of the following is not one of the 7 ……. is an indicator that is used to measure
features of common stocks? the relative changes and differences in a variable or
A. They provide priority right on the liquidation between the variables?
surplus. A. Index
B. They give the right of voting to the holder. B. Covariance
C. The financial liability is limited to the amount C. Regression
of share. D. Standard deviation
D. The holders of these stocks are residual owners E. Discount rate
of the company.
E. They give the right of receiving dividends.
8 Which of the following statements is false
related to stock indices?
4 Which of the following is one of the preferred
stocks’ features that distinguishes them from the A. They can be used as a benchmark in
common stocks? performance measurement.
B. They provide information about volatility of
A. They provide interest payments. stock markets.
B. They provide the right to vote. C. They are regarded as leading indicators for the
C. They provide the right to dividend. real economy.
D. They provide priority right on the profit of the D. They are independent of the expectations of
company. the society for the future.
E. They represent ownership of the company. E. They can be used as investment vehicles.

79

9 ……. is one of largest stock exchanges in the
world in terms of market capitalization and the
number of listed companies, which was established
in 1878 and is located in Japan?
Test Yourself
A. Hong Kong Stock Exchange
B. Fukuoka Stock Exchange
C. Tokyo Stock Exchange
D. Shanghai Stock Exchange
E. Shenzhen Stock Exchange
80
Stock Markets
10 Which of the following statements is false
related to volatility?
A. There is no relationship between the volatility
of financial variables
B. Volatility is affected by new public information
C. There is a positive correlation between the past
and current volatility
D. Volatility is a measure of risk of a financial
variable
E. Bad economic conditions increase the volatility
Financial Markets & Institutions

If your answer is wrong, please review

1. D 6. B If your answer is wrong, please review the
the “Definition and Properties of Stocks”
“Stock Valuation” section.
section.

Answer Key for “Test Yourself”

If your answer is wrong, please review
2. B 7. A If your answer is wrong, please review the
the “Definition and Properties of Stocks”
“Stock Indices” section.
section.

3. A If your answer is wrong, please review the 8. D If your answer is wrong, please review the
“Types of Stocks” section. “Stock Indices” section.

4. D If your answer is wrong, please review the 9. C If your answer is wrong, please review the
“Types of Stocks” section. “Major Stock Markets” section.

5. C If your answer is wrong, please review the 10. A If your answer is wrong, please review the
“Stock Valuation” section. “Major Stock Markets” section.

81
 Stock Markets

How does inflation affect the stock returns?

Suggested answers for “Self Review”

Investors aim to obtain a capital gain besides the dividend payment. This gain
arises from the difference between the buy and sell prices. Therefore, if the price
decreases after the investor buys the stock there will be capital loss, and if the price
increases the investor obtains capital gain. There are too many factors that affect
stock prices and, so that the return of the investments, and inflation is one of
self review 1 these factors. Actually, inflation increases the value of the company assets, and the
company raises the price of goods and services they sell. Therefore, this situation
increases the return of the stockholder and investment is protected against inflation.
But, in some cases, sales of the company decrease due to inflation. This situation
decreases the return of the stockholders by causing decreases in the profitability.
On the other hand, inflation increases production and borrowing costs of the
company, which may result in decreases in the return of the stockholders.

What are the differences between common stocks and

preferred stocks?

Companies issue different types of stocks depending on their needs and purposes,
and the investors choose from these stocks depending on their expectations.
Two of these stock types are common stocks and preferred stocks. Both of these
stocks represent ownership of the company and provide receiving dividends.
But, differently from the common stock, preferred stock provides priority on the
profit and the assets of the company in case of liquidation. Common stockholders
self review 2 cannot take dividends unless the dividends of preferred stockholders are fully paid.
Also, dividend payments of preferred stockholders are generally stipulated. While
the dividends of common stockholders change depending on the profitability,
the preferred stockholders typically receive fixed dividend payments. However,
differently from the common stockholders, they have a lifetime and they can vote
only for decisions that affect their right attached to the stock.

What are the difficulties encountered when The Dividend

Discount Model is used in stock valuation?

Investors try to find the real value of the assets that they will invest in. In
this context, there are models developed to determine the real value of the
stocks. One of these models is The Dividend Discount Model which can be
used in different fields of finance. This model is quite popular since it is easy
to apply. But, besides the ease of implementation, there are some limitations
and difficulties in the valuation process. Three key elements are needed in
valuing stocks, which are expected cash flows, timing of the cash flows and
self review 3 the discount rate, and these elements determine the success of The Dividend
Discount Model. In order to find realistic results, future dividends should
be determined correctly and risks related to dividends should be taken into
account. This is a really difficult and complicated process. Another difficulty
in the application of model is to determine the appropriate discount rate. In
practice, to overcome this difficulty, the rate of return expected by the investor
is generally used as the discount rate.

82
Financial Markets & Institutions

What are the advantages of stock index investing?

Suggested answers for “Self Review”

Stock indices are quite important to follow the changes in the stock markets. They
provide information to the investors that they may use to construct and manage
their portfolios. In addition to its importance in terms of portfolio management,
indices are also valued as financial instruments today. Index investing is less
complicated and less expensive than constructing a portfolio because investors will
self review 4 not bear the costs of information and will not have to make complicated analyses
if they invest in indices. It is not surprising that the return of the index is greater
than the return of a portfolio constructed by an investor. On the other hand, the
risk of the index will be less than the risk of many of the portfolios constructed by
the investors. In other words, the indices are well diversified portfolios since they
consist of a large number of stocks.

What are the factors that affect the stock market volatility?

There are several factors that affect the volatility in a stock market. One of these
factors is the positive correlation between the past and current volatility. In stock
markets, there occur large price changes after the large price changes, and small
price changes are followed by the small price changes. In other words, the past
price changes increase the volatility of the stock market. The trading and non-
trading days also cause volatility in the stock markets. In some days, price changes
are higher in proportion to other days due to the arriving of new information
to the market. Another reason for the volatility is the bad economic situation
self review 5 in the country. Recessions and financial crises increase the volatility of the stock
markets. In such an economy, the volatility is higher in proportion to normal
periods. Fourthly, nominal interest rates is one of the major factors that affects
the volatility changes in stock markets. High levels of nominal interest rates cause
high volatility in stock markets. Finally, it is seen after the great financial crises that
volatility spillover phenomenon is another factor that explains the increases in the
volatility of a stock market.

83

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85
 Chapter 4 Derivative Markets
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Identify forward commitments, future contracts,

Describe derivative market
swaps and options

3 Explain the basic logic of derivative pricing and

valuation

Chapter Outline Key Terms

Introduction Derivatives
Underlying Asset
Derivatives and Derivative Markets
Forward
Types of Derivatives: Forward, Futures, Swap and Futures
Options Swaps
Basics of Derivative Pricing and Valuation Options
Derivative Pricing
Valuation

86
Financial Markets & Institutions
INTRODUCTION
It is clear that with globalization, a change
process has started in the national economies.
Because of this change process, the integration
between the economic units has accelerated and
the risks to which financial markets are exposed
have increased considerably. The inadequacy of
traditional instruments in managing these risks
paved the way for the development of derivative
instruments.
Derivative instruments whose performance
is determined by underlying assets are generally
classified as forward, futures, swap, and option
contracts. The point to be considered here is
that there is no need to buy and sell the assets on
which the derivative instruments are based. In this
context, the underlying assets have an important
role in increasing the application efficiency of the
derivative instruments.
In this chapter, we are going to define
derivatives and their uses. Besides, we compare
the characteristics of forward contracts, futures
contracts, options, swaps, and the reasons behind
emergence of derivative markets and the purposes
they serve for the investors. Finally, this chapter
discusses the basics of derivative pricing and
valuation.
DERIVATIVES AND DERIVATIVE
MARKETS
A derivative as defined by Security and
Exchange Commission (SEC) is: “a type of
financial instrument whose value is derived from
another underlying product”. By derivative product,
we mean those financial instruments that derive
its value from the performance of an underlying
(asset). In other words, a derivative is a legal contract
that involves two parties, a buyer and a seller who
agree to do something for each other. Derivative
contracts are recognized by the legal system as
commercial contracts and they set the right and
obligations of each involved party. For instance,
let’s assume that there are two parties, A and B.
In the contract, Party A agrees to sell an APPLE
stock (AAPL) to party B for $200 after 3 months
from now. Here, our underlying asset is AAPL and
Party A is obligated to sell this stock to party B
after 3 months. The value of this contract is based
on the performance of AAPL. If the value of the
stock rises from $191to $200, this contract will be
valuable for Party B who is buying the underlying
asset for $191. If AAPL price increases to $200 and
Party A refuses to sell the stock to Party B, Party B
can refer to the related authorities (lawyers, judges,
and juries) to step in and resolve this issue.
There are two types of derivatives: forward
commitments, and contingent claims. Forward
commitments contracts (such as forward contracts,
futures contracts, and swaps) provide a buyer or
seller the ability to lock in a price to buy or sell an
underlying asset whereas contingent claims (such
as option) provide a buyer or a seller the right to
buy or sell an underlying asset at a price previously
fixed.
Derivatives are useful instruments in financial
markets through which a risk can be transferred
from one party to another. Investors use derivatives
to hedge risk arising from unexpected changes in
the market value of an underlying asset. Moreover,
derivatives are helpful in creating trading strategies.
Derivatives are more liquid than the underlying
asset and less costly in terms of participating in
deals and transactions.
Derivatives are high leverage contracts that
require a small amount of capital to initiate a
derivative related contract.
There are two categories of markets where
derivatives are created: Exchange-traded derivatives
markets and Over-the-counter derivatives
markets (OTC). Exchange-traded derivatives are
standardized such that its terms and conditions
are precisely specified by the exchange where
OTC is the customizable contract that can be
customized by the involving parties. In other
words, derivatives exchange-trade standardizes
every term and condition of contracts except
their prices. For example, suppose an exchange
introduces a standardized contract for metal
Gold. It specifies the quality of gold, the quantity
of gold, expiration date, and the location where
the gold should be delivered. Normally, the price
of a derivative contract is defined by buyers and
sellers (long and short parties). Chicago Mercantile
87
 Derivative Markets

Exchange (CME) is an example of exchange-
traded derivatives markets in which contracts
such as futures and options are traded. CME is
responsible for the clearing and settlement process.
Clearing is the procedure by which an exchange
settles a transaction and registers the buy and sell
parties’ identities. The settlement is the procedure
by which an exchange transfers money from
one party to another. Since futures contracts are
standardized contracts, it makes derivatives more
liquid in comparison to OTC markets contracts.
Moreover, the price process in the exchange-traded
derivatives is more transparent in comparison to
OTC markets.
When two parties get involved in a contract on
an exchange-traded market, ultimately, one party
will make a profit and the other party will lose
money. Hence, the clearinghouse of the exchange
provides a guarantee to the winning party that if
the counterparty refuses to pay, the clearinghouse
will pay instead.
important
Any participant that wants to engage in exchange-
traded derivative needs to deposit cash usually
called margin bond or performance bonds that
secures that there will not be any default. The other
attribute of cleaning houses is that there are daily
settlements and any party, which is in the profit as a
result of the performance of the underlying asset, the
clearinghouse deducts money from the losing party
and adds them to the winner party.
In the over-the-counter derivatives markets,
investors directly trade legal derivative contracts
without involving an intermediary. Such markets
are also called informal derivative markets because
the engaged parties are not obligated to carry out
their promises. Though both buyer and seller of
OTC contracts informally agree to buy or sell
derivative contracts, there is still the possibility of
a default. It is worth mentioning that the market
makers make a profit through the bid-ask spread
as they fulfill the needs of both buyer and seller
through buying from a seller at one price and
selling to a buyer at a higher price.
important

Exchange-traded derivatives also provide

The OTC contracts are customized contracts,
credit guarantee and ensure that there will
and they are less liquid than exchange-traded
not be any credit risk.
derivative contracts. They are also relatively
less transparent.

Learning Outcomes

1 Describe derivatives market

Self Review 1 Relate Tell/Share

What is the difference between

Associate the structure of the Tell the differences between
the Exchange-traded derivatives
derivative market with credit forward commitments, and
markets and Over-the-counter
risk. contingent claims.
derivatives markets?

88
Financial Markets & Institutions

TYPES OF DERIVATIVES: FORWARD, FUTURE, SWAP AND OPTIONS

As we mentioned earlier, derivatives can be classified into two main groups: forward commitments, and
contingent claims. Forward commitments impose an obligation on both sides of the contract to engage
in a future transaction as agreed upon previously, whereas contingent claims give the right but not the
obligation to do so.

Forward Commitments
Forward commitments can be defined by Pirie (2017) as:
“contracts entered into at one point in time that require both parties to engage in a transaction at a later point
in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the
underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at
which the underlying will be exchanged. This fixed price is called the ``forward price”.

To explain this definition, let us recall our previous example in which we assumed that both parties A and
B sign a contract that states Party A will sell an APPLE stock (AAPL) to Party B, and Party B commits to buy
the stock after 3 months. This type of contract is called a forward contract. In forward contracts, both involving
parties agree to do something for one another after 3 months. Both sides of the forward contract agree on the
underlying asset (AAPL) at a later point in time (3 months). They have established the identity of underlying
(AAPL) and its quantity (1 stock) at a fixed price regardless of what it will cost at the expiration date. Both
parties on the manner in which the contract will be executed or will be settled when it expires (whether to deliver
the underlying asset physically or pay in cash).
In brief, forward commitments have the following characteristics:
• They are customized contracts so to suit both involving parties’ needs i.e. grade, time, and place of
delivery.
• There is no specific location or address to trade forward contracts.
• Any type of commodities can be traded via forward contracts.
There are three different types of forward commitments: Forward, Futures, and Swaps contracts. We
will discuss each type of forward commitments in the forthcoming sections.

Forward Contracts
It is an OTC contract in which a buyer and a seller commits each other to do a transaction on a
specific underlying asset at a future date at a previously determined fixed price. To further explain forward
contracts, let’s assume how a forward contract looks like. Suppose there are two parties, A and B. Party A
(long position) agrees to buy one stock of Facebook from Party B (short position) for $165 at a later time
in April, 1. This agreement between the buying party and selling party is an example of forward contract.
The amount $165 is called forward price and the date April, 1 is called expiration date. If the stock price
increases to $170 on the expiration date, it means this contract is in favor of buyer since the buyer will
be paying only $165 for a stock is worth $170. According to forward contract characteristics, the seller is
obligated to deliver the stock at a loss of $5. Thus, this agreement pays off is $5 ($170-$165) to the long
party, which is the value of the contract at expiration. The payoff from a forward contract at expiration
date is calculated as follows:

Payoff to long forward = Spot price at expiration − forward price

Payoff to short forward = Forward price − spot price at expiration

The short has the opposite side of the long. The short is obligated to deliver the stock at $170. The
payoff for short is of -$5 ($165-$170).

89
 Derivative Markets

important
It can be said that both the long and the
short parties are engaged in a zero-sum game,
meaning that one participant’s gains are the
other party’s losses.
Figure 4.1 illustrates the payoffs from both
taking long and short positions in a forward
contract. From the figure, it is clear that the long
wishes the price of the underlying stock to increase
above, whereas the short wishes the price of the
underlying stock to drop below.
whoever has consented to sell euro at the forward
rate of $1.1500/€ has a motivation to not carry
out his/her obligation. In the event that the euro
devalues to $1.1400/€, at that point whoever has
consented to buy pounds at the forward rate of
$1.1500/€ has a motivation to not carry out his/
her obligation. Since the forward contract is signed
between two parties without the intermediation of
a third party; therefore, there will not be anyone
to resolve this matter except if one of the parties
ask for the intervention of the court. Here, futures
contracts emerge as a solution to forward contracts.
Futures contracts present a solution for the default
hazard natural in forward contracts through the
conventions shown below.

K
Payoff ($)
Futures Contracts
10 Futures contracts are the same as forward
5
contracts except that futures contracts are organized,
regulated and managed by an exchange. In other
0 ST
words, futures contracts are standardized. A futures
5 contract as defined by Chisholm (2011) is:
10
“an agreement made through an organized
160 165 170 175 180 185
exchange to buy or to sell a fixed amount of an
underlying commodity or financial asset on a
Figure 4.1 Payoffs from taking long positions a forward contract.
future date (or within a range of dates) at an
Payoff ($) K agreed price”.

10 Unlike forward contracts, futures contracts

5
0 ST
5 of derivatives are allowed, only certain contracts
10
160 165 170 175 180 185
Figure 4.2 Payoffs from taking short positions a forward contract.
Even though forward contracts play a significant
role in managing risks, there are still some associated
problems. One of these problems is counterparty
risk. This risk raises when one of the agreement
parties refuses to carry out his/her obligation to
deliver the underlying asset on the expiration date
at the location specified in the forward contract.
Let’s consider a forward contract on euro at a rate
of $1.1500/€. In the event that the euro appreciates
to $1.1600/€ on the expiration date, at that point
require the existence of a legally recognized futures
exchange that provides, manages and organizes
these contracts. On the exchange, not all types
are authorized for trading. Futures contracts
can be accessed through both physical locations
as well as through an electronic system. The
derivative exchange has a mechanism that offers
the two parties a guarantee against any default. An
organized Exchange has a Clearing house through
which it settles daily the losses and gains of futures
contracts and protects itself against loss.
The Clearing house requires investors to
deposit an initial margin, which is then used
in the marking-to-market or settling of changes
in the value of contracts on a day to day basis.

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Financial Markets & Institutions
For example, suppose there are two parties, A
and B. Party A goes long (buyer) on a contract of
Crude Oil (WTI) at $60/Barrel and one contract
of WTI is 1000 barrels. Party B goes short (seller)
on the same contract. At the end of the day, if the
spot price of WTI rises to $61, the Clearing house
of exchange the Clearing house attempts to mark
the futures contract to the market at $61 known as
the daily settlement. The Clearing house determines
the final futures trades of the day and designates that
price as the settlement price. Party A’s (long) margin
account will be marked with $1000 gain and Party
B’s (short) account will be marked with $1000 loss.
In other words, the $1000 will be transferred to the
margin account of Party B to the margin account
of Party A. The opposite is true, if the futures
price drops to 59, Party A’s marginal account will
be marked with $1000 loss, and the $1000 will be
transferred to the marginal account of Party B.
important
While transacting on the futures market, it is
required that both involving parties must deposit
a minimum sum of money as an initial margin
in their margin account, typically less than 10%
of the futures price to cover possible future losses.
After a contract is bought or sold, both parties
are asked to maintain an extra amount in their
margin accounts to surplus their initial margin
deposits. In other words, the amount of money
in margin account must be greater than the initial
margin to meet any drop in futures price. At the
end of the day, the Clearing house will mark to
market and compare each party’s balance with the
maintenance margin, and if there was any increase
or decrease in futures price, both parties’ margin
accounts will be settled accordingly. If the price
of a future increase in favor of a long party such
that the balance of short party falls below the
maintenance margin requirement, the short party
will then receive a margin call requesting to deposit
additional funds to raise its balance level up to
initial margin requirement level. The short party
can choose not to deposit additional funds and just
close its position. Additionally, through a margin
account, an investor can borrow from a broker to
buy extra other assets and his/her maintenance
margin functions as a deposit with the broker.
Let’s consider the following example, a contract
of €125,000 futures is bought at $1.1500/€. To
carry out this contract, the exchange asks the buyer
to deposit a specific amount of money as an initial
margin to compensate for any drop in future prices.
At the end of the trading day, if the futures price raise
by $0.0010/€ to $1.1510/€, then the Clearing house
adds $125 ($0.0010/€*€125,000) to the buyer’s
margin account. On the other hand, if the $/€, price
drops to $1.14900/€, then $125 will be taken from
the buyer’s margin account to the clearinghouse’s,
and then to the counter party’s margin account.
Through this process, the clearinghouse’s exposure
to default risk or currency risk is bounded to the
gain or loss from daily fluctuations in the currency
price. The Clearing house sets the maintenance
margins big enough to cover all daily price volatility
except for the unexpected big movements. In case
if an investor’s loss is higher than the maintenance
margin and the investor cannot meet a margin call
on the following day, the Clearing house liquidates
the contract and offsets its position.
For instance, on the off chance that a maintenance
margin for a €125,000 prospects contract is
$2,000. Then, the base dollar value tick of 1 basis
point (0.01%) of futures contract is worth $12.50
($0.0001/€*€125,000/contract) per contract. On
the off chance that the futures contract price moves
down 1% or 100 basis points, then the value of the
contract goes down by $1,250, and thus the investors
deposit with the Clearing house reduces to $750.
The clearinghouse can recoup 1-day price variations
and later calls the investor to re-deposit an amount of
$1,250 to maintain the margin at $2,000 level.
Swaps
A swap contract can be defined as an OTC
contract between two parties who agree to
exchange cash flows on regular dates, where one
party pays a variable payment, and the other party
pays either a fixed or variable amount calculated on
a different basis. Since swap is an OTC contract, it
contains terms and conditions such as the identity
of the underlying asset, dates of payments, and the
procedure of payment that are agreed upon and
written in the contract. In currency swap trades, one
party trades swaps currency for a fixed interest rate
and where another party trades another currency
for a floating interest. Traders usually exchange
only the difference in interest payments. In swap
trades, the principal traded is called notional.
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 Derivative Markets

Currency swaps first traded in 1970 when two financial managers from two different firms in two
countries borrowed money in two different currencies and agreed to pay each other’s obligation. Later in
1981, the first official swap was traded between the World Bank and International Business Machines.
Since then, investment banks started providing swap services and the volume and liquidity started to grow
and “plain vanilla” swaps were introduced. Plain vanilla swaps are the most famous swap contracts that
pursue the conventions of the International Swaps and Derivatives Association Butler. Plain vanilla swap
for fixed-for-floating interest rate swap is the most popular type of swap that was introduced to the market
in the 1980s.
Figure 4.3 shows the growth in swap dealers in the over-the-counter (OTC) derivatives market since
1998. In 2017, interest rate swaps and options, and interest rate forward contracts were highly traded among
investors with a $426.65 trillion in notional principal outstanding. Currency swaps, options and forwards
contracts were the second most traded contracts with notional principal outstanding of 87.12 trillion.

700

600

500

400

300

200

100

0
Jun-98
Jun-99

Jun-00

Jun-01

Jun-02

Jun-03
Jun-04

Jun-05

Jun-06

Jun-07
Jun-08

Jun-09

Jun-10

Jun-11
Jun-12
Jun-13

Jun-14

Jun-15
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Jun-17

Jun-18
Dec-98

Dec-99
Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06
Dec-07

Dec-08
Dec-09
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Dec-11

Dec-12

Dec-13
Dec-14

Dec-15

Dec-16

Dec-17

Dec-18
Figure 4.3 (a) Notional Amounts Outstanding in OTC Derivatives Markets ($ trillions).

USD trn

750

500

250

0
2002 2006 2010 2014 2018

Foreign exchange [B] Commodities [J] Credit Derivatives [T] Equity [E]

Interest rate [D]

Figure 4.3 (b) Notional Amounts Outstanding in OTC Derivatives Markets ($ trillions).
Sources: International Swap Dealers Association (www.isda.org)

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Financial Markets & Institutions
A firm’s commitment to pay an international
counterparty with an asset also contains a swap.
These firms use swap to offset position on the
balance sheet and records the swap output as interest
expense in the profit and loss sheet. In the currency
swap, one party trades one type of currency for a
fixed interest rate and another party trades another
type of a currency for a floating interest.
In comparison to futures contracts, swaps
contracts are more prone to default risk in the
following aspects: First, a performance bond is
not required in swaps contracts, whereas a margin
is required in futures contracts, and this tends to
give swaps slightly more default risk than futures
contracts. Second, the counterparty in swaps
contracts are generally a commercial or investment
bank, whereas in futures contracts the clearinghouse
is considered the counterparty and commercial or
investment bank are more prone to default than a
clearinghouse. Third, futures contracts are daily
marked-to-market and the entire gain or loss is
settled from day to day, whereas the settlement in
swaps contracts are longer payments is longer i.e.
six months. The riskiness of a swaps contracts falls
somewhere between the riskiness of futures contracts
and the forward contracts. Moreover, swaps are less
riskier than straight debt because the principal is not
at risk as it is in a loan. In addition, since interest
payments depends on the difference between the
interest rates, they are less prone to default risk.
In order to illustrate swap contracts, let us
consider the following example. Suppose there are
two parties, Party A agrees to pay Party B for a fixed
rate of 5% I/Y on a notional amount of $100,000
and Party B in return agrees to pay Party A the
annual $ LIBOR rate on a notional of $100,000.
LIBOR stands for London Interbank
Offered Rate, which is the floating rate used
in swap contracts.
Suppose that at the end of the year the LIBOR
rate 4.5%, Party A will owe $5000 to the Party B
and Party B will owe Party A $4500, and the amount
will be netted out and Party A will pay $500 to Party
B. Figure 4.4 clearly shows this relationship.
5%
Party A Party B
$ LIBOR=%4.5
Figure 4.4 Interest rate swap payment.
important
Similar to futures and forward contracts, swap
contracts do not require money exchange
at the beginning of the contract, the initial
value of a swap contract is zero.
Generally, LIBOR are quoted on a Money
Market Yield (MMY) or “Actual/360” basis that
assume interest accrues over 360 days in a year.
Fixed rates are quoted on an “Actual/365” or Bond
Equivalent Yield (BEY) basis that assume interest
accrues over 365 days in a year. This conversion
helps us to compare fixed rate yields with floating
rate yields. U.S. Treasury bonds are quoted as fixed
rate. The relationship between MMY and BEY is
as follows:
MMY = BEY*(360/365)
BEY = MMY*(365/360)
Let us consider the following question. If a
quote on a U.S. Treasury bond 4.40% BEY, then
what is the MMY? We can say that the MMY
for U.S. Treasury bond is approximately equal to
4.3% (4.40%)*(360/365).
Let us consider an interest rate swap example.
Consider companies X and Y; each company
wants to borrow $ 50 million with a 3 year term.
Company X wants to finance interest rate sensitive
assets, and therefore wants to borrow at floating
interest rates. Company X has a good credit ranking
and can borrow from the LIBOR rate. Company Y
wants to finance non-interest-sensitive assets, so it
wants to borrow with fixed interest. Company Y
has a low credit ranking and can borrow at 6.5%
fixed interest rate. For a 3-year swap, the Swap
bank quotes against the dollar LIBOR 6.1—6.2 (if
the Swap bank receives LIBOR, it gives 6.1% fixed
interest rate; gives LIBOR if it receives 6.2% fixed
interest rate).
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 Derivative Markets

Table 4.1 Interest Rates for Company X and Company Y.

Fixed rate Floating rate
X %6 LIBOR
Y 6.50% LIBOR + . %20

If Company X borrows from Bank A with a fixed interest rate of 6.0% first, and then accepts swap
bank’s offer (6.1%), it converts its 6.0% fixed interest rate debt to LIBOR - 0.10%.
Total cost of Company A = 6.0% + LIBOR - 6.10% = LIBOR - 0.10%

6.10%
Company X Swap Bank
LIBOR

Bank A

Figure 4.5 Interest rate swap (Company X).

If Company Y borrows from Bank B with a LIBOR+0.20% first, and then accepts swap bank’s offer
(6.2%), it converts its floating interest rate debt to 6.40% fixed interest rate.
Total cost of Company B = -LIBOR + LIBOR +0.20% + 6.20% = 6.40%
6.20%
Swap Bank Company Y
LIBOR

LIBOR+0.2%

Bank B

Figure 4.6 Interest rate swap (Company Y).

%6.10 %6.20

Company X Swap Bank Company Y

LIBOR LIBOR

Figure 4.7 Interest rate swap (Swap Bank).

Swap Base earns 10 basis points from this transaction.

Total cost of the Swap Bank = -LIBOR + LIBOR - 6.20% + 6.10% = –0.10%
In the above swap transaction, the nominal size was $ 50 million and the maturity was 3 years. In this
context, Company X, Company Y and Swap bank earn $ 50,000 per year from this transaction. Company
X converted its fixed debt into variable debt and saved 0.1% by borrowing from LIBOR - .10%. Company
B converted its floating rate debt to fixed interest and saved 0.1% by borrowing from 5.40%, (Eun and
Resnick, 2009).

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Financial Markets & Institutions
Contingent Claims
A contingent claim is a derivative that provides a
buyer of option the right to buy or sell an underlying
asset at a price previously agreed upon on a specified
future date. Unlike forward commitment contracts,
contingent claims give the holder of the contract the
right, not the obligation to buy or sell an underlying
asset. Its payoff also depends on the performance of
the underlying asset.
Options
Options are contingent claim contracts that
provide the right but not the obligation to buy an
asset at a specific price at a later date in the future.
In other words, the buyer pays a sum amount
of money, known as premium, to the writer of a
contract to receive the right to either buy or sell an
underlying asset at a specific price at a later date in
the future. In options, one side of the contract has
the option to carry out the terms and the other side
of contracts has obligation.
Option contracts convey most of the
characteristics of forward, and futures contract as
options can be traded on the OTC markets. They
can be customized as well as they can be traded
on options exchanges as regulated standardized
contracts. The customized options contracts
are subject to default risk like forward contract,
whereas standardized options are protected by
clearing house of options exchange. With an
option contract, the biggest money that a buyer
may lose on the deal is the option premium of the
deal, while the loss that the writer of option may
face is virtually unlimited.
Almost all multinational corporations use
options as a tool to manage their exposure
to currency risk, and exchange rates are the
underlying assets in their case.
Based on the right to exercise a buy or sell,
options contracts can be divided into two: call
options and put options. A call option is the right
to buy an underlying asset, while a put option is
the right to sell an underlying asset.
Additionally, options can also be divided into
two types according to the time when options can
be exercised: American Options and European
Options. American Options can be exercised any
time up to the expiration date, while European
Options are exercised only on the expiration date.
important
Option exchanges are considered to be a zero-
sum game in efficient markets. The gain or
loss on one side of an agreement precisely
counterbalances the gain or loss on the
opposite side of the agreement.
Call Options
As mentioned earlier, call option is the right to
buy an underlying asset. It offers unlimited upside
return with limited downside risk. In order to have
a clear picture of call options, let us consider the
following example. Suppose there is an investor who
buys an American call option of FB stock at a strike
price of $160 after 3 months from now. The option
premium to initiate the contracts is $5. Suppose that
the underlying stock price drops under $160, here
the investor decides not to exercise the call option
because there is no benefit for the investor to buy
FB stock for $160 as the investor can buy the same
stock at a lower price in the market. When the
investor does not exercise the option, he/she will lose
the option premium of $5 he/she paid to initiate
the option contract. Due to limited risk, unlimited
return, call options are more attractive to investors.
On the other hand, if the price of underlying stock
FB increases to $165 and then the investor exercises
the option, he/she will be able to make $5 profit by
buying the underlying stock now at $160 and selling
it immediately in the market at $165. We ignore
transaction cost in this example.
A call option is in the money, if the market
price is above the strike price.
A call option is out of the money, if the
market price is below the strike price.
A call or put option is at the money, if the
market price is equal to the strike price.
A put option is in the money, if the market
price is below the strike price.
A put option is out of the money, if the
market price is above the strike price.
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 Derivative Markets

Figure 4.8 illustrates the payoff and net profit/ The short call is the mirror image of the long
loss of an investor exercising a call option. In some call as in Figure 4.9. This is a zero-sum game.
cases, an investor may lose money even though he/
Payoff($)
she exercises the option. For example, if the price of Long Call

the underlying stock FB is $162 at the expiration

date and the investor exercise the option at that
price, he/she will still be in loss (($162-$160) - $5) Profit

= -$3, when taking the initial cost of the option

into account. Therefore, it is important for the Payoff($)

investor to take the option premium cost into

Payoff($)
account while exercising a call option.
Profit
Payoff($) Short Call
ST
15
Figure 4.10 Payoff and Profit from Buying and Selling
10 for call option.

5
Payoff Put Options
0
Profit
Put option contracts grand their buyers the right
C0=-5 but not obligation to sell the underlying asset. To
observe the meaning of put options, let us continue
with our previous example. Suppose the investor
150 155 160 165 170 175
ST
buys an American put option of FB stock at a
Figure 4.8 Payoff and Profit from a Call Option for Buyer.
strike price of $160 after 3 months from now. The
premium to begin with the contract is $5 and the
underlying stock price drops under $160, the put
In another scenario, when the investor is on the option contract is said to be in-the-money and in
short side of the call option (as the seller or the favor of the investor to exercise it. The investor can
writer of the contract), the profit that he/she can make a profit from this contract selling it at a higher
make is the option premium that he/she receives price than the market and buying it back with a lower
at the start of the option contract. In our previous price. On the other hand, if the price of underlying
example, if the buyer did not exercise the option stock FB increases to $165 and it is not in favor of
due to being out-of-money ($155), the profit that investor to exercise the option, because he/she sells
the option writer would gain is $5. If the option the underlying asset at a lower price than the market
is in-the-money ($170) and the buyer of the call and the maximum loss that short position will lose is
option exercises the contract, the losses that the $5. Figure 4.11 illustrates the payoff and net profit/
option writer would face is $10. loss of an investor exercising a long put option.

Payoff($) Payoff($)

10
15 Payoff
Profit
10
C0=5

Payoff 5
0

-5 0

P0=-5
-10 -10 Profit

0 ST ST
150 155 160 165 170 175 140 145 150 155 160 165 170

Figure 4.9 Payoff and Profit from a Call Option for Seller. Figure 4.11 Payoff and Profit from a Put Option for Buyer.

96
Financial Markets & Institutions

In another scenario when the investor is on the writer of a put option, the maximum profit that the writer
can make is the option premium ($5) that he/she receives at the start of the contract and the maximum loss
that he/she faces is $155. In our previous example, if the price of the underlying stock closes at or above
$160 at $165, it is not in favor of counterparty to exercise the contract, and thus the writer gains the option
premium of $5. On the other hand, if the price of the underlying stock closes below $160 at $155, it is
favorable to the owner of the put option to exercise the contract and the writer of the put option has to sell the
contract is worth $155 at $160, and thus making a loss of $5. However, the $5 is offset by the initial option
premium. Figure 4.12 illustrates the payoff and net profit/loss of an investor exercising a short put option.
Payoff($)

10

P0=5
Payoff
0

-5
Profit
-10

ST
140 145 150 155 160 165 170

Figure 4.12 Payoff and Profit from a Put Option for Seller.

The short put is the mirror image of the long call. This is a zero-sum game.
Payoff($)
Payoff

Profit

Payoff

Profit

ST
Learning Outcome
Figure 4.13 Payoff and Profit from Buying and Selling for put option.
Learning Outcomes

2 Identify forward commitments, future contracts, swaps and options.

Self Review 2 Relate Tell/Share

How many different types What benefits can options Tell how futures can be used
of derivatives are there in the provide for speculators or by companies to manage
market? hedgers? currency risks.

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 Derivative Markets

BASICS OF DERIVATIVE PRICING AND VALUATION

In this section, we will discuss the impact of underlying assets on derivatives and how we use the
principle of arbitrage in pricing derivatives. As we mentioned earlier, a derivative drives its value from an
asset or a rate. Therefore, the value of a derivative depends on an underlying asset or a rate.
If there is any benefit we add that benefit into it, and if there is any risk we deduct that cost discounted
at a rate appropriate for the risk assumed. The following equation below exhibits how to calculate the
E(ST )
current price S0 of an underlying asset. The expression is basically the present value (PV) of the
(1+r +λ)T
underlying asset. We divide E(ST) which is the expected future price of the underlying asset by the risk-free
rate r and the risk premium λ, over the period from 0 to T.
The price of the underlying asset at time t = 0:

E(ST )
S0 = – θ+ γ
(1+r +λ)T

where γ (gamma) is PV of any benefits received while holding the asset between t = 0 to T, and θ (theta) is
PV of any costs that occur while holding the asset between t = 0 to T.
Let us consider the following example in order to better understand the above formula. Suppose that
the expected future value E(ST) of the underlying asset at t = 1 is 100. The interest rate (risk free rate + risk
premium γ) is 10%, the discounted storage cost for one year is 5, and the discounted benefit from holding
the asset for one year is 2. What would be the current price of an underlying asset?

The current price of an underlying asset is the PV of it.

100
The current price of the underlying asset = S0 = – 5 + 2 = 87.90
(1+ 0.1)1
γ is the present value of any monetary (dividend) and non-monetary (pleasure) benefits received from
holding the asset between t = 0 and t = 1, and it is necessary to add the discounted γ into the current price.
θ is the present value of the costs paid for holding an asset between t = 0 and t= 1. In case of holding gold
as an asset and paying for a locker rent to store the gold is considered incurred cost ; therefore, it must be
subtracted from the current price.

Pricing and Valuation of Forward Contracts

In order to understand the forward contracts pricing and valuation, let us assume the following example.
Suppose John owns a stock of FB, whose S0 (spot price) is $100. Sam agrees today to buy from John a share
of FC at $101 after 1 month. The terms of the forward contract are as follows:
• The forward price is $101 and the contract is for 1 month.
• There is no premium or initial pay down at t = 0 when both parties enter into the contract.
After one month when the contract expires, the forward contract can be settled in the following ways:
• Sam physically receives the FB share and pays $101 to John.
• John pays Sam the difference between the spot price of the stock and price agreed-upon price (ST)
in the forward contract. After one month, if FB share price is $103, then John pays $2 to Sam.
However, in case if the stock price goes up to $103, a default risk may emerge in forward contracts.
Sam may become concerned that John may fails to deliver him the FB stock as agreed upon. On the other
hand, if the share price drops to $99, John may become worried that Sam may not buy him the FB stock
as agreed upon.

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Financial Markets & Institutions

Figure 4.14 below shows the transactions from the perspective of long at times t = 0 (initiation date)
and at time t = T (expiration date) expires.

Agree to pay F0(T) at Pay F0(T) and receive

time T to buy the asaet the asset worth ST

Figure 4.14 Transactions from a perspective of a long party.

Before we go further in valuation of forward contracts, let us explain the key features and notations of:
• F0 (T) denotes for the forward price agreed upon at time t = 0. T shows the expiration date of the
contract at time T.
• S0 denotes for the spot price at the beginning of the contract. ST denotes for the spot price at the
expiration of the forward contract at t = T. St stands for the price of the forward contract at any time
during the life of the contract.
• The contract value at time t is denoted as Vt(T).
• There is no premium or initial down payment at t = 0 when both parties enter into the contract.
No party pays anything to the other party.
The price agreed upon at the beginning of the forward contract is simply S0 compounded at the risk-
free rate over the contract life.

F0(T) = S0(1+r)T

Suppose the risk-free rate is 10%, S0 = 100, and t (time period) is 1 month. What is the forward price?

1
T= = 0.0833; F0 (T ) = S0 (1+ r)T = 100×(1.1)0.0833 = 101
12

If we analyze why the forward price equals to S0 compounded at the risk-free rate over the contract
life, it can be said that if Sam did make a deal with John he could deposit $100 in a bank at a risk-free
rate for period T and earn 10% or $1 at the end of one month. Therefore, the forward contract must earn
the risk-free rate; otherwise; an excess return will lead to an arbitrage opportunity. Since no party pays
any money at the start of a forward contract, its value is equal to zero and it has no value to either party.
At the expiration date, John is as a seller and he is obligated to sell the asset to Sam (long party) for $101.
Moreover, there is no arbitrage opportunity from this transaction since S0 price is $100 and forward price
101 and Sam can make $101 by simply deposit $100 at a bank at a risk-free rate of 10%. The forward is
priced so that no arbitrage opportunity should exist.
The value of a forward contract at expiration from the perspective of a buy (long) party:
Vt(T) = ST – F0(T)
important
where, ST is the spot price of the underlying asset at the expiration,
F0(T) is agree upon forward price. At contract expiration, if ST >
F0(T), then the value of the forward contract is positive for the The value of a forward contract is positive to
buyer and if St < F0(T), then the value is negative. the short party if F0(T) > ST and negative if
F0(T) < ST at expiration.
The value of a forward contract at expiration from the
perspective of a sell (short) party:
Vt(T) = –ST – F0(T)

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 Derivative Markets

Suppose that at time T, the spot price is 105, here Sam (long) receives the asset from John by paying
$101 and immediately sells it for $105 at the market and makes a profit of $4. The value of forward
contract to the long party is as follows:

-St – F = 105 - 101 = 4.

The value of a forward contract during the life of the contract is estimated with the following formula:
F
Vt = St –
(1+r) T –t

This is simply the difference St (spot price)between spot price) at time t, and F (present value
(1+r) T –t
of forward price) for the remaining life of the contract.
Suppose that t is 15 days and the spot price (St) is $106, then the value of the contract equals to:

101
Vt = 106 – = 9.7
(1.1)0.5

Thus, we can say that the value to the long party is positive.

Pricing and Valuation of Futures Contracts

At the expiration date, if it was written on the contract to deliver physical product to a specific location,
the seller of the contract must deliver the underlying asset to the designated location, and the buyer of the
contract is required to pay for it at the spot price.

The payoff for futures contracts is: spot price at expiration - the forward price (ST – F0 (T)).

Since clearing houses settle every futures contract on a daily basis, a futures contract can be
considered a bundle of consecutive 1-day forward contracts. In other words, at the beginning of each
day a forward contract is constructed and at the end of that day the forward contract is delivered
and at the beginning next day again a new forward contract is constructed and the process continues
until the expiration of the future contract. The buyer of this contract buys the entire package of
forward contracts. For instance, a buyer of a three-month futures contract buys a 90 renewable 1-day
forward contracts which daily renews by clearinghouse. Forward contracts equal futures contracts
if their differences are adjusted. Therefore, a future contract of currency can be calculated as:

Futt d/f = Ft d/f = S0 d/f [(1 + id )/(1 + if )]t

where, Fut denotes future price in the futures contract and F denotes for forward contract. S0 stands for
spot price and i stands for inflation. From the equation, if the inflation in the foreign currency is higher
than expected, then the forward rate decreases.

Pricing and Valuation of Swap Contracts

To understand the logic behind swap pricing and valuation, let us consider the following example first.
Suppose that John and Tom enter into a 3-year plain vanilla interest rate swap. John pays 10% fixed-rate
to Tom and receives the floating rate (LIBOR) from Tom. If floating rates at t = 0, 1, and 2 are 9%, 10%
and 11% respectively, what could be the value of this contract?

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Financial Markets & Institutions

0 1 2 3

Net gain to Fixed -1% 0% 1%

Fixed payment 10% 10% 10%
Floating payment 9% 10% 11%
Figure 4.15 3-year plain vanilla interest rate swap.

As it is obvious from the above diagram that there are two parties in this swap contract, who agree to
exchange a series of payments (fixed rate: 9%, 10% and 11 %) in return for LIBOR rate at times 0, 1, and
2 respectively. John makes a fixed rate of 9%, 10%, and 11% payment and receives LIBOR rates at the end
of each subsequent year for 3 years. It is also obvious that swap is similar to a series of forward contracts in
the way that each contract expiring at specific times and renews until contract’s expiration date.

important

The value of a swap at the start of contract is typically

Swap rates are locked in for the future like in the
zero, and the swap price is determined through
case of a forward rate agreement. It is the same
replication. The swap price is simply the PV of all net
as locking in multiple forward rate agreements
cash flow payments from the swap. Throughout the life
of a swap contract, the value of a swap also changes. for different periods at different forward prices.

Now let us apply the replication process to our previous example. The fixed rate of the swap is 10%,
which is also its price. The replication of a swap is as follows:

Make qual fixed payment FS0(T)

John Tom

Borrow money to purchase a floating rate bond which pays coupons S1, S2, … Sn

Figure 4.16 Replication of a swap.

• First, John buys a floating-rate bond that pays coupons S0, S1, q....SN at times t = 1, 2...N.
• Then, John borrows money (equivalent to issuing a fixed-rate bond) in order to purchase this
floating rate bond. The payments for the money borrowed are equal fixed-payments of FS0(t) at
t = 1, 2, ...N.
• The price of the swap is the rate at which the money was borrowed by floater. By considering the
principle of no-arbitrage pricing, the fixed rate on the swap should be equal to the fixed-rate bond,
which was issued in the second step.
• The PV of the expected future cash flows is considered the value of the swap during its lifetime. The
floating payments depend on the underlying rate’s market price.

Pricing and Valuation of Option Contracts

The option-pricing models are mathematical formulas or calculation processes that use certain variables
to calculate the theoretical value of an option. In the option pricing models, the output is the theoretical
actual value of an option. If the model works well, the market price (option premium) of the option will
be equal to its theoretical actual value. Option-pricing models provide us with the fair value of an option.

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 Derivative Markets

Black-Scholes Option Pricing Model

The process of obtaining the theoretical real
value of options is called option pricing.
important
Knowing the estimate of the fair value
of an option, finance professionals could
adjust their trading strategies and portfolios.
Therefore, option-pricing models are
powerful tools for finance professionals
involved in options trading.
Binomial Option Pricing Model and Black
Scholes Option Pricing Model are commonly
used models for option pricing.
First, the binomial option pricing model, which
is a calculation process rather than a formula, will
be examined. Then, Black Scholes option pricing
model based on a mathematical formula will be
discussed.
The Black-Scholes model is another commonly
used option pricing model which was developed by
Fischer Black and Myron Scholes in 1973. The Black-
Scholes model was developed mainly for the pricing
European options on stocks. The model operates
under certain assumptions regarding the distribution
of the stock price and the economic environment.
The main variables used in the Black-Scholes
model include:
• Price of underlying asset, which is a current
market price of the asset
• Strike price, which is a price at which an
option can be exercised
• Volatility, which is a measure of how
much the security prices will move in
the subsequent periods. Volatility is the
trickiest input in the option-pricing model
as the historical volatility is not the most
reliable input for this model
• Time until expiration, which is a time
between calculation and option’s exercise date
• Interest rate, which is the risk-free interest rate.

Binomial Option Pricing Model
The simplest method to price the options is to
use a binomial option-pricing model. Under the
binomial model, we consider that the price of the
underlying asset will either go up or down in the
period. Given the possible prices of the underlying
asset and the strike price of an option, we can
calculate the payoff of the option under these
scenarios, then discount these payoffs and find the
value of that option as of today.
In 1973, Fisher Black and Myron Scholes
proved a formula for pricing European call
options and put options on non-dividend-
paying stocks. Their model is probably the
most famous model of modern finance.
important
In general, the higher the historical volatility of
the underlying asset, the higher the option price.

Learning Outcomes

3 Explain the basic logic of derivative pricing and valuation

Self Review 3 Relate Tell/Share

Tell the application cases

How can derivatives be priced?
Associate the price of options
of pricing and valuation of
with the volatility of the
different tips of derivative
underlying assets.
agreements.

102
Financial Markets & Institutions

In Practice

Hedging instruments in emerging market economies

Sweta Saxena and Agustín Villar
BIS Papers No 44
…………..The FX derivatives market is the most important and most developed in EMEs. The
demand for hedging in the FX market is driven by investors’ desire to invest in emerging market
bonds and equities. FX derivatives markets are most developed in countries with deep and efficient
spot markets (eg Hong Kong and Singapore). However, they have also developed in some other EMEs
(namely Brazil, India, Korea, Mexico, Russia and South Africa). The banking sector is the biggest user
of OTC derivatives in EMEs. Among FX derivatives, FX swaps dominate the OTC derivatives market
in EMEs as they enable foreign investors to access the local money market. FX forwards are dominant
in Korea and Taiwan and are fairly liquid in a few other EMEs (eg Chile, Hong Kong, India, Russia,
Singapore and South Africa). Currency swaps constitute a very small share of FX derivatives and are
traded mainly in Brazil and Korea. FX options have relatively large trading volumes in Hong Kong,
India and Singapore. Offshore trading of many EME currencies is quite significant, with NDFs and
options being the main hedging instruments traded in this way.
While the FX derivatives market is quite developed in EMEs, the OTC derivatives market for
hedging interest rate risk is rather underdeveloped and mostly concentrated in interest rate swaps. Some
reasons for their underdevelopment may include the low level of interest rate risk, which in any event
mostly resides with the banking sector and can be handled in other ways. CDS provide a hedge against
credit risk, but for EMEs they are mostly concentrated on sovereign entities instead of corporations.
The benefits of hedging exchange rate risks with derivative products come at the price of some
risks. In the absence of derivatives markets, speculative attacks channeled through the spot markets
can be resisted by the central banks, provided they have sufficient reserves and a banking sector
strong enough to withstand high interest rates. However, with derivatives markets, speculators can
take virtually unlimited positions in forward and swap markets and reduce the effectiveness of central
bank’s intervention (Dodd (2001). Furthermore, as markets become one-sided, dynamic hedging in the
derivatives market can amplify market movements. Authorities should bear these risks in mind, even
while fostering the development of the derivatives market (Chan-Lau (2005)).

https://www.bis.org/publ/bppdf/bispap44d.pdf

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 Derivative Markets

LO 1 Describe derivatives market

There are two categories of markets where derivatives are created, Exchange-traded derivatives markets and
Over-the-counter derivatives markets (OTC). Exchange-traded derivatives are standardized such that its terms
and conditions are precisely specified by the exchange where OTC is the customizable contract that can be
customized by the involving parties. In other words, derivatives exchange-trade standardizes every term and
condition of contracts except their prices. For example, suppose an exchange introduces a standardized contract
for metal Gold. It specifies the quality of gold, the quantity of gold, expiration date, and the location where
the gold should be delivered. Normally, the price of a derivative contract is defined by buyers and sellers (long
and short parties). Chicago Mercantile Exchange (CME) is an example of exchange-traded derivatives markets.
The exchange-traded derivatives also provide credit guarantee and ensure that there will not be any credit risk.
Summary

On the over-the-counter derivatives markets, investors directly trade legal derivative contracts without involving
an intermediary. Such markets are also called informal derivative markets because the engaged parties are not
obligated to carry out their promises. Through both buyer and seller of OTC contracts informally agrees to
buy or sell derivative contracts, but still, there is the possibility of a default. The OTC contracts are customized
contracts and they are less liquid than exchange-traded derivative contracts as well as they are less transparent. It
is worth mentioning that the market makers make a profit through the bid-ask spread as they fulfill the needs
of both buyer and seller through buying from a seller at one price and selling to a buyer at a higher price.

Identify forward commitments,

LO 2 future contracts, swaps and
options

There are two types of derivatives, forward commitments, and contingent claims. Forward commitments
contracts such as forward contracts, futures contracts, and swaps provide a buyer or seller the ability to
lock in a price to buy or sell an underlying asset whereas contingent claims such as option provide a buyer
or a seller the right to buy or sell an underlying asset at a price previously fixed.
Forward commitments can be defined as the contracts entered into at one point in time that require both
parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start.
The parties establish the identity and quantity of the underlying, the manner in which the contract will
be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This
fixed price is called the forward price.
Futures contracts are the same as forward contracts except that futures contracts are organized, regulated
and managed by an exchange. In other words, futures contracts are standardized. A futures contract can
be defined as an agreement made through an organized exchange to buy or to sell a fixed amount of an
underlying commodity or financial asset on a future date (or within a range of dates) at an agreed price”.
A swap contract can be defined as an OTC contract between two parties agree to exchange cash flows on
regular dates where one party pays a variable payment, and the other party pays either a fixed or variable
payments calculated on a different basis. Since swap is an OTC contract, it contains terms and conditions
such as the identity of the underlying asset, dates of payments, and the procedure of payment that are
agreed upon and written in the contract.
Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific
price at a future date. In other words, the buyer pays a sum amount of money, known as premium, to the writer
of a contract to receive the right to either buy or sell an underlying asset at a specific price at a future date.

Explain the basic logic of

LO 3 derivative pricing and valuation

Derivatives drive their value from an asset or a rate. Therefore, the value of a derivative depends on an
underlying asset or a rate. The price/value of a financial asset is the expected future value of it.
The value of a forward contract is positive to the short party if F0(T) > ST and negative if F0(T) < ST at expiration.
The payoff for futures contracts is: spot price at expiration - the forward price (ST – F0 (T)).
The PV of the expected future cash flows is considered the value of the swap during its life time.
Binomial Option Pricing Model and Black Scholes Option Pricing Model are commonly used models for
option pricing.

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Financial Markets & Institutions
1 A type of financial instrument , the value of
which is derived from another underlying product
can be defined as…………………………?
A. mortgage
B. forfaiting
C. factoring
D. franchising
E. derivative
2 Which of the following is an example of
exchange-traded derivatives market?
A. Chicago Mercantile Exchange (CME)
B. Central Management Europe (CME)
C. Canadian Manufacturers and Exporters (CME)
D. Continuing Market of Exchange (CME)
E. Central Management of Exchange (CME)
3 Which of the following is false?
A. Futures contracts are more liquid than forward
contracts.
B. Futures contracts are marked to market.
C. Futures contracts allow fewer delivery options
than forward contracts.
D. Forward contracts amount are negotiable.
E. Forward contracts trade on OTC (Over-the-
counter) derivative market.
4 A put option has a strike price of $135. The
price of the underlying stock is currently $142.
The put is:”............”.
A. at the money
B. out of the money
C. in the money
D. near the money
E. put the money
5 A call option with a strike price of $155 can
be bought for $4. What will be your net profit if
you sell the call and the stock price is $152 when
the call expires?
A. $9 B. $4
C. $3 D. $0
E. -$4
6 The buyer of the forward contract is said to
be …………………forward.
A. put B. call
C. cross D. long
Test Yourself
E. short
7 Which of the following statements is false?
A. Interest rate swaps are a form of over-the-
counter derivative.
B. A European-style option will give the right to
buy or sell at any time up to and including the
expiry date.
C. There are two categories of markets where
derivatives are created, Exchange-traded
derivatives markets and Over-the-counter
derivatives markets (OTC).
D. Options provide a buyer or a seller the right
to buy or sell an underlying asset at a price
previously fixed.
E. The value of a derivative depends on an
underlying asset.
8 Which of the following cannot be defined as
a derivative security?
A. Forward B. Futures
C. Swap D. Option
E. Barter
9 Suppose that the expected future value E(ST)
of the underlying asset at t = 1 is 200. The interest
rate (risk free rate + risk premium) is 20%, the
discounted storage cost for one year is 5, and the
discounted benefit from holding the asset for one
year is 2. What would be the current price of an
underlying asset?
A. 158,66 B. 160,66
C. 163,66 D. 169,66
E. 173,66
10 Which of the following is not among the
main variables used in the Black-Scholes model?
A. Price of underlying asset
B. Strike price
C. Volatility
D. Time until expiration
E. Euro/Dollar Parity
105
 Derivative Markets

Yanıtınız yanlış ise “Derivatives: Definitions

1. E 6. D Yanıtınız yanlış ise “Types of Derivatives”
And Uses” konusunu yeniden gözden
konusunu yeniden gözden geçiriniz.
geçiriniz.
Answer Key for “Test Yourself”

Yanıtınız yanlış ise “The Structure Of

2. A 7. B Yanıtınız yanlış ise “Types of Derivatives”
Derivative Markets” konusunu yeniden
konusunu yeniden gözden geçiriniz.
gözden geçiriniz.

3. C Yanıtınız yanlış ise “Types of Derivatives” 8. E Yanıtınız yanlış ise “Types of Derivatives”
konusunu yeniden gözden geçiriniz. konusunu yeniden gözden geçiriniz.

Yanıtınız yanlış ise “Basics of Derivative

4. B Yanıtınız yanlış ise “Types of Derivatives” 9. C
Pricing and Valuation” konusunu yeniden
konusunu yeniden gözden geçiriniz.
gözden geçiriniz.

Yanıtınız yanlış ise “Basics of Derivative

5. B Yanıtınız yanlış ise “Types of Derivatives” 10. E
Pricing and Valuation” konusunu yeniden
konusunu yeniden gözden geçiriniz.
gözden geçiriniz.

What is the difference between the Exchange-traded

derivatives markets and Over-the-counter derivatives
markets?

There are two categories of markets where derivatives are created: Exchange-
Suggested answers for “Self Review”

traded derivatives markets and Over-the-counter derivatives markets (OTC).

Exchange-traded derivatives are standardized such that its terms and conditions
are precisely specified by the exchange where OTC is the customizable
self review 1 contract that can be customized by the involving parties. In other words,
derivatives exchange-trade standardizes every term and condition of contracts
except their prices. On the over-the-counter derivatives markets, investors
directly trade legal derivative contracts without involving an intermediary.

How many different types of derivatives are there in the

market?

There are two types of derivatives, forward commitments, and contingent claims.
Forward commitments contracts (such as forward contracts, futures contracts,
self review 2 and swaps) provide a buyer or seller the ability to lock in a price to buy or sell an
underlying asset, whereas contingent claims (such as option) provide a buyer or a
seller the right to buy or sell an underlying asset at a price previously fixed.

How can derivatives be priced?

A derivative drives their value from an asset or a rate. Therefore, the value of a derivative
depends on an underlying asset or a rate. The price/value of a financial asset is the
self review 3 expected future value of it. If there is any benefit we add that benefit into it, and if
there is any we deduct that cost discounted at a rate appropriate for the risk assumed.

106
Financial Markets & Institutions

References
Brzychczy, E. (2012). Proposal of using SWAPs Hull, J. (2012). Options, futures and other derivatives,
by hard coal mining companies in Poland, (8th Ed), Upper Saddle River, NJ: Prentice Hall,.
Gospodarka Surowcami Mineralnymi-Mineral
Lu, T. H., Chen, Y. C., & Hsu, Y. C. (2015). Trend
Resources Management, 28(2), 87-102.
definition or holding strategy: What determines
Butler, K. C. (2016). Multinational Finance: Evaluating the profitability of candlestick charting?, Journal
the Opportunities, Costs and Risks of Multinational of Banking & Finance, 61, 172-183.
Operations, John Wiley & Sons.
Pirie, W. L. (Ed.). (2017). Derivatives, John Wiley &
Chisholm, A. M. (2011). Derivatives demystified: a Sons.
step-by-step guide to forwards, futures, swaps and
Sevil, G. (Ed.). (2013). Türev Araçlar, Anadolu
options, John Wiley & Sons.
Üniversitesi Açıköğretim Yayınları, No: 2913.
Eun, C. and B.G. Resnick. (2009). International
Financial Management, McGraw-Hill, Singapore.

Internet References
https://corporatefinanceinstitute.com/resources/knowledge/valuation/option-pricing-models/

107
 Chapter 5 Commercial Banking
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Describe the main functions of commercial Identify the sources of funds and uses of funds
banks for commercial banks

3 Identify revenues and expenses of commercial

banks 4 Describe the main types of risks that
commercial banks are exposed to

Chapter Outline Key Terms

Introduction Money,
Functions of Commercial Banking Deposits,
Loans,
Sources of Funds and Uses of Funds in Interest Income,
Commercial Banking Interest Expense,
Revenues and Expenses of Commercial Banks Liquidity Risk,
Risk Management in Commercial Banking Interest Rate Risk,
Credit Risk,
Operational Risk

108

Financial Markets & Institutions
INTRODUCTION
Banks are one of the most significant foundations
of a modern economy. The roots of modern
banking date back to the sixth century B.C. The
first banking operations existed in Mesopotamia,
Ancient Greece and the Mediterranean region,
where goldsmith bankers originated to facilitate
trade by providing loans to merchants. Later,
merchants started to become bankers and merchant
banking flourished. Merchant bankers gained
dominance during the Roman Empire times. In
fact, the origin of the term “bank” is the merchant’s
bank, or banco on which money was exchanged in
the market. In Italy, merchant bankers such as the
Medici family gained economic and political power
and financed Italian artists of the Renaissance in
the 15th and 16th century. Some Italian Merchant
bankers moved their operations to other European
cities like London and Berlin and financed the
royal families of Europe around the 17th and 18th
century. Other bankers followed and the modern
banking industry evolved around the banking
practices of maintaining deposit accounts, granting
loans and processing payments.
Commercial banks or deposit banks collect
savings from lenders, deposit them and use
these savings to make loans to borrowers.
Hence, financial assets of savers are transformed
into liabilities for borrowers. In other words,
commercial banks make profits by matching
savers and borrowers. Commercial banks also play
important roles in the economy by bringing small
amounts of money together from many savers
and re-packaging these funds into larger packages
of loans for businesses and individual clients.
Moreover, they transform the maturity of funds
by borrowing deposits usually with a short term
and lending those funds in the form of loans with
a long term. They also help diminish asymmetric
information problems. They reduce adverse
selection problems by collecting information
about the creditworthiness of loan applicants.
They also reduce moral hazard problems by
carefully watching the borrowers.
In this chapter, we discuss the main functions
of Commercial Banking, explain how they operate
and earn money by identifying their sources of
funds and uses of funds as well as their revenues and
expenses. We also elaborate on how commercial
5
banks manage their assets and liabilities and their
risks in order to survive and succeed in a highly
competitive market.
FUNCTIONS OF COMMERCIAL
BANKING
There are various actors in the economy:
businesses, households, government, foreigners.
Some economic units, the revenues of which exceed
their expenditures have a surplus and therefore they
save; while some economic units, the revenues of
which are not sufficient to cover their expenditures
have a deficit and they borrow to finance their deficit.
Likewise, some economic units may seek funds
to borrow in order to undertake some profitable
investment projects. Hence, surplus units or savers
would like to invest their savings by lending them
to the deficit units or potential borrowers desiring
to finance capital investments; whereas deficit units
would like to cover their deficit by borrowing from
the surplus units.
The financial system brings economic actors
together through financial markets and financial
institutions and channels those funds between
surplus and deficit units. Thus, there is a continuous
flow of funds from surplus units to deficit units
either directly through financial markets or
indirectly through financial intermediaries.
Financial intermediaries act like a bridge between
lenders and borrowers.
We can classify financial intermediaries or
financial institutions as depository institutions
and non-depository institutions. Depository
institutions include commercial banks, savings
banks and savings and loans associations as well as
credit unions. Non-depository institutions include
insurance companies, pension funds, mutual
funds, finance companies and investment banks.
Commercial banks are financial firms, which
collect deposits from savers and channel those
deposits to borrowers in the form of loans. In
other words, commercial banks are depository
financial institutions, which specialize in making
commercial loans. Commercial banks offer
borrowers short-term loans such as lines of credit
or overdraft facilities. On the other hand, they offer
depositors the ability to withdraw or pay money
on demand or on a specific date at a fixed return.
109
5
Hence, commercial banks provide guarantee of
money at short notice. Especially, in countries with
unreliable stock markets, banks provide people a
safe and trustworthy investment opportunity. The
most dominant financial institutions in Turkey and
in most European countries are commercial banks.
Commercial banks hold financial assets for
others and invest those financial assets to
create more wealth in the economy.
important
The regulation of the banking sector is the key
to maintaining the public’s trust. Governments
naturally have laws in place to prevent banks
from engaging in dangerous activities.
Commercial banks play an important role in
the financial system by collecting deposits from
savers and making loans to borrowers. Commercial
banks facilitate the transfer of funds and enhance
efficiency in the economy.
Households
Financial
Businesses
Markets
Government
Foreigners
In the case of direct finance, a saver lends
money to parties seeking funds without a financial
intermediary such as a bank. In the case of
indirect finance, a financial intermediary issues
its own financial instruments called securities
using funds of savers. Indirect finance enables
funds of savers to be transferred to borrowers
110
Commercial Banking
through financial intermediaries. The existence
of asymmetric information in financial markets is
the main reason for indirect finance. Asymmetric
information exists if one party in a financial
transaction has information not possessed by the
other party. Asymmetric information may lead
to adverse selection problems or moral hazard
problems. Those businesses, which seek funds for
low quality investment projects are likely to be
the ones which desire to borrow most. As savers
cannot distinguish between these high quality and
low quality potential borrowers due to asymmetric
information, they may be less willing to lend their
funds. This problem arising from asymmetric
information is called adverse selection. Even if
savers lend their funds, there is a likelihood that
the borrower may act immorally and engage in
a behavior such as lax management of the loan
that increases risk after the loan is made. This
kind of problem, which stems from asymmetric
information is called moral hazard.
Reducing adverse selection and moral hazard
problems is very costly for savers as they must
evaluate the creditworthiness of the borrowers
before making the loan and monitor their behavior
after making the loan. These processes require time
and resources. Financial intermediaries can reduce
those asymmetric information problems and save
lenders from incurring these costs by specializing
in assessing potential borrowers and monitoring
loans. By pooling savings together in mutual funds
or pension funds and spreading the management
costs across a great number of savers, financial
intermediaries may permit savers to benefit from
economies of scale by reducing the average cost of
managing those funds. Hence, commercial banks are
able to provide lending to companies at a relatively
low rate of return because of the economies of scale
they can enjoy compared with the primary investor.
These economies of scale include:
• Efficiencies in gathering information on
the riskiness of lending to a particular firm
and subsequent monitoring
• Risk spreading across a large number of
borrowers
• Low transaction costs due to standardized
securities
• A regular flow of liquidity through deposits
or borrowings.

Financial Markets & Institutions
Commercial banks are financial institutions,
which can create credit and money.
In fact, banks create deposits when they lend
money through loans. Instead of giving loans in
cash, banks issue checks against the name of the
borrowers. The borrowers can draw checks and the
people who receive the checks deposit them in other
banks. Banks must keep a certain proportion of
deposits with the central bank, which is called the
legal minimum cash reserve. The remaining portion
can be used to make loans and create money.
important
Commercial banks create money or credit
against deposits through the money
multiplier.
internet
You can watch videos on “the money
multiplier” on YouTube.
We can define money as anything that
economic actors use as a payment mechanism in
economic transactions or debt settlement. We need
money since economic actors exchange goods and
services in return for money. Although goods and
services can also be exchanged directly through
a barter system without money, parties involved
should bear the costs arising from the time and
resources spent in the search of trading partners.
High transaction costs and inefficiencies of the
barter system encourage people to use something as
a standard “medium of exchange”. By eliminating
the costs and inefficiencies of the barter system,
money enables people to specialize their production
and consequently enhances higher productivity in
the economy.
5
Besides providing a medium of Exchange,
money provides a way of measuring value as
well. We call this function of money as “the
unit of account”. Money also allows people to
accumulate wealth in a widely accepted “store of
value”, which can be used for consumption or
investment purposes today or in the future. Money
smooths and boosts transactions in the economy
by providing a payments system. The mechanisms
used in the payments range from gold and silver
to paper currency and checks to electronic funds
transfers and digital money.
Commercial banks attract funds by issuing
securities with characteristics that appeal to the
primary investor. They create an intermediate
security such as a deposit account or loan and
generate opportunities for savers and investors by
transforming the risk level, maturity or liquidity
and volume of assets.
Business lines in the commercial banking
industry can be classified as Retail Banking and
Corporate Banking. Retail banking mainly
covers individuals and includes financial services
such as credit cards and consumer loans as well as
mortgages. It also covers very small enterprises, such
as those of physicians or home services. Corporate
banking transactions cover large businesses and
include financial services like overnight loans,
short-term loans, revolving facilities, term loans,
committed lines of credit or large commercial and
industrial loans.
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Learning Outcomes
1 Describe the main functions of commercial banks
Self Review 1
How do commercial
banks reduce asymmetric How do banks create money?
information problems?
SOURCES OF FUNDS AND USES
OF FUNDS IN COMMERCIAL
BANKING
The sources of funds and uses of funds of bank
are shown on the balance sheet of the bank.
important
The liabilities and the capital of a commercial
bank constitute its sources of funds, while the
assets of a commercial bank constitute its uses
of funds.
The primary source of funds for commercial
banks are deposits, whereas the primary use of
funds is loans. Besides deposits, other liabilities
or sources of funds for commercial banks include
borrowings from other financial institutions.
Besides loans, other assets or uses of funds for
commercial banks include required reserves against
deposits and excess reserves held in the Central
Bank, currency in ATMs, deposits with other
banks and assets invested in marketable securities
such as government bonds, corporate bonds and
asset backed securities.
Excess reserves are reserves held by commercial
banks above the reserves held to meet reserve
requirements of the Central Bank.
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Commercial Banking
Relate Tell/Share
Tell the difference between
Retail Banking and Corporate
Banking.
An asset-backed security (ABS) is a financial
security such as a bond or note, which is
collateralized by a pool of assets such as loans,
leases, credit card debt, royalties, or receivables.
Liabilities and Equity Capital of
Commercial Banks
Liabilities are claims on the assets of
businesses at a certain point of time. Liabilities
of a commercial bank can be categorized as
controllable and uncontrollable liabilities. Non-
controllable liabilities are the liabilities over which
clients have discretion rather than the bank and
mainly consists of deposits in the form of demand
deposits, checkable deposits, savings deposits and
small denomination time deposits. Liabilities, the
amount of which can be controlled by the bank are
referred to as controllable liabilities. Controllable
liabilities include large denomination time
deposits and short-term borrowings in the
interbank money market.
important
The deposit account held in a bank is an asset
for the deposit holder, who is household or firm
whereas it is a liability for the commercial bank
 5
Financial Markets & Institutions

The interbank money market is a market, in which banks extend loans to one
another for a specified term. Most interbank loans are for maturities of one week or
less, the majority being overnight. Such loans are made at the interbank rate.

The most important source of funds and liability item for commercial banks is deposits. Bank deposits
may offer savers interest revenue as well as liquidity and safety against theft. Savers may make deposits for
daily transactions and hold those funds in the form of demand deposits, which allow them to access those
funds immediately on demand. Demand deposits may also enable savers to write checks against them.
Checkable accounts do not pay any interest to the deposit holders. On the other hand, time deposits offer
interest payment to the savers, as the deposit holders must keep their deposits in the bank for a certain
period. Time deposit holders can access those funds only at maturity.
Equity capital or net worth of a commercial bank is the excess of assets over liabilities.

Equity Capital (Net worth) = Total Assets – Total Liabilities

Exhibit 5.1 Summary Balance Sheet of a Commercial Bank.

Source: http://www.bankingforsociety.be/bank-balance-sheet.

Assets of Commercial Banks

Assets are items of value owned by businesses at a certain point of time. Those assets include notes and
coins, balances with the Central Bank, inter-bank loans, advances, investments, premises and computers.
The most important assets of a commercial bank can be categorized as follows:

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• Loans
• Securities
• Cash Assets
• Fixed Assets
Asset composition of commercial banks or how
commercial banks allocate their funds to various uses
reflects how banks operate. In general, the proportion
of individual loans and government securities is larger
in small banks, whereas the proportion of corporate
loans is larger for large banks.
The main category of assets commercial banks
hold is loans. Loans extended to businesses are
called corporate or commercial loans. Banks may
sometimes require businesses to pledge some assets
as a collateral to secure the loan, so that they can be
seized in the event of repayment failure. However,
some loans granted to businesses with high
creditworthiness are uncollateralized. Banks often
extend a line of credit to businesses so that they
can borrow up to a limit. A line of credit (LOC)
is an arrangement between a financial institution,
usually a bank, and a customer that establishes
the maximum amount a customer can borrow.
Businesses may use this line of credit in the form of
revolving credits or spot credits.
Revolving credits are widely used by businesses
to finance their short-term working capital needs.
These credits are self-liquidating working capital
loans, which can be withdrawn and repaid at
different points of time within a certain limit.
Hence, the balance of the loan fluctuates over time
and interest rate applied to the loan may vary over
time due to changing market conditions. Interest
accumulates based on the fluctuating balance of
the loan and is paid at the end of every quarter (end
of March, June, September, December). Another
common type of loan made by commercial banks
are spot credits or term loans, which are offered
for a specific amount for a specific time charging
a fixed interest. Term loans are generally used for a
specific purpose like purchase of machinery.
Banks also make loans to individuals in the
form of consumer loans. Consumer loans are
granted to finance purchase of autos, houses, home
improvements, household appliances or durable
consumer goods. Most of these loans are installment
credits. Those credits require borrowers to repay
the principal and the interest of the loan in equal
periodic (monthly, quarterly etc.) installments over
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Commercial Banking
a certain period of time, typically spanning over 1
to 5 years. Interest rates are usually determined as
fixed in the credit agreement, though sometimes
the interest rates can be variable.
Loans include commercial loans, consumer
loans and short-term loans extended in the
interbank market or loans extended through
repurchase agreements.
important
Loans granted by commercial banks to
businesses and individuals constitute the
most significant portion of commercial
banks’ assets.
Another instrument through which banks
provide credit to consumers is credit cards. Banks
designate a certain limit to qualifying customers to
allow them use the credit card to make purchases
within that limit and pay the credit card debt
balance each month at a specific date without
interest if customers pay all the balance on time.
Banks also offer loans in the interbank
market. The funds lent are returned with interest
at the maturity of the loan. Repurchase agreements
(repos) are another way of providing short term
loans. Banks purchase Treasury securities to sell
them back at a later date by the repo agreement.
The bank provides short-term financing to the
customers and the securities of the customer
provides security for the funds lent by the bank
through the repo transaction.
Another category of assets includes investments
in securities such as government bonds and
Treasury bills. Banks own some assets in cash as
a medium of Exchange in daily operations. Banks
hold some vault cash at their offices to meet
withdrawal demands. They also maintain some
reserve deposits with the Central Bank as well as
deposits with other commercial banks which are
called correspondent balances. Last but not the
least, banks maintain some fixed assets like land
and buildings to carry out their operations.
 5
Financial Markets & Institutions

Commercial banks grant loans to households and businesses. Loans granted to businesses are called
commercial loans or industrial loans, while loans granted to households to finance automobile, furniture
or consumer goods are called consumer loans. Commercial banks also grant real estate loans which are
backed with real estate as collateral. Real estate loans granted to purchase homes are classified as residential
mortgages. Real estate loans granted to purchase stores, offices, factories etc. are classified as commercial
mortgages.
important

The difference between the average interest Commercial banks attempt to diminish their
rate banks receive on their assets and the risks by diversifying their loans and other
average interest rate they pay on their investments to avoid an unexpected loan
liabilities is called the bank’s spread. default from sinking the entire bank.

Learning Outcomes

2 Identify the sources of funds and uses of funds for commercial banks

Self Review 2 Relate Tell/Share

Where can you find

How does the spread affect Tell the difference between
information about the main
the profitability of commercial commercial loans and
sources of funds and uses of
banks? corporate loans.
funds of a commercial bank?

REVENUES AND EXPENSES OF COMMERCIAL BANKS

A commercial bank can earn profit if its revenues exceed its expenses. The main sources of revenue in
the form of interest revenue, commissions and fees for a commercial bank are as follows:
• Granting loans
• Investing in marketable securities
• Providing credit cards and debit cards
• Servicing deposit accounts
• Providing financial advice
• Providing wealth management services
• Carrying out foreign exchange
The expenses of a commercial bank in the form of interest expense and costs arise mainly from the
following:
• Collecting deposits
• Borrowings
• Providing financial services

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Commercial Banking

Commercial banks earn interest income on the loans they grant and the securities they invest in.
In general, Interest income has the largest share as a source of revenues for commercial banks. Some
revenues that commercial banks generate stem from the charges for services provided by the bank, such as
commissions, service fees or trading profits. These revenues constitute noninterest income. Non-interest
income is generated by services like trading derivative instruments (futures, options, swaps etc.), printing
checks, clearing checks, transferring funds, electronic fund transfer (EFT) services providing ATM
(automated teller machine) services, depositing money.

important

In recent years, non-interest income has

Loan principal payments are not sources
become a significant source of revenue, as
of revenue, while the interest payments
interest rates have declined and competition
on the principle are sources of revenue for
has become tougher.
commercial banks.

Commercial banks incur interest expense as they pay interest to the deposit holders. Interest expense
constitutes the largest proportion of expenses for commercial banks.
Besides interest expense, another significant cost item for commercial banks are the expenses for loss
provisions. In case some proportion of loans are not repaid, commercial banks hold a certain proportion of
their assets in liquid assets, which are referred to as loan
important
loss reserves. These reserves are depleted, as some of the
loans default. Therefore, some additional funds must be
allocated to these reserves. These additions to the loan loss In recent years, commercial banks have been
reserves are an expense for commercial banks, which are cutting their expenditures on real resources
called provisions for loan loss reserves. by reducing human resources as the industry
Commercial banks also bear operating expenses has become more digitalized. (Please refer to
for real resources such as labor, capital, land to provide “Further Reading”)
banking services.
The profit of a commercial bank is the difference between the total income (the interest income and
non-interest income) and the total costs (interest expense, loan loss provisions and operating expenses).

Profit = Total Revenues –Total Expenses

Learning Outcomes

3 Identify revenues and expenses of commercial banks

Self Review 3 Relate Tell/Share

Which income items are Discuss how commercial

Tell how commercial banks
classified as non-interest banks can improve their
generate revenues.
income of a commercial bank? profitability.

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Financial Markets & Institutions
RISK MANAGEMENT IN
COMMERCIAL BANKING
Commercial banks aim to raise shareholders’
wealth by enhancing profitability in order to
meet the expectations of their shareholders, just
like other businesses. For this aim, they struggle
to increase operational efficiency in the short run
and optimize risk-adjusted profitability in the
long run. Therefore, commercial banks need to
ensure that they establish and operate effective risk
measurement and management systems in order to
assess and mitigate the risks they are exposed to.
Risk can be defined as the potential of loss
resulting from uncertainty. For commercial
banks, risk denotes negative consequences due to
uncertainty of outcomes, which may influence
the bank adversely. The uncertainty cannot be
removed, but the exposure to uncertainty can be
changed.
Risk management in commercial banking
necessitates that the risks are identified,
assessed and controlled.
Effective risk management is vital for
commercial banks to strengthen their profitability,
to ensure solvency and guarantee survival. Risk
management in commercial banks involve the
following processes:
• Identification of risks
• Measurement of risks
• Pricing of risks
• Control of risks
The necessary mechanisms and rules to carry
out these processes should be determined clearly
and shared within the organization to ensure they
are well understood and committed by managers
and employees.
An integrated risk management framework
to mitigate individual and overall risks can help
quantify and allocate the optimal capital and
enhance the value creation strategy of the bank.
5
important
Top managers should participate in the
definition of objectives and procedures of the
risk management system.
The most important types of risks, which
commercial banks face, can be classified as follows:
• Interest rate risk, which arises from the
different maturity structure of the banks’
assets and liabilities.
• Liquidity risk, which is the risk that a bank
may not be able to meet its cash needs by
selling assets or raising funds at a reasonable
cost.
• Credit risk, which is the risk of changes
in the economic value of the bank’s
assets due to unexpected changes in the
creditworthiness of counterparties.
• Operational risk, which includes the
risk of damages caused by human and
technological factors
Interest rate Liquidity
risk risk
Types of Risks
in
Commercial
Banking
Credit Operational
Risk Risk
Interest Rate Risk
Usually, banks finance their assets such as loans
or bonds by deposits or issuing other liabilities,
the maturity of which is shorter than those assets.
The imbalance between maturities of assets and
liabilities leads to exposure to the interest rate risk.
Interest rate risk stems from changes in market
interest rates. Fluctuations in market interest rates
influence the profitability of banks.
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Interest rate risk is connected with the positions
in the bank’s assets and liabilities portfolio. This risk
can be measured by considering the following items:
• Interest-earning financial instruments
• Interest-bearing financial instruments
• Contracts on both sides of the balance sheet
• Derivatives whose value depends on market
interest rates
Principles on estimating interest rate risk on
the banking book are established by the Basel
Committee (an advisory body whose members are
representatives of banking supervisory authorities
from major industrialized countries). According
to these principles, banks must hold capital
commensurate with the level of interest rate risk
they undertake.
Commercial banks use the Gap analysis and
Duration analysis to measure interest rate risk.
Changes in market interest rates affect only interest
rate-sensitive assets and liabilities. The main logic
behind these concepts is the fact that interest-
earning assets and interest-bearing liabilities exhibit
different sensitivities to changes in market rates.
The Gap over a given time period (gapping
period) is defined as the difference between the
amount of interest rate sensitive assets and interest
rate sensitive liabilities.
important
Changes in market interest rates may also
influence the capital of commercial banks
as well as the profits of the banks. Duration
analysis measures the sensitivity of the bank’s
capital to changes in market interest rates.
Duration gap is the difference between the
average duration of the assets and the average
duration of the liabilities of a commercial bank.
A positive duration gap implies that the duration
of the assets is greater than the duration of
liabilities. Thus, an increase in the market interest
rates will cause a greater decrease in the value of
assets compared to liabilities and consequently the
equity of the bank will decrease. On the contrary, a
decrease in the market interest rates will lead to an
increase in the equity of the bank.
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Commercial Banking
important
In general, falling market interest rates
implies increases in profits and net worth
of commercial banks, whereas rising interest
rates implies decreases in profits and net
worth of commercial banks.
In order to diminish interest rate risk,
commercial banks with negative gaps may attempt
to make more floating rate loans rather than fixed
rate loans. They may also use interest rate swaps
to exchange payments from a fixed rate loan to
a floating rate loan. Moreover, they may utilize
derivatives such as futures and option contracts to
hedge interest rate risk.
A hedge is an investment position intended
to offset potential losses that may be incurred
by a companion investment. A hedge can be
constructed from many types of financial
instruments, including derivatives.
Liquidity Risk
Liquidity risk is the inability of the bank to
meet its financial obligations when they become
due. A commercial bank may be unable to meet
short-term financial demands, if it experiences
sudden unexpected cash outflows due to large
deposit withdrawals, large credit disbursements,
or unexpected market movements. During the
2008 financial crisis, many big banks in the United
States of America failed or faced insolvency issues
because of liquidity problems.
important
Illiquidity of commercial banks may lead to
reputation risk. Thus, bank managers must
ensure that the bank maintains sufficient
liquidity.
 5
Financial Markets & Institutions

Credit Risk
Credit risk is the risk that borrowers may default on their loans. Credit risk arises because of asymmetric
information problems mentioned before. Because commercial banks know less than the borrowers about
their financial health, commercial banks may extend loans to risky borrowers (adverse selection). Likewise,
borrowers may use the loans for purposes not intended by commercial banks (moral hazard).
The common process for controlling risks is based on risk limits and risk delegations. Limits impose
upper bounds to the potential loss of transactions, or of portfolios of transactions. Delegations serve for
decentralizing the risk decisions, within limits.

“Credit approval processes vary across banks and across types of transaction. In retail banking, credit
scoring mechanisms and delegations are used. In normal circumstances, the credit officer in charge of the
clients of a branch is authorized to make decisions as long as they comply with the guidelines. For large
transactions, the process involves credit committees. The committee makes a yes/no decision, or might
issue recommendations for altering the proposed transaction until it complies with risk standards.”
Joël Bessis

Commercial banks may utilize various methods to manage credit risk including diversification, commercial
credit analysis, collaterals, monitoring, restrictive covenants and establishing long-term relationships.

important

Relationship banking is a strategy used by Banks that do not differentiate risks of

banks to strengthen loyalty of customers and their customers would suffer from adverse
provide a single point of service for a range of selection. Overpricing good risks would
products and services. discourage good customers. Underpricing
bad risks would attract bad customers.

Operational Risk
Within the scope of operational
risk, damages and losses may arise
mainly due to the following reasons:
• Infidelity of human resources
• IT crashes
• Human errors
• Software breakdowns
• Fraud
• Electronic theft
• Adverse natural events
• Robberies
• Inadequacy of the procedures, control systems and organizational procedures

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Commercial Banking

Further Reading

Turkey’s banking sector expected to display strong performance in 2020

https://www.dailysabah.com/finance/2019/12/16/turkeys-banking-sector-expected-to-display-
strong-performance-in-2020
Turkey’s banking sector is signaling a strong future performance for 2020 after weathering a
challenging period in 2018-2019 with success, according to KPMG’s report Monday. The sector is
expected to spearhead economic recovery due to its open channels to international financial sources and
to show better performance compared to the other industries, according to KPMG’s Sectoral Overview
2020 Banking report.
KPMG’s Financial Services Sector Leader Kerem Vardar said that Turkish banks have moved to a
better position in 2019 in terms of having better access to foreign financial assets. “After overcoming
the 2018-2019 period successfully, the banking sector’s 2020 focus will now be on preserving its asset
quality,” Vardar said, adding that the economic activity by various sectors renewed after the turbulent
period will make a significant contribution to the banking sector’s profitability. Vardar underlined
that it was natural for the banking sector to be the first industry to reflect the overall recovery in the
economy, which performed better than expectations despite the international pressure over Turkey’s
Operation Peace Spring in Syria, domestic political tensions and expectations over a contraction in the
economy. Having remained under the pressure of internal and external uncertainties throughout the
year, the sector kept its asset size at the same level as of the end of the 3rd quarter of 2019 with total
assets of the sector reaching TL 4.27 trillion.
Despite the growing assets, profitability failed to show a similar positive performance. The banking
sector recorded a profit of TL 36 billion in the first three quarters of 2019, a 13% decline compared
to the same period the previous year. Banks’ inability to increase interest margins due to the maturity
mismatch played a significant role in the decline in profits, KPMG reported. However, the report
forecasted a 15% increase in net profits thanks to productivity increases and effective cost management
in the sector but warned that net interest margins will be limited due to uncertainties over the inflation
outlook. KPMG said the banking sector’s strengths were its diverse and reliable foreign capital sources,
asset quality, high liquidity as well as strong corporate and technological capabilities, which successfully
managed past crises and adapted to new developments. “Despite the high level of liquidity, maturing
external debt payments pose certain threats to the sector,” the report warned. Turkey’s proximity to
conflict areas in the region and the internal economic dynamics’ increased sensitivity to external threats
were cited as potential threats to the banking sector in 2020.
Digital transformation remains to be at the top of the sector’s agenda as many of the Turkish banks
have become “digital champions,” leading the adoption of digital technologies. The report said that the
banks continue to allocate a significant portion of their investment expenditures and budgets to improve
their digital platforms. “The current performance shows the magnitude of the Turkish banking sector’s
appetite for digitalization and that the growth will not slow down in the short term,” it added. According
to KPMG, Turkish banks should not only see digitalization as “enhanced internet banking” but should
consider automating their internal operations and therefore, optimizing their operational expenses.

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Financial Markets & Institutions

In Practice

https://corporatefinanceinstitute.com/resources/knowledge/credit/commercial-credit-analysis/
The 5 C’s of Commercial Credit Analysis
The 5 C’s of credit analysis is a basic framework that guides the lender in assessing the creditworthiness
of a borrower. The 5 C’s are as follows:
1. Character
Character is an important element of credit analysis, and it looks at the borrower’s reputation
for paying debts. The lender is interested in lending to people who are responsible and needs to be
confident that they have the right experience, education background, and industry knowledge to
operate the business.
In addition, the lender assesses the borrower’s character by looking at their credentials, reputation,
interaction with other people, as well as credit history. It will review the borrower’s credit report to know
how much they have borrowed in the past, and whether they paid the credit on time. Most lenders
have a base credit score that loan applicants must meet in order to qualify for a specific type of credit.
2. Capacity
Capacity evaluates the borrower’s ability to service the loan using the cash flows generated by the
business. The lender wants the assurance that the business generates enough cash flows to able able to
make principal and interest payments in full.
The lender will assess the capacity of the borrower by looking at their cash flows statements, credit
scores, as well as the payment history of current loans and expenses. It will calculate how repayments
are supposed to take place, the timing of repayments, current cash flows, and the probability that the
borrower will make successful repayments.
3. Capital
Capital is the amount of money that the business owner or executive team has invested in the
business. Lenders are willing to extend credit to borrowers who have invested their own money into the
business, which serves as proof of the borrower’s commitment to the business.
Borrowers with a large capital contribution in the business find it easier to get loan approval
because they present a lower risk of default. For example, when buying a home, a borrower who has
placed a down payment of about 20% of the value of the house can get better rates and terms for
the mortgage.
4. Collateral
Collateral is the security that the borrower provides as a guarantee for the loan, and it acts as a
backup in the event that the borrower defaults on the loan. Most often, the collateral provided for the
loan is the asset that the borrower is borrowing money to finance. For example, a home acts collateral
for mortgages, and auto loans are secured by vehicles. The collateral can also be inventory for the
business, real estate property, factory equipment, and working capital.

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Commercial Banking

5. Conditions
The condition of the loan refers to the purpose of the loan, as well as the conditions of the business.
The loan’s purpose can be to purchase factory equipment, finance real estate development, or serve as
working capital. Loans with a specific purpose are easier to approve than signature loans that can be
used for any purpose.
The lender also considers the condition of the environment in which the business operates. The
conditions can be the state of the economy, industry trends, competition, etc., and how these factors
may affect the borrower’s ability to repay the loan.

Learning Outcomes

4 Describe the main types of risks that commercial banks are exposed to

Self Review 4 Relate Tell/Share

How do changes in market

Which processes do Which methods may
interest rates influence
commercial banks use for commercial banks use to
profitability of commercial
credit approval? manage credit risks?
banks?

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Financial Markets & Institutions

Describe the main functions of commercial

LO 1 banks.

Commercial banks collect deposits from savers and make loans to borrowers. In this way, commercial
banks facilitate the transfer of funds from surplus units to deficit units. Facilitating transfer of funds
enhances efficiency. Commercial banks create money or credit against deposits through the money
multiplier and help to create more wealth in the economy.

Summary
Identify the sources of funds and uses of
LO 2 funds for commercial banks.

The primary source of funds for commercial banks are deposits, whereas the primary use of funds is loans.
Besides deposits, other liabilities or sources of funds for commercial banks include borrowings from other
financial institutions. Besides loans, other assets or uses of funds for commercial banks include required
reserves against deposits and excess reserves held in the Central Bank, currency in ATMs, deposits with
other banks and assets invested in marketable securities such as government bonds, corporate bonds and
asset backed securities.

Identify revenues and expenses of

LO 3 commercial banks.

Commercial banks earn interest income on the loans they grant and the securities they invest in. In
general, Interest income has the largest share as a source of revenues for commercial banks. Some
revenues that commercial banks generate stem from the charges for services provided by the bank, such
as commissions, service fees or trading profits. These revenues constitute noninterest income. Interest
expense constitutes the largest proportion of expenses for commercial banks. Commercial banks incur
interest expense as they pay interest to the deposit holders. Besides interest expense, another significant
cost item for commercial banks are the expenses for loss provisions. Commercial banks also bear operating
expenses for real resources such as labor, capital, land to provide banking services.

Describe the main types of risks that

LO 4 commercial banks are exposed to.

The most important types of risks, which commercial banks face, can be classified as follows:
• Interest rate risk, which arises from the different maturity structure of the banks’ assets and liabilities.
• Liquidity risk, which is the risk that a bank may not be able to meet its cash needs by selling assets or
raising funds at a reasonable cost.
• Credit risk, which is the risk of changes in the economic value of the bank’s assets due to unexpected
changes in the creditworthiness of counterparties.
• Operational risk, which includes the risk of damages caused by human and technological factors.

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Commercial Banking

1 Which one of the following is a revenue item 6 The difference between the amount of
for commercial banks? interest rate sensitive assets and interest rate
A. Loan principal repayments sensitive liabilities shows the ………….. of the
commercial bank.
B. Loan loss provisions
Test Yourself

C. Depreciation expense A. duration B. convexity

D. Labor cost C. gap D. maturity
E. Fees E. profit

2 Which one of the following is an expense 7 What is the difference between the average
item for commercial banks? interest rate banks receive on their assets and the
average interest rate they pay on their liabilities?
A. Interest on deposits
B. Interest income A. Gap B. Spread
C. Trading income C. Duration D. Convexity
D. Credit card commissions E. Profit
E. EFT fees
8 What is the difference between the total
3 Which one of the following is a source of income (the interest income and non-interest
funds for commercial banks? income) and the total costs (interest expense,
loan loss provisions and operating expenses) of a
B. Land commercial bank?
C. Deposits
A. Gap
D. Loans
B. Spread
E. Building
C. Duration
D. Convexity
4 Which one of the following is a use of funds E. Profit
for commercial banks?
A. Borrowings in the interbank market 9 Which one of the following is a measure of
B. Deposits the sensitivity of the bank’s capital to changes in
C. Loans market interest rates?
D. Equity A. Gap
E. Interest income B. Spread
C. Duration
5 The imbalance between maturities of assets D. Convexity
and liabilities leads to……. E. Profit
A. liquidity risk
B. interest rate risk 10 The risk that borrowers may use the loans
C. market risk for purposes not intended by commercial banks is
D. credit risk associated with ……………
E. operational risk A. liquidity risk
B. interest rate risk
C. market risk
D. credit risk
E. operational risk

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Financial Markets & Institutions

If your answer is wrong, please review the If your answer is wrong, please review
1. E 6. C
“Revenues and Expenses of Commercial the “Risk Management in Commercial
Banks” section. Banking” section.

Answer Key for “Test Yourself”

If your answer is wrong, please review the If your answer is wrong, please review the
2. A 7. B
“Revenues and Expenses of Commercial “Sources of Funds and Uses of Funds in
Banks” section. Commercial Banking” section.

If your answer is wrong, please review the If your answer is wrong, please review the
3. C 8. E
“Sources of Funds and Uses of Funds in “Revenues and Expenses of Commercial
Commercial Banking” section. Banks” section.

If your answer is wrong, please review the If your answer is wrong, please review
4. C 9. C
“Sources of Funds and Uses of Funds in the “Risk Management in Commercial
Commercial Banking” section. Banking” section.

If your answer is wrong, please review If your answer is wrong, please review
5. B the “Risk Management in Commercial
10. D
the “Risk Management in Commercial
Banking” section. Banking” section.

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Commercial Banking

How do commercial banks reduce asymmetric

information problems?
Suggested answers for “Self Review”

Commercial banks reduce those asymmetric information problems and

save lenders from incurring these costs by specializing in assessing potential
borrowers and monitoring loans. By pooling savings together in mutual
self review 1 funds or pension funds and spreading the management costs across a great
number of savers, financial intermediaries may permit savers to benefit from
economies of scale by reducing the average cost of managing those funds.

Where can you find information about the composition

of sources of funds and uses of funds of a commercial
bank?

The liabilities and the capital of a commercial bank constitute its sources
of funds, while the assets of a commercial bank constitute its uses of funds.
self review 2 Hence, you can find information about the composition of sources of funds
and uses of funds of a commercial bank in the liabilities and equity and assets
side of the balance sheet of the bank.

Which income items are classified as non-interest income

of a commercial bank?

Non-interest income is generated by services like trading derivative

self review 3 instruments (futures, options, swaps etc.), printing checks, clearing checks,
transferring funds, electronic fund transfer (EFT) services providing ATM
(automated teller machine) services, depositing money.

Which processes do commercial banks use for credit

approval?

In retail banking, credit scoring mechanisms and delegations are used. In

normal circumstances, the credit officer in charge of the clients of a branch
is authorized to make decisions as long as they comply with the guidelines.
self review 4 For large transactions, the process involves credit committees. The committee
makes a yes/no decision, or might issue recommendations for altering the
proposed transaction until it complies with risk standards.

126
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Financial Markets & Institutions

References
Bessis, J. (2015). Risk Management in Banking, Wiley. Mishkin, F. S. and Eakins, S. G. (2012). Financial
Markets and Institutions, Pearson.
Hubbard, R. G. and O’Brien A. P. (2014). Money,
Banking and the Financial System, Pearson. Sironi, A. and Resti A. (2007). Risk Management
and Shareholders’ Value in Banking, From Risk
Lipscombe, G. and Pond K.(2002). The Business of
Measurement Models to Capital Allocation Policies,
Banking, Financial World Publishing.
Wiley.
Miller R. L. and VanHoose D. D. (1997). Money,
Banking, and Financial Markets, Southwestern
College.

Internet References
https://www.dailysabah.com/finance/2019/12/16/turkeys-banking-sector-expected-to-display-strong-
performance-in-2020 (accessed on 28/01/2020)
https://corporatefinanceinstitute.com/resources/knowledge/credit/commercial-credit-analysis/ (accessed on
28/01/2020)
http://www.bankingforsociety.be/bank-balance-sheet (accessed on 28/01/2020)

127
 Chapter 6 Investment Banking
After completing this chapter, you will be able to:
Learning Outcomes

1 Identify the main functions of investment banks 2 Explain the roles of investment banks in
bringing new securities to market

3 Explain the roles of investment banks in

Mergers and Acquisitions 4 Explain the roles of investment banks in
advising corporations

Chapter Outline Key Terms

Introduction Investment
Overview of Investment Banking Banking
Underwriting
Bringing New Securities to the Market
Mergers and Acquisitions
Deal Making in Mergers and Acquisitions Advising
Advising Corporations

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Financial Markets & Institutions
INTRODUCTION
Financial intermediaries, an important part
of the financial system, have evolved with the
purpose of lowering transaction costs and allowing
small savers and borrowers to benefit from the
financial markets. One solution to the problem
of high transaction costs provided by financial
intermediaries is to pool the funds of many
investors together so that they can take advantage
of economies of scale, which is the reduction in
transaction costs per dollar of investment as the size
of transactions increases. The presence of economies
of scale in financial markets helps to explain why
financial intermediaries have developed and have
become such an important part of our financial
system.
Financial intermediaries are also better in
developing expertise to reduce transaction costs.
A financial intermediary becomes an expert in
producing information about firms to deal with
asymmetric information and adverse selection
problems, so that it can sort out good credit risks
from bad ones. Then it can acquire funds from
depositors and lend them to the good firms.
Because the financial intermediary is able to lend
mostly to good firms, it is able to earn a higher
return on its loans than the interest it has to pay
to its depositors. The profit that the financial
intermediaries earn gives them the incentive to
engage in this information production activity.
The financial intermediary’s role as an intermediary
that holds mostly non-traded loans is the key to
its success in reducing asymmetric information
in financial markets. These are the most crucial
aspects of investment banking firms as a financial
intermediary in the financial system (Mishkin &
Eakins, 2018, pp. 179-185).
There are two fundamental ways that new
financial claims can be brought to the market:
direct or indirect financing. In the indirect credit
market, commercial banks are the most important
participants; in the direct market, investment
banks are the most important participants.
Investment banks are firms that specialize in
assisting businesses and governments sell their
new security issues (debt or equity) in the primary
markets to finance capital needs (Kidwell et al.,
2016, p. 579).
6
To raise money, corporations usually use the
services of investment banks, whose main job is
marketing securities and dealing with the securities
markets. Investment bankers act as intermediaries
between corporations or governments and the
general public when corporations or governments
want to raise capital (Melicher & Norton, 2017,
p. 299).
OVERVIEW OF INVESTMENT
BANKING
A generation ago, we had merchant banks
operating in a few developed countries, now they
have been renamed as investment banks following
the US nomenclature. In modern usage merchant
banking is occasionally used for the subset of
investment banking businesses concerned with
using the bank’s capital to facilitate a transaction
such as engaging in mergers and acquisitions
(Arnold, 2012, p. 81).
Investment banking changed dramatically
during the two decades prior to the global financial
crisis that started during mid-2007, when market
forces pushed banks from their traditional low risk
role of advising and intermediating to a position
of taking significant risk for their own account
and on behalf of their customers. This high level
of risk-taking, combined with high financial
leverage, transformed the field during 2008, when
several major banks failed, huge trading losses
were recorded and all large firms were forced to
reorganize their activities.
Risk-taking activities of investment-banking
firms reduced following large losses that stemmed
mainly from mortgage-related assets, bad loans,
and an overall reduction in revenues due to the
financial catastrophes. This led to an industry wide
effort to reduce leverage ratios and a string of new
equity capital issuances.
By the end of 2008, five US based “pure-
play” investment banks (which did not operate
deposit-taking businesses, unlike large “universal”
banks such as JP Morgan Chase, which operated a
large investment bank, a deposit-taking business,
and other businesses) had undergone significant
transformations. Goldman Sachs and Morgan
Stanley turned into bank-holding companies; the
129
6
US Federal Reserve (Fed) forced Bear Stearns into
the arms of JP Morgan to avoid a bankruptcy;
Lehman Brothers filed for bankruptcy protection
after the Fed and Treasury Department ignored
its requests for government support; and Merrill
Lynch, presumably to avoid a similar bankruptcy
filing, agreed to sell their firm to Bank of America at
a significant discount to historical prices (Stowell,
2017, pp. 3-4).
Investment-banking firms are best known as
intermediaries that help corporations raise funds.
However, this definition is too narrow to accurately
explain the many valuable and complicated services
these firms provide (Howells & Bain, 2007, pp.
65-66). Despite its name, an investment bank is
not a bank in the ordinary sense; that means, it is
not a financial intermediary that takes in deposits
and then lends them out, but in countries where
there is no legislation commercial banks provide
investment banking services as part of their daily
range of business activities. Countries where
investment banking and commercial banking are
combined have what is called a universal-banking
system. Universal banks are allowed in most
European countries (Kidwell et al., 2016, p. 580).
Universal banks are institutions that are
allowed to accept deposits, make loans,
underwrite securities, engage in brokerage
activities, and sell and manufacture many
other financial services such as insurance.
Investment-banking firms are mostly involved in
security market operations. They employ ‘analysts’
whose job is to study corporate movements and
identify corporations as over or under-valued, or as
high-growth and low-growth, high-risk and low-
risk, etc. The results of the research are served to
clients who are often managers of mutual funds.
Sometimes investment-banking firms act
as ‘market makers’ in equity or bond markets.
Because of this field expertise, they usually handle
the issue of new securities on behalf of companies
that want to become limited companies for the
first time or that want to raise additional capital for
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Investment Banking
expansion. Their most high-profile activity, which
does occasionally bring them into the eyes of the
public, involves their negotiating on behalf of
clients during mergers and acquisitions or ‘M&As’
(Howells & Bain, 2007, pp. 65-66).
Investment-banking firms and their role in the
financial system is very important. For example,
executives go to investment-banking firms when
contemplating a once-in-a-career business move,
such as buying another firm. They do not have the
knowledge and skill set themselves to be able to
cope with the regulations, the raising of finance or
the tactics to be employed, so they apply to the
specialists at the bank who regularly undertake
these tasks for client companies.
Another area where executives need specialist
assistance is in raising money by selling bonds or
stocks. Total raised capital can be in the tens or
hundreds of millions, and all the details have to
be right if investors are to be convinced and the
regulators satisfied.
Investment banking firms also assist companies
in managing their risks. For example, they may
advise a farming company on the use of derivatives
to reduce the risk of commodity prices moving
adversely, or interest rates, or currency rates.
(Arnold, 2012, p. 76).
One characteristic of investment banking firms
that distinguishes them from brokers and dealers
is that they usually earn their income from fees
charged to clients rather than from commissions
on stock trades. These fees are usually set as a fixed
percentage of the dollar size of the deal being
made. Because the deals mostly involve huge
amounts of money, the fees can be sizable. The
percentage fee mostly is smaller for large deals,
from neighborhoods of 3%, and much larger for
smaller deals, to the sometimes exceeding 10%
(Mishkin & Eakins, 2018, p. 571).
In conclusion, investment-banking firms have
three distinctive primary market functions in
financial structure and these are as follows:
• bringing new securities to market,
• deal making in the mergers and
acquisitions,
• advising corporations.
 6
Financial Markets & Institutions

Bringing new Deal making Advising

securities to n M&As corporations
market

Learning Outcomes

1 Identify the main functions of investment banks.

Self Review 1 Relate Tell/Share

Associate the level of Tell the difference between

What are the main functions/
financial development of a brokers or dealers and
roles of investment banks in
country and functions of investment banks in terms
financial markets?
investment banks. of their revenues.

BRINGING NEW SECURITIES TO THE MARKET

The main business of investment banking is raising debt and equity financing for corporations or
governments. This involves originating the securities, underwriting them, and then placing them with
investors. When a corporation has an intention to borrow or raise funds, it may decide to issue long-term
debt or equity instruments. It then generally gives the job to an investment banking firm to make the
issuance easier and subsequent sale of the securities.

Preparation for Public Offerings

Investment banking firms occasionally engage in originating securities. As an originator, the
investment bank tries to identify corporations that may benefit from a security sale. Once an agreement
is reached between an investment bank and an issuer, the investment bank makes a detailed study (called
due diligence) of the corporation (Melicher & Norton, 2017, p. 300). This means that they are required
to diligently search out and disclose all relevant information about an issuer before securities are sold to
the public, or the underwriter can be held responsible for investor losses that occur after the issue is sold
(Kidwell et al., 2016, p. 587). The investment bank uses this information to determine the best means of
raising the needed funds.

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6
The investment-banking firm recommends
the types, terms, and offering price of securities
that should be sold. It helps the corporation in
preparing the registration and informational
materials required by the regulator (Melicher &
Norton, 2017, p. 300).
For bond issues, in order to reduce the cost of
borrowing for their clients, investment banking
firms also design securities with aspects that were
more attractive to investors but not inconvenient
to issuers. They also design security structures for
low-quality bond issues, so-called high-yield or
junk bond structures.
The investment bank is obviously taking a huge
risk at this point. One way that helps it to reduce
the risk is by forming a syndicate. Then each firm
in the syndicate is responsible for reselling its share
of the securities.
A syndicate is a group of investment banking
firms, each of which buys a portion of the
security issue.
important
Most securities issues are sold by syndicates
because it is such a powerful way to reduce
the risk by spreading it among many firms.
Investment banking firms advertise upcoming
securities offerings with ads called tombstones
in business journals. One major and carefully
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Investment Banking
regulated piece of information is the prospectus,
which shows the issuer’s detailed finances and must
be provided to each buyer of the security (Mishkin
& Eakins, 2018, p. 274).
The prospectus acts as a marketing tool as
the firm tries to persuade investors to apply
for shares.
important
By law, investors must be presented with a
prospectus before they can invest in a new
security.
The information in the prospectus allows
investors to make intelligent decisions about the
proposed project and its risk. This may include far
more information about the corporation than it
has previously dared to put into the public domain.
The content and accuracy of this highly important
document are the responsibility of the directors not
the regulators. Regulators’ approval implies only
that the information presented is timely and fair
(Arnold, 2012, p. 380).
Types of Offerings
The most important types of offering in the sale
of new securities can be classified as initial public
offering or unseasoned offering, secondary
common stock offering or seasoned offering,
and bond offering.
An initial public offering (IPO) or unseasoned
offering is a common stock offering issued by
corporations that had not previously issued
common stock to the public. A secondary common
stock offering or seasoned offering is an offering of
common stock that had been issued in the past by
the corporation (Fabozzi et al., 2014, pp. 274-275).
One of the problems investment banking firms
face with IPOs is how to price them, since they are
securities that have never been traded. In secondary
common stock offerings, there is no prior market
price on which to base the offering price. The price
for which a security is sold is important to the
issuer because the higher the price means the more
 6
Financial Markets & Institutions

money the company gets. If the security is priced too high, there may not be sufficient demand for the
security as expected, and the offering may be canceled or the investment-banking firm may not be able to
sell the issue at the desired offering price. In this case, the investment banking firm suffers a loss (Kidwell
et al., 2016, p. 587).
The reputation of the investment-banking firm is at stake when it attempts to place the stock of the
issuing firm. It is obvious that other corporations that may issue stock in the future will monitor closely its
ability to place the stock (Madura, 2015, p. 642). Because of the risk related to pricing and then selling an
IPO to investors, the gross spread is higher than for a secondary common stock offering. For traditional
bond offerings, the gross spread mostly is even lower than for a secondary common stock offering (Fabozzi
et al., 2014, pp. 274-275).

Public Offerings Practices

There are several different types of arrangement between the investment banking firm and the
corporation in security offerings. Sometimes the financing takes the form of a private placement in which
the securities are sold to a tiny number of large institutional investors, such as life insurance companies or
pension funds, and the investment-banking firm receives a fee. On other occasions, it takes the form of
a public offering, where securities are offered to the public. A public offering might be a best efforts or
firm commitment practice:
In the case of a best efforts public offering, the investment-banking firm does the best it can do to place
the securities with investors and is paid a fee that depends, to some extent, on its success.
In the case of a firm commitment public offering, the investment-banking firm agrees to buy the securities
from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price.
As shown in Figure 6.1., an investment banking firm makes a profit that is equal to the difference
between the price at which it sells the securities (offer price) and the price it pays (firm commitment price)
the issuer. This difference is called the gross spread, or the underwriter discount. If for any reason it is not
able to sell the securities, it ends up owning them itself (Hull, 2012, p. 32).

Securities Securities
Investment
Issuer Investors
Bank
Firm Commitment Offer Price
Price

Figure 6.1 Firm Commitment Practice.

Source: Melicher and Norton, 2017.

In the sale of new securities, the investment banking
firm does not need to undertake the function of buying the
securities from the issuer. An investment-banking firm may
only act as an advisor and/or distributor of the new security.
In the firm commitment practice, the function of buying
the securities from the issuer is called underwriting.
When an investment-banking firm buys the
securities from the issuer and takes the risk
of selling the securities to investors at a lower
price, it is referred to as an underwriter.
important
When the investment-banking firm agrees to
buy the securities from the issuer at a set price,
the underwriting arrangement is referred to
as a firm commitment. In contrast, in a best
efforts practice, the investment-banking
firm agrees only to use its expertise to sell the
securities—it does not buy the entire issue
from the issuer.

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Investment Banking

The fee earned from underwriting a security is the difference between the price paid to the issuer and
the price at which the investment-banking firm reoffers the security to the public. This difference is called
the gross spread, or the underwriter discount. Numerous factors affect the size of the gross spread. Two
major factors are the type of security and the size of the offering (Fabozzi et al., 2014, pp. 277-280).
There is also a phenomenon known as underpricing.
Stocks are typically sold to investors at an offering price that important
is, on average, about 15 percent below the closing price of
the stocks after the very first day of trading. This implies The returns to investors who buy the stocks
that underwriters deliberately (and consistently) sell stocks shortly after the IPO are generally poor.
to investors for merely six-sevenths of their value. (Kidwell
et al., 2016, p. 587).
In a private placement, securities are sold to a limited
number of investors rather than to the public as a whole.
The buyers of private placements must be large enough to Private placements are more common for
purchase large amounts of securities at once. This means the sale of bonds than for stocks.
that the usual buyers are mutual funds, commercial banks,
pension funds, and insurance companies. (Mishkin &
Eakins, 2018, pp. 575-576).
Investment banking firms assist in the private placement of securities in several ways. They work with
the issuer and potential investors on the design and pricing of the security. Often, it has been in the
private placement market that investment bankers first design new security structures. (Fabozzi et al.,
2014, pp. 277-280).
The process of taking a security public is summarized in the Figure below.

! decides to issue
Firm Investment bankers and firm agree
new securities on type and price of security

Firm prepares prospectus with Regulator reviews

investment bank help prospectus

Prospectus is distributed to
brokerage network

Regulator’s approval is received

Securities are bought by investment

bank and resold to public

Figure 6.2 Process of Taking a Security Public.

Source: Mishkin and Eakins, 2018.

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Financial Markets & Institutions
Variations in the Offering Process
Variations in the United States, the Euromarkets,
and foreign financial markets include the bought
deal for the underwriting of bonds, the auction
process for both bonds and stocks, and a rights
offering for underwriting common stock.
The structure of a bought deal is as follows:
• The lead manager or a group of managers
offers a potential issuer of debt securities
a certain bid to purchase a predetermined
amount of the securities with a fixed
interest (coupon) rate and maturity.
• The issuer is given a day or two (maybe
even only a few hours) to accept or reject
the bid. If the bid is accepted, that means
the underwriting firm has bought the deal.
Another variation for underwriting securities is
the auction process. The auction form is mandated
for certain securities of regulated public utilities
and many municipal debt obligations.
The auction process is commonly known as
competitive bidding underwriting.
As for a regular IPO, a prospectus is issued
and usually there is a road show. In this practice,
the issuer announces the terms of the issue, and
interested parties submit bids for the entire issue.
In a variant of the process, the bidders specify the
price they are willing to pay and the amount they
are willing to buy. Then the security is allocated
to bidders from the highest bid price (lowest yield
in the case of a bond) to the lower ones (higher
yield in the case of a bond) until the whole issue is
allocated (Fabozzi et al., 2014, pp. 277-280).
Auctions potentially overcome two of the
problems with a traditional IPO. First, the price
that clears the market should be the market
price if all potential investors have participated
in the bidding process. Second, the situations
where investment-banking firms offer IPOs only
to their favored clients are avoided. However,
the corporation does not take advantage of the
relationships that investment-banking firms have
developed with large investors that usually enable
the investment banking firms to sell an IPO very
quickly. One high-profile IPO that used an auction
was the Google IPO in 2004 (Hull, 2012, p. 34).
6
For the shares sold via a preemptive rights
offering, the underwriting services of an investment-
banking firm are not needed. However, the issuing
corporation may use the services of an investment-
banking firm for the distribution of common stock
that is not subscribed to. A standby underwriting
arrangement will be used in such instances. This
arrangement calls for the underwriter to buy the
unsubscribed shares. The issuing corporation pays
a standby fee to the investment banking firm
(Fabozzi et al., 2014, pp. 277-280).
The sales function of an investment bank
is divided into institutional sales and retail
sales. Retail sales involve selling the securities
to individual investors and companies that
purchase in small quantities.
Investment banking firms must also attempt to
satisfy the institutional investors that may invest in
the IPO. Investment banking firms recognize that
other institutional investors monitor stock prices
after offerings to determine whether the initial offer
price charged by the investment banking firms was
appropriate. If the institutional investors do not gain
reasonable returns on their investment, they may
not invest in future IPOs. Since investment-banking
firms rely on institutional investors when placing
shares of newly issued stock, they want to maintain a
good relationship with them (Madura, 2015, p. 642).
The higher the price institutional investors
pay for the stock being issued, the lower the
return they earn on their investment when
they sell the stock.
The investment banking firm’s primary concern
is to sell the securities as quickly as possible at the
offering price (Kidwell et al., 2016, p. 591).
important
The longer the investment-banking firm
holds the securities before reselling them to
the public, the greater the risk that a negative
price movement will cause losses.
135
6
Investment Banking

The aim in an IPO is to fully subscribe the issue. A fully subscribed issue is one where all of the
securities available for sale have been spoken for before the issue date. Issues of securities may also be
undersubscribed. That means the sales agents have not been able to generate enough interest in the security
among their clients to sell all of the securities by the issue date. An issue may also be oversubscribed, and
that means there are more offers to buy than there are securities available (Mishkin & Eakins, 2018, p. 274).

Learning Outcomes

2 Explain the roles of investment banks in bringing new securities to market.

Self Review 2 Relate Tell/Share

Which type of an IPO is

Tell the difference between
Why is pricing important riskier for the investment
a best efforts and a firm
for IPOs? bank, best efforts or a firm
commitment IPO.
commitment?

DEAL MAKING IN MERGERS AND ACQUISITIONS

Mergers and acquisitions are practices that fall under the investment banking segment. Beginning in the
1980s, mergers and acquisitions (M&as) became one of the most important and highly profitable business
activities for investment banking firms. Growth in the M&A business resulted from the large number of
firm consolidations driven by technology and the globalization of business (Kidwell et al., 2016, p. 591).
Firms with powerful M&A departments compete intensely for the highly profitable activity of corporate
mergers or acquisitions. Investment banking firms act on behalf of corporate clients in identifying firms
that may be suitable for merger. Large fees are charged for this service (Melicher & Norton, 2017, p. 312).
A merger happens when two businesses come together to form one new company. Both firms are
behind the merger, and corporate officers are usually selected so that both companies contribute to the
new management team. Shareholders turn in their share for share in the new firm.
In an acquisition, one firm acquires ownership of another firm by buying its shares. Often this process
is friendly, and the firms agree that certain economies and synergies can be captured by combining
resources. Sometimes, a firm suffering financial stress may even seek out a company to acquire them.
At other times, the firm being bought may resist. Resisted acquisitions are called hostile. In these cases,
the acquirer attempts to buy sufficient shares of the target corporation to gain a majority of the seats on
the board of directors. Then board members are able to vote to merge the target corporation with the
acquiring corporation.
Investment bankers serve both acquirers and target corporations. Acquiring corporations require help
in locating attractive corporations to pursue, soliciting stockholders to sell their stocks in a process called
a tender offer, and raising the required capital to complete the transaction. Target corporations may hire
investment bankers to help avoid undesired takeover attempts (Mishkin & Eakins, 2018, pp. 577-578).
Investment banking firms assist in finding merger partners, underwrite any new securities to be issued
by the merged corporations, assess the value of target corporations, recommend terms of the merger
agreement, and even assist target corporations in preventing a merger (for example, writing restrictive
provisions into a potential target firm’s securities contracts) (Cornett & Saunders, 2014, p. 504).
Investment banking firms may suggest steps their customers should take to avoid a merger or takeover.
These are known as poison pills. Examples of poison pills are (Hull, 2012, p. 36):

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Financial Markets & Institutions
1. A potential target adds to its charter a
provision where, if another company
acquires one third of the shares, other
shareholders have the right to sell their
shares to that company for twice the
recent average share price.
2. A potential target grants to its key
employees stock options that vest (i.e., can
be exercised) in the event of a takeover.
This is liable to create an exodus of key
employees immediately after a takeover,
leaving an empty shell for the new owner.
3. A potential target adds to its charter
provisions making it impossible for a new
owner to get rid of existing directors for
one or two years after an acquisition.
4. A potential target issues preferred shares
that automatically are converted to regular
shares when there is a change in control.
5. A potential target adds a provision where
existing shareholders have the right to
purchase shares at a discounted price
during or after a takeover.
6. A potential target changes the voting
structure so that shares owned by
management have more votes than those
owned by others.
Poison pills have to be approved by a
majority of stockholders. Often stockholders
stand against poison pills because they see
them as benefiting only management.
Categories of M&A
Investment banking firms provide four categories
of M&A services for which they earn fees:
First, investment-banking firms help
corporations identify M&A candidates that
match the acquiring corporation’s needs. Large
investment banking firms have a global network
of industry and regional contacts that can quickly
identify potential acquisition candidates and assess
their interest in being acquired.
Second, the investment-banking firm does all
of the analysis necessary to price the deal once an
acquisition candidate corporation is located. These
activities include reviewing the target corporation’s
financial statements and financial projections;
6
forecasting the expected future cash flows;
evaluating the corporation’s management team;
performing due diligence; and, finally, determining
the estimated value (price) of the corporation.
Due diligence is checking the validity of all
the important information the corporation
provided for the potential buyers. The
potential buyers want to make sure that if a
corporation is purchased, they get what they
are promised.
The expected cash flows are the core of the
valuation process. Two cash flows must be estimated:
1. the cash flows of the acquired corporation
as a stand-alone business,
2. the additional cash flow that the acquiring
corporation can generate if it purchases the
business.
Third, the investment banking firms work with
the acquiring corporation management, provide
advice, and help them negotiate the deal.
Finally, once the deal is complete, investment-
banking firms assist the acquiring corporation in
obtaining the funds to finance the purchase. These
activities range anywhere from arranging bank
loans to arranging bridge financing, underwriting
the sale of equity or debt, or arranging a leveraged
buyout (LBO) deal.
Bridge financing is just a temporary loan
until permanent financing is obtained.
An LBO is where a corporation is acquired
by issuing debt and then taken private.
important
Both buying and selling corporations may
seek the services of investment banking firms
because, for most corporations, M&As are
occasional or intermittent events. Therefore,
hiring expert counsel is a good business
practice.
137
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Investment Banking

The fee charged by investment banking firms depends on the extent of the work they do and the
complexity of the tasks they are asked to do. In some cases, the investment-banking firm may simply
receive an advisory fee or retainer for its service. In most cases, however, the banking firm receives a fee
based on the percentage of the selling price (Kidwell et al., 2016, p. 592).
The mergers and acquisitions businesses require very specialized knowledge and expertise. Investment
banking firms involved in this market are highly trained (and, not by chance, highly paid) (Mishkin &
Eakins, 2018, p. 578).

Learning Outcomes

3 Explain the roles of investment banks in Mergers and Acquisitions.

Self Review 3 Relate Tell/Share

How do investment Associate the fees charged

banks assess the value of by investment banks with Tell the difference between
companies to price the deal the size of the deal in mergers and acquisitions.
in M&As? M&As.

ADVISING CORPORATIONS
Investment banking firms often serve as advisers for corporations that wish to restructure their
operations. They conduct a valuation of various existing and potential parts of a corporation so that they
can recommend how a corporation should restructure its businesses.
important

Valuation, strategy, and tactics are the key aspects of the

advisory services offered by an investment-banking firm.

Investment banking firms commonly suggest that the corporation could benefit from revising its
ownership structure. It may recommend a carve-out, in which the corporation would sell one of its units
to new stockholders through an IPO. The proceeds of the IPO go to the parent company.
Alternatively, an investment-banking firm may advise the corporation to spin off a unit by creating new
stocks representing the unit and distributing them to existing stockholders. Alternatively, an investment-
banking firm might recommend that a corporation engage in a divestiture, in which it sells one or more
of its existing divisions that suffered recent losses. That means the investment-banking firm may receive a
fee for advising and another fee for finding buyers of the divisions that are sold.
Investment banks also commonly serve as sole advisors as well as makers of mergers. They assess
potential synergies that might result from combining two businesses, and they attempt to determine
whether the synergies would be worthwhile for the potential acquirer after considering the premium that
the acquirer will likely have to pay to obtain controlling interest in the target corporation. Investment
banking firms may suggest that some of a target corporation’s divisions will not be compatible with the
acquirer’s operations. Thus, after a target corporation is acquired, some of its individual divisions may be
sold. This process is referred to as asset stripping (Madura, 2015, pp. 645-646).
In addition, investment-banking firms are making increasing inroads into traditional bank service
areas such as small-business lending and the trading of loans. In performing these functions, investment-

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Financial Markets & Institutions

banking firms normally act as agents for a fee. Fees charged are often based on the total bundle of services
performed for the client by the corporation. The portion of the fee or commission allocated to research and
advising services is called soft dollars. When one area in the corporation, such as an investment advisor,
uses client commissions to buy research from another area in the corporation, it receives a benefit because
it is relieved from the need to produce and pay for the research itself. Therefore, advisors using soft dollars
face a conflict of interest between their need to obtain research and their customers’ interest in paying the
lowest commission rate available (Cornett & Saunders, 2014, p. 505).
Other activities of investment banking firms include the
management of pension and endowment funds for businesses,
colleges, churches, hospitals, and other institutions. Many
times, officers of investment banking firms are on the boards Some firms, widely known as boutique
of directors of major corporations. Thus, they can offer investment banks, specialize in a few
financial advice and participate in the financial planning activities, such as advising companies on
of the corporation. Investment banking firms also provide financing issues and mergers, but does not
financial counseling on a fee basis. raise finance for the firm, or underwrite, or
Not all investment-banking firms engage in every one of engage in securities trading.
these activities. The size of the firm largely dictates the various
services it provides(Melicher & Norton, 2017, p. 312).

Further Reading

Ethics in Investment Banking  –  John N. There have been cases where relatively junior
Reynolds, Edmund Newell investment bankers have received criminal or
The scope of ethical issues (extract from Chapter 1) civil penalties for their involvement in illegal
activities. By contrast with the sentence received
…………Understanding ethics in
by Mr Bayly, William Fuhs, a Vice President (a
investment banking is not just about the major
mid-level banker) at Merrill Lynch was sentenced
abuses identified in high-profile scandals.
to a longer period of custody – over three years.
Individual investment bankers face specific ethical
The New York Times described Mr Fuhs’ role
issues as part of their day-to-day activities. These
as “a Sherpa” on the deal (a “Sherpa” carries
can involve dealing with client-facing areas such
luggage for mountaineers, and this implies that
as conflicts of interest or presenting misleading
Mr Fuhs’ role was not a leading one). As the case
information in a pitch, as well as internal issues
of Jamie Olis, an accountant at Dynegy, showed,
such as promotion and compensation decisions,
sentencing guidelines based on calculations
misuse of resources and management abuses.
of the level of losses resulting from fraudulent
Many of these issues can be relatively minor,
activities can lead to lengthy prison sentences –
but, nonetheless, how they are dealt with will
the original sentence given to Mr Olis was a 24-
be crucial in inculcating ethical decision-making
year prison term (reduced to 6 years on appeal)
within an investment bank.
in relation to a $300 million accounting fraud.
When investment banks behave unethically,
This underscores the importance for
there can be significant consequences, including
investment bankers at all levels to be able to raise
making losses or incurring fines. It can also
legitimate questions about the ethics of what
involve criminal cases against individual bankers.
they are being asked to do – both to have a forum
Daniel Bayly, Merrill Lynch’s former head of
to raise questions, and to understand when it is
investment banking, received a 30-month prison
necessary to do so. In extreme cases, the impact of
sentence for his role in a trade by Enron involving
unethical decisions can be very painful…………
Nigerian barges, aimed at misrepresenting
Enron’s earnings.

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Investment Banking

In Practice

China Speeds Up Opening of Market to Investment Bank Giants

Bloomberg News (15 January 2020)
China brought forward the planned opening of its $21 trillion capital market by eight months,
swinging the door open for global investment banks such as Goldman Sachs Group Inc.
The New York-based powerhouse, and rivals including JPMorgan Chase & Co. and Morgan
Stanley, will now be allowed to apply to form fully owned units to do a broad array of investment
banking and securities dealing in the Communist Party-ruled nation in April, compared with an earlier
timetable set for December.
The decision was included in the signing of a trade deal with the U.S., partially resolving a protracted
dispute that has weighed on the world’s second-largest economy. China had already committed to a
broader opening of its $45 trillion financial markets, which also includes given access to its asset-
management and insurance markets.
“China shall eliminate foreign equity limits and allow wholly U.S.-owned services suppliers to
participate in the securities, fund management, and futures sectors,” according to the text of the
landmark Phase 1 trade agreement released Wednesday.
China said it won’t take longer than 90 days to consider applications from providers of electronic-
payments services including American Express Co., Mastercard Inc. and Visa Inc. to handle transactions
in the nation. It will remove restrictions to allow U.S.-owned insurance companies into its markets and
also open its $14 trillion market to U.S. credit-rating companies.
As a reciprocal move, the U.S. will “consider expeditiously” pending requests by Chinese financial
firms including Citic Securities Co., China Reinsurance Group Corp. and China International Capital
Corp. It committed to “non-discriminatory” treatment of payment providers such as UnionPay Co. and
Chinese credit rating companies.
China is also opening its market to allow more foreign investment into the country’s 2.37 trillion
yuan ($344 billion) non-performing loan market, giving U.S. investors direct access to the market as
part of its trade deal amid a surge in bad loans.
While Wall Street’s giants and their European counterparts have been present in mainland China for
decades, and done deals for the country’s corporate titans, they have until now had limited opportunity to
do direct business, having had to operate through joint ventures with local partners. Full ownership would
be a final step after they in late 2018 were given the go-ahead to take majority control over their ventures.
Much Welcome
China has made “significant commitments” in the deal, Jake Parker, vice president at the U.S.-
China Business Council, said in an e-mailed comment. “While China has already in the past year
announced many of the commitments on the financial openings in the agreement, the inclusion of
specific timelines on when these commitments will be implemented is very much welcome and will
improve enforceability going forward.”
UBS Group AG, Nomura Holdings Inc. and JPMorgan already hold a majority in their ventures,
while the others are in the process of applying for a 51% stake. It’s unclear if the application process will
now move straight to the 100% hurdle.
By dismantling the wall to its financial market, China is counting on foreign financial firms to
plow $1 trillion in fresh capital into the nation over the next few years, cushioning a slowdown in the
economy and helping a transition to more consumer-led growth model.

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Financial Markets & Institutions

The global banks, meanwhile, have a lot to gain in getting access to China’s still-fast growing
economy and its increasingly prosperous population. Up for grabs is an estimated $9 billion in annual
profits by 2030 in the commercial banking and securities sectors alone, Bloomberg Intelligence
estimates.
But they will still need to steer an often opaque and precarious political landscape. After meeting
with global banking executives in November, President Xi Jinping warned that China would seek to
preserve its “financial sovereignty” even as he committed to the market opening.
China’s official People’s Daily newspaper said in a comment that the deal is generally in line with its
direction of advancing reforms and opening up, and will support its need for “high-quality economic
growth.”
The newspaper said that the reforms and opening up will be done “at its own pace.”
The nation has plans to create investment banking behemoths of its own to compete with the
foreign influx and expand abroad. Right now, China has a fragmented market of brokerages, with about
131 firms and a limited global presence. Their combined assets equal to what Goldman Sachs sits on
by itself.
— With assistance by Lucille Liu, and Jun Luo

Learning Outcomes

4 Explain the roles of investment banks in advising corporations.

Self Review 4 Relate Tell/Share

How do investment banks How do investment banks

resemble traditional banks improve the success of Tell the difference between
in terms of their advisory M&As with the advisory the carve-out and spin off.
roles? roles?

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Investment Banking

Identify the main functions of

LO 1 investment banks.

Investment banks are firms that specialize in assisting businesses

and governments sell their new security issues (debt or equity)
in the primary markets to finance capital needs. Investment-
banking firms have three distinctive primary market functions
in financial structure and these are as follows: bringing new
securities to market, deal making in mergers and acquisitions,
advising corporations.
Summary

Explain the roles of investment banks in

LO 2 bringing new securities to market.

The main business of investment banking is raising debt

and equity financing for corporations or governments. This
involves originating the securities, underwriting them, and
then placing them with investors. When a corporation has an
intention to borrow or raise funds, it may decide to issue long-
term debt or equity instruments. It then generally gives the job
to an investment banking firm to make the issuance easier and
subsequent sale of the securities.

Explain the roles of investment banks in

LO 3 Mergers and Acquisitions.

Investment bankers serve as both acquirers and target

corporations. Acquiring corporations require help in locating
attractive corporations to pursue, soliciting stockholders to
sell their stocks in a process called a tender offer, and raising
the required capital to complete the transaction. Target
corporations may hire investment bankers to help avoid
undesired takeover attempts. Investment banking firms assist
in finding merger partners, underwrite any new securities to
be issued by the merged corporations, assess the value of target
corporations, recommend terms of the merger agreement, and
even assist target corporations in preventing a merger.

Explain the roles of investment banks

LO 4 in advising corporations.

Investment banking firms often serve as advisers for

corporations that wish to restructure their operations. They
conduct a valuation of various existing and potential parts of
a corporation so that they can recommend how a corporation
should restructure its businesses. In addition, investment-
banking firms are making increasing inroads into traditional
bank service areas such as small-business lending and the
trading of loans.Other activities of investment banking firms
include the management of pension and endowment funds for
businesses, colleges, churches, hospitals, and other institutions.

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Financial Markets & Institutions

1 Which of the following choices is the main 6 Which of the following is a type of common
reason for investment banking’s transformation stock offering that had been issued in the past by
during 2008? the corporation?
A. High risk taking with high leverage A. Seasoned offering
B. Regulated environment B. Initial public offering
C. Financial globalization C. Bond offering

Test Yourself
D. China’s rapid economic growth D. Unseasoned offering
E. FED’s high interest rates policy E. Commercial paper offering

2 Which of the following investment banks 7 Which of the following terms describes the
was filed for bankruptcy at the end of 2008? process when an investment-banking firm buys
the securities from the issuer and takes the risk of
A. Lehman Brothers
selling the securities to investors at a lower price?
B. Merrill Lynch
C. Morgan Stanley A. Underwriting
D. Goldman Sachs B. Rights offering
E. JP Morgan C. Auction
D. Public offering
E. Private placement
3 I.Bringing new securities to market
II.Deal making in the mergers and acquisitions
8 Investment banking firms may suggest steps
III.Advising corporations their customers should take to avoid a merger or
Which of the above choices is/are among the takeover. These are known as……….…
distinctive primary market functions of investment A. poison pills B. prospectus
banking firms in the financial system? C. tombstones D. tender offer
A. Only I B. Only III E. asset stripping
C. I and II D. II and III
E. I,II and III 9 Checking the validity of all the important
information the corporation provided the potential
buyers is………….
4 An investment bank tries to identify
corporations that may benefit from a security sale, A. due diligence
as...................... B. originating
C. underwriting
A. an originator B. an underwriter
D. divestiture
C. a regulator D. a issuer
E. asset stripping
E. a syndicate

10 Which of the following activities is among

5
Which one of the following is used by boutique investment banks’ specialized activities?
investment banks to primarily reduce risk in public
offerings? A. Advising firms on financial issues
B. Market making in IPOs
A. Forming a syndicate
C. Trading securities in secondary markets
B. Presenting a prospectus
D. Providing brokerage services
C. Implementing poison pills steps
E. All of above
D. Originating the issuer
E. Underwriting the securities

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Investment Banking

1. A If your answer is wrong, please review the 6. A If your answer is wrong, please review the
“Overview of Investment Banking” section. “Bringing New Securities to Market” section.
Answer Key for “Test Yourself”

2. A If your answer is wrong, please review the 7. A If your answer is wrong, please review the
“Overview of Investment Banking” section. “Bringing New Securities to Market” section.

If your answer is wrong, please review the

3. E If your answer is wrong, please review the 8. A
“Deal Making in Mergers and Acquisitions”
“Overview of Investment Banking” section.
section.

If your answer is wrong, please review the

4. A If your answer is wrong, please review the 9. A
“Deal Making in Mergers and Acquisitions”
“Bringing New Securities to Market” section.
section.

5. A If your answer is wrong, please review the 10. A If your answer is wrong, please review the
“Bringing New Securities to Market” section. “Advising Corporations” section.

What are the main functions/roles of investment banks in

financial markets?
Suggested answers for “Self Review”

Investment-banking firms have three distinctive primary market functions in

financial structure and these are as follows:
self review 1 • bringing new securities to market,
• deal making in the mergers and acquisitions,
• advising corporations.

Why is pricing important for IPOs?

The price for which a security is sold is important to the issuer because the
higher the price means the more money the company gets. If the security
is priced too high, there may not be sufficient demand for the security as
self review 2 expected, and the offering may be canceled or the investment-banking firm
may not be able to sell the issue at the desired offering price. In this case, the
investment-banking firm suffers from loss.

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Financial Markets & Institutions

How do investment banks assess the value of companies

to price the deal in M&As?

Investment banks:

Suggested answers for “Self Review”

• Review the target corporation’s financial statements and financial projections;
• Forecast the expected future cash flows;
self review 3
• Evaluate the corporation’s management team;
• Perform due diligence;
• Determine the estimated value (price) of the corporation.

How do investment banks resemble traditional banks in

terms of their advisory roles?

Investment banks also provide traditional bank services such as small-business

self review 4 lending and the trading of loans. In performing these functions, investment-
banking firms normally act as agents for a fee.

References
Arnold, G. (2012). Modern Financial Markets &
Institutions, Pearson Higher Ed.
Cornett, M. M. & Saunders, A. (2014). Financial
Markets and Institutions, Mcgraw-hill Education-
Europe.
Fabozzi, F. J., Jones, F. J. & Modigliani, F. (2014).
Foundations of financial markets and institutions,
Pearson Education.
Howells, P. & Bain, K. (2007). Financial markets and
institutions, Pearson Education.
Hull, J. (2012). Risk management and financial
institutions,+ Web Site (Vol. 733), John Wiley &
Sons.
Kidwell, D. S., Blackwell, D. W., Sias, R. W. &
Whidbee, D. A. (2016). Financial institutions,
markets, and money, John Wiley & Sons.
Madura, J. (2015). Financial Markets and Institutions:
With Stock-trak Coupon, Cengage Learning.
Melicher, R. W. & Norton, E. A. (2017). Introduction
to finance: Markets, investments, and financial
management, John Wiley & Sons.
Mishkin, F. S. & Eakins, S. G. (2018). Financial
markets and institutions (Ninth ed.), Pearson
Education India.
Stowell, D. P. (2017). Investment banks, hedge funds,
and private equity, Academic Press.

145
 Financial Crises and
Chapter 7 Regulations
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Discuss the reasons and effects of global

financial crises Identify financial crises in Turkey

3 Explain the main objectives of regulations in

the financial industry

Chapter Outline Key Terms

Introduction Crises
Fluctuations
Global Crises
Balloons
Crises in Turkey Panics
Regulations in the Financial Industry Depression
Contagion
Moratorium
Regulation
Supervision

146

Financial Markets & Institutions
INTRODUCTION
The concept of ‘crisis’ has been a significant
economic problem for human beings for the last
two centuries. We have been observing them more
frequently and more severely especially for the
last four decades. In this period, with the gradual
decline of the governments’ share in the economy
since 1970s (with the impact of the Oil Crisis and
stagnation), the acceleration of financial liberalization
and deregulation activities since the 1980s, and
the fact that globalization has accelerated since the
1990s, many developed and developing countries
experienced financial and/or economic more
frequently than before.
Funding the public sector’s needs in the
financing of development may cause fluctuations
in the financial system. These fluctuations not
only affect the country with financing problems,
but also other countries that have close economic
relations with this country. These fluctuations
may turn into crises. In this context, a crisis may
sometimes influence only a country or a region
or sometimes affects the whole world. While the
former is called local and/or national crisis, the
latter refers to a global crisis. These facts have led
to the creation of a field of study, particularly on
the causes and effects of crises, and the prevention
policies of these crises.
In this chapter, firstly a brief history of global
economic and financial crises is introduced.
Following this attempt, the national crises and
the ramifications of the global crises in Turkey are
mentioned at a glance. In the last part, an insight
into the regulations against financial crises is
submitted.
GLOBAL CRISES
According to Mishkin (2012), “a financial crisis
occurs when an increase in asymmetric information
from a disruption in the financial system prevents
the financial system from channeling funds efficiently
from savers to households and firms with productive
investment opportunities”.
Although it is a controversial issue what the
concept of crisis refers to, there is a consensus on
that there exists four types of financial or economic
crises in general:
7
• money crisis
• banking crisis
• external debt crisis
• systemic financial crisis
A speculative attack on the value of a currency is
called a currency crisis, if it leads to a depreciation
of the foreign exchange reserves or a significant rise
in interest rates in order to prevent the depreciation
of the currency.
A banking crisis arises when the actual or
potential bank failures prevent banks from fulfilling
their obligations, or when the government is forced
to intervene to prevent this failure. An external
debt crisis occurs if an entity cannot pay the foreign
debts, whether it is a government or private sector.
On the other hand, systemic financial crises are
defined as financial distortions that have significant
effects on the real economy by preventing the
efficient functioning of financial markets (IMF,
1998, p.74-75).
The common feature of all types of financial
crises is that they have significant fluctuations
in financial asset prices (or exchange rate) and
unsustainable economic imbalances.
Financial crises are usually caused by the
following factors (Mishkin and Eakins, 2012):
• Mismanagement of financial liberalization
• Asset Price bubbles or booms, meaning
market prices of assets realized above
economic values
• High uncertainty, usually following
economic downturns or stock market
crashes
• Current account deficits
• Budget deficits
• Excessive borrowing of government
• Excessive borrowing of businesses
• Vulnerability or fragility of banking
industry
The effects of financial crises, in general, may
include:
• Economic downturn
• Deterioration of cash flows
• Decline of lending
147
7
• Deterioration in the balance sheets of
financial institutions
• Deterioration in the balance sheets of
businesses
• Currency crises
• Rises in debt burdens
• Bank failures
• Company failures
• Increased volatility in financial markets
• Rises in inflation and interest rates
• Rises in unemployment
We can classify crises in the world as crises prior
to 1980 and crises after 1980.
Crises Prior to 1980
For the last 6 centuries, the world economy
has experienced several local and global economic
crises. In this section crises and crisis-like incidents
such as speculative balloons and/or economic
panics prior to the year 1980 are examined briefly.
Financial Crises and Panics Before
the 1929 Great Depression
The Tulip Madness occured in a time when the
Netherlands lived in the Golden Age. In this period,
the prices of newly emerging tulip bulbs have risen to
high prices and suddenly hit the bottom. In February
1637, when the tulip madness reached the stage, the
onions of some rare tulips were sold to more than 10
times the annual income of a skilled craftsman.
Dutch Golden Age
The name given in the Dutch history
between the years 1585-1702. In this
period, the Netherlands became one of
the world’s leading countries of science,
commerce and art.
important
During the Tulp Madness, tulip bulbs were
bought and sold at a higher price than gold.
148
Financial Crises and Regulations
The Tulip Madness is often seen as the first
recorded speculative balloon.
18. Century is called the era of stock market
balloons. The first two famous stock market
balloons are:
• the South Sea Company (UK), which was
based in the UK, and
• the Mississippi Company (Project), which
was based in France.
These two balloons suddenly burst out in 1720
and thousands of unsuspecting investors went
bankrupt. Another incident in this century is the
Bengal balloon. This balloon has come to the fore
in India because of the excessive exaggeration of
the value of the British East India Company before
the company took over Bengal. The price of shares
fell to 122 pounds in 1769, and in late 1769 the
Great East India Company went bankrupt.
The first panics were also experienced in this
century. During the last 30 years of the 18th
century, the first panics began to occur. These
panics were the precursors of panic that would
happen almost every decade in the next century.
The 1772 credit crisis is the first of these panics.
This crisis was an indirect consequence of the
bankruptcy of the East India Company, and it took
place in England in 1772 in connection with the
bombing of the Bengal Balloon.
Especially in the 18th century, the companies
and institutions were at the center of global affairs.
Companies and institutions that influenced
sovereignty and commercial factors were the main
causes of the bankruptcy of the East India Company
and hence the Dutch banks that invested in them
at that time.

Financial Markets & Institutions
The second of these panics occurred in 1792.
This panic was basically an economic confidence
crisis and took place between March and April 1792.
The last of these three panics occurred in the
18. Century was 1796-1797 panic and the main
cause of this panic were the downturn in Atlantic
credit markets and the panic that took place in this
period led to greater commercial bottlenecks in the
United Kingdom and the United States.
On the other hand, in the 19. Century, firstly
The Danish government declared a moratorium
on January 5 1813, after six years of naval wars.
Expenditures related to the war dried up the
national resources of the country, the employment
fell at very low levels and the tax revenues decreased
at unprecedently low levels. There were panics every
decade in this century, and in the last quarter of the
century there was a period of depression that affected
the whole world, including the USA and Britain.
This depression led to an economic stagnation
in the United States between 1873 and 1879. In the
years 1819, 1824, 1837, 1947, 1957, 1866, 1873,
several panics occurred due to various reasons.
Ultimately, the panic in 1873 turned into an
international economic crisis in many parts of
the world, including the USA and Europe. In
some countries, including Britain, it continued
to the mid-1890s and was named “Long (Great)
Depression”. At the end of this process, Britain
lost its leadership position in the economy (Balı &
Büyükşalvarcı, 2011).
important
World War I was one of the main causes of
the Great Depression, causing 10 million
dead, 20 million wounded, and 8 million
missing soldiers.
1929 Great Depression
The Great Depression is the name given to the
economic depression that started in 1929 and con-
tinued throughout the 1930s. The depression cre-
ated destructive effects in the rest of the world (es-
pecially in the industrialized countries), despite the
fact that it centers on North America and Europe.
The 1929 Crisis was the cause of unemployment,
economic contraction, and stagnation.
7
While World War I was a destruction in terms
of defeated states, the victorious states that did not
fight in the war on their own territory were saved
from this destructive effect. The US was the luckiest
of these countries because at the same time it had a
significant portion of the gold reserves in the world
and consequently the countries borrowed from the
US to finance restructuring of their economy. In
this period, the total amount of the USA credits
with interest given to 15 countries reached 11.563
Million Dollars. While these debts were making
the depression more severe in the economies of
borrower countries’, they made the United States
both the supreme power of the world and gave a
start to the golden age of the American economy.
In the period, which is known as the roaring
20s, increasing demand for the electronic
goods and automobiles supported serial
production of these industrial products.
Henry Ford’s mass production (Fordist) and
his raising of the wages of his workers to a level
well above the time (five dollars per day) led to a
further increase in automobile demand. The start
of the annual leave caused a revival in the tourism
and real estate sector and the vitality of the real
estate market, especially in Florida, increased the
demand for this sector due to its profitability in
the stock market.
During the period of 1923-29, there was also
excessive mobility in the finance sector. People
believed that the stock market would continue to
rise despite the adverse developments such as the
bankruptcy of two banks in a day. Most people
withdrew all their savings from bank deposits,
and invested in the stock market. While the real
estate market was the majority of the stocks, the
two hurricanes that occurred in 1926 lowered the
value of land prices there and left the investors in
a difficult position. This was a breaking point for
the financial sector and things started to reverse.
Another reason for the downturn in the financial
sector was the lack of supervision and necessary
laws in the sector. There was no banking law to
determine how much of the reserves of the banks
could be given as loans.
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7
In the days of the outbreak of the crisis, the
reason for the rapid sinking of the banks was
that they traded in the New York stock exchange
with the deposits they had collected. The New
York stock market went down and the banks
went bankrupt. There were also no legal measures
to protect investors from fraud. The Securities
Exchange Commission was founded after the crisis.
In the same period, there were also disruptions in
the real sector. The prevailing economic view was
preparing a suitable ground for the formation of
monopolies, which was proposed at the lowest
level of economic intervention by the government.
As a result, competition decreased and prices and
production were affected, and also manipulations
in the financial sector were experienced. (Ay &
Uçar, 2015; Bakırtaş & Tekinşen, 2004)
In this context, one of the reasons for the crisis
was the excessive financial strength of the companies
in America. In the 1870s, there were many large
and small companies in America. Small companies
had to merge in the face of the difficulties of World
War I, and they formed a monopoly after the war.
In 1929 the number of conglomerates controlling
50% of the American economy was only 200. This
meant that even a single conglomerate bankruptcy
would shake the whole economy. A second reason
was that the banks were badly structured. There
was no law governing the capital markets, reserves
and credit ratios of banks. A third reason can be
said to be the inexperience of the president Hoover
administration in the economy. According to the
advocates of this idea, President Hoover did not
approve the state intervention of the economy
according to the liberal economy concept, which
was prevailing in the 1920s. But later on, the social
cost of not interfering with the 1929 crisis was
150
Financial Crises and Regulations
huge. When the president decided to intervene, it
was too late and the intervention was not successful.
A demonstration of government inexperience
was the government’s insisting on adhering to the
gold standard. The government refused to print
money and followed a tight monetary policy, and
economic activity ceased when the money was not
available on the market, and the real sector shrank.
This means more unemployment, less income.
The last reason to be emphasized is that America
was the major creditor of the world. In addition,
he demanded that Germany and England pay the
compensation they deserve after the First World
War as gold. However, the gold stock in the
world was inadequate, and the existing stock was
already controlled by the USA. For this reason,
the compensation and the payment of credits as
goods and services were tried, but this also hit
America’s own goods and services sector. As a last
resort, the US tried to implement the tariff walls,
but only foreign trade shrank. After all, America
could not get back the loans that it gave without
any consideration. (Turan, 2011)
The 1929 Wall Street Depression (October
1929) or the Great Depression was the most
devastating financial collapse ever seen in US
history to that date when its consequences
were taken into account.
Despite speculative danger warnings, many
people believed that high price levels could remain
unchanged. Shortly before the crisis economist
Irving Fisher made a famous statement, “Stock
prices have reached what looks like a permanently
high plateau” (Teach, 2007). On October 29
1929, -also known as ‘The Black Tuesday’-, the
price of shares went down for a full month at an
unprecedented rate. With the collapse of 1929, the
Roaring Twenties came to an end.
With the collapse, wide-ranging and long-
term problems began for the United States. The
ambiguous environment also affected the job
security of the employees. As American workers
faced insecurity about their incomes, consumption
also declined.

Financial Markets & Institutions
Declines in stock prices led to significant
macroeconomic problems such as:
• diminishing credits,
• closure of workplaces,
• firing of workers,
• bankruptcy of banks,
• declining money supply,
• other economically detrimental events.
Although it started at different times in various
countries, it is argued that the Great Depression
started around 1929 and continued until the
late 1930s or early 1940s. Although some of the
country’s economies began to recover in the mid-
1930s, in many countries, the negative effects of the
Great Depression lasted until the beginning of the
Second World War. (Balı & Büyükşalvarcı, 2011)
important
The financial collapse caused by the Great
Depression initiated a ten-year economic
slowdown affecting all western industrialized
countries.
Crises After 1980
The world debt crisis emerged on 12 August 1982
when Mexico declared a moratorium. Following
this incident, many developing countries, mainly
Latin American countries, declared moratorium
and thus the world recognized the existence of the
global debt crisis.
The effects of the crisis were the rise in interest
rates, increase in recession in the economies and
the sudden capital outflows. There were various
solutions to the global debt crisis: Baker’s plan,
7
Brady’s plan, legal and political regulations and
debt-equity changes.
Some of the debt crises from past to today are as
follows (Yavuz et al, 2013; Ulusoy, 2012):
• The crisis in Southeast Asia in 1990s,
• The Mexican crisis in 1994,
• The crisis in Russia in 1998 -which is a
classic bad management crisis-,
• The crisis in Argentina in 2000,
• European debt crisis that started in Greece,
Portugal and Ireland in 2010 and later
included Italy and Spain.
1980 Global Debt Crisis
After World War II, emerging economies
started to receive debts from the international
market and a worldwide debt problem did not arise
until the last quarter of the 1970s. But, since the
last quarter of 1970s, especially in Latin American
countries a debt problem arose. Shortly after
that, an international debt crisis broke out. These
crises occurred not only due to national policies,
but they also had international aspects. The debt
crisis threatened the international financial system
and a number of plans were devised, namely
Brady and Baker plans. Also, new methods such
as debt decreasing and debt delaying started to be
implemented. (Akdemir, 2003, p.1)
In October 1973, with the start of the Arab-
Israeli War, Arab states stopped oil shipments to
the US and Western European countries. Shortly
after that, OPEC increased oil prices dramatically.
The oil demand that grew in 1973 and the lack
of and alternative energy sources caused western
economies to experience a significantly expensive
cost. This development caused inflation and
balance of payments problems around the world as
the crisis increased developed countries’ production
costs very rapidly. As a result, inflationary pressures
in developing countries increased steadily and the
crisis began to be felt more deeply (Akkaya, 2010).
The second oil crisis repeated economic
problems of the first oil crisis. The second oil crisis
which broke out in 1979-80 further increased the
current account deficits of undeveloped countries
which did not export oil. In conclusion, towards
the end of 1970s, with the effect of the oil crises,
the fact that the developing countries started to
experience difficulties to pay their external debt
were the first signs of the global debt crisis.
151
7
Weaker production structures and increasing
costs emanating from the actions of the OPEC
further increased the balance of payment deficits
of the undeveloped and developing countries. On
the other hand, some of these countries applied
to Ponzi finance and thus tried to pay back its
existing debts through new debts. When the signs
of the international debt crisis emerged, the debtors
(lenders) made some arrangements in lending
policies (such as floating interest rates) to guarantee
their receivables as well as to encourage borrower
countries to set up and mobilize effective external
debt management mechanisms to repay their debts
(Karagöz, 2006, p.99).
Ponzi finance is a type of financial fraud
based on the principle of continuous fund
raising from newcomers to the system.
In 1982, Mexico declared that it had
temporarily suspended its external debt service and
thus triggered the global debt crisis. In this period,
thirty-four underdeveloped countries could not
fulfill their debt services.
There are some external and internal reasons
behind this crisis. Among the external factors, there
are international conjunctural changes, changes in
international credit markets and fluctuations in
exchange rates. First of all, the post-war positive
economic conjecture began to reverse from the
mid-1970s. The fixed exchange rate system
introduced by the Bretton Woods system ended in
1971, and oil prices rose four times after the oil
152
Financial Crises and Regulations
crisis. The second oil crisis made the debt service of
oil-importing countries troublesome.
During the ten-years period between 1973 and
1982, the additional costs caused by the increase
in oil prices reached considerable dimensions. On
one hand, the developing oil importer countries
were forced to pay higher oil bills; on the other
hand, the contraction in western markets reduced
the import capacities of these countries. This, in
turn, led to the reduction of investments and the
pause of economic development. Also, in this
period the tight monetary policy imposed by the
US boosted the funds’ return to the US due to
the impact of the increase in US dollar exchange
rate. Then again, since the second half of the
1970s, there had been a change in the structure of
international credits. Moreover, in countries where
the income level was not high enough to realize a
net transfer, repayments of debts caused a decrease
in the resources to allocate to investment or other
social spending. Therefore, after 1982, the debt
crisis was gradually turning into a growth crisis. As
a result of the fall of the growth and the expected
decrease in investments, the produced resources
reduced and the dependence on external financing
increased (Sarı, 2004).
From the beginning of the 1980s, a number
of developing countries began to experience
a debt crisis. The Mexican moratorium in
August 1982 gave a start to the period which
is called the “Debt Decade” in the economic
literature. This country was followed by
some other Latin American countries such
as Brazil, Chile and Argentina, and some
African countries.
During the process, solutions such as Baker Plan
and Brady Plan were developed. Also, the Paris Club
and the London Club were regarded as potential
places for the solutions of the debt problems. In
this period, ‘Paris Club’ was the place of official
borrowing negotiations, while private sector debt
restructuring mostly took place in London Club.
From 1985 onwards, all plans to overcome
the external debt crisis brought important duties
to the developed countries, generally by taking

Financial Markets & Institutions
the attitudes of the IMF and commercial banks
to the forefront. For this reason, these plans have
experienced many difficulties in implementation
and could not be completely successful (Sarı, 2004;
Çalışkan, 2003).
2008-2009 Global Financial and
Economic Crisis
In the aftermath of September 11 2001, due
to the economic downturn in the US, the Central
Bank reduced the interest rate, which was 6.5%
in 2001 to 3% in 2003 to stimulate the country’s
economy. As expected, this fall in interest rates also
affected the interest rates applied to housing loans.
Demand for this sector has increased significantly
as low inflation rates and low interest rates reduced
the cost of acquiring a house.
Increased demand has also led to an increase
in housing prices. For example, a house worth
100,000 Dollars in 2000 reached at a value of
160,000 Dollars in 2007. Increasing housing
prices during this period have also made housing
a major investment instrument. The ratio of house
ownership, which was 64 percent in 2004, increased
to 69.2 percent in 2006 due to speculative housing
purchases. With the impact of low interest rates,
financial institutions took more risks and started
to market the mortgage loans for low-income
households in order to earn more profits (Kutlu &
Demirci, 2011: 122).
Another reason for this crisis was the lack of
transparency. According to Mehrez and Kaufmann
(2000), if financial liberalization is accompanied
with poor transparency, such a situation increases
the probability of a financial crisis. As transparency
increases, less financial crises occur.
7
In some relevant literature, developing countries
have often been described as less transparent, but
ironically, the recent global crisis started in the
“developed world” where transparency is supposed
to be the greatest. That shows us that developed
economies are also not transparent enough and
it is also necessary to redefine the definition and
criteria of “transparency”. In this crisis, what kinds
of assets banks and brokers have, what their value
is, and who their bankers are were not sufficiently
transparent. These problems have made it difficult
for companies such as Lehman Brothers, which
have complex commercial contracts that can be
called derivatives, to calculate and analyze the
resulting risk of bankruptcy.
important
Regulatory supervisory agencies, especially
Federal Reserve System (FED), were late in
taking measures against the changing the risk
environment and this was one of the reasons
behind the 2008-2009 global financial and
economic crisis.
Non-objective behaviors of the credit rating
agencies were another factor that escalated the
financial crisis. One of the most important
examples of this was the conflict of interest
between rating agencies and companies. Rating
agencies that give credit notes to banks and
other financial institutions are funded by these
companies. Therefore, the ability of rating agencies
to make objective assessments is diminishing. On
the other hand, rating agencies are not always
able to determine the financial problems of firms.
Sometimes they can see the problem partly or
very delayed. For example, until a very short
time before Enron’s bankruptcy filing, the rating
agencies could not determine that the company
was problematic. Of course, there is also the effect
of the financial statements prepared by Enron in
contradiction to this fact. Rating agencies may
not have information about underlying assets
as well as banks and instrument designers who
design financial instruments. Another problem
is that rating agencies only rate the default risk.
However, the liquidity risk must also be measured.
Customers of ratings agencies are not aware of this
narrow scope of rating services.
153
7
In the last financial crisis, the rating agencies did
not work very effectively either. However, after the
financial crisis began, credit ratings were lowered.
During the one-year period from the third quarter
of 2007 to the second quarter of 2008, ratings of
mortgage-backed securities of $ 1.9 trillion were
lowered by two major rating agencies (Alantar,
2008). All these were serious problems of the US
economy since the Credit Rating Agencies’ analyses,
the credit notes they give and their situation
assessment statements can affect the money and
capital markets seriously (Pirdal, 2017, p.121).
Due to the reemergence of the financial crisis
in the real economy, the global financial crisis
had very severe results. The US fell into economic
stagnation in December 2007. Growth rates in both
the developed world and developing countries also
decreased. The global crisis significantly affected
the unemployment rates. Especially in the US
and developed economies, the upward trend was
striking. The rise in inflation in 2007 and 2008 was
not only due to the financial crisis. In this period,
increases in oil and food prices led to significant
inflationary effects. Especially in developing
countries where energy demand was increasing,
inflation rates increased rapidly.
The reason for the start of the crisis was that
housing loans given with low interest rates,
which were not paid back to the banks when
the due dates came.
important
While the rise in housing prices was one of
the most important reasons of the global
financial crisis, the decline in housing prices
was among the most important results of
this crisis. In the US, since the beginning
of 2007, housing prices have decreased
significantly.
Another consequence of the financial crisis was
the increase in regulatory requirements, especially
in developed economies. New regulations were
implemented on lightly regulated risk instruments
154
Financial Crises and Regulations
such as hedge funds. The thesis of solving all the
problems of the market by itself or with self-
regulation was no longer spoken (Alantar, 2008;
Verick & İslam, 2010).
In short, the global crisis in the US began in the
financial sector, then leapt to the real sector and
spread the whole economy over time. Unrequited
debt led to the bankruptcy of financial institutions,
consumer confidence was shaken in the market
and the financial crisis was transmitted to the real
sector as demand in the real sector contracted
(Önder, 2009, p.17).
As the global crisis caused liquidity and
confidence problems, short-term money
movements such as direct foreign capital inflows
and portfolio investments also decreased (Engin
& Yeşiltepe, 2009, p.17). Moreover, arrangements
aimed at preventing the adverse effects of the global
crisis have led to budget deficits and increases in the
borrowings of EU countries (Oskay, 2010, p.72).
2010 European Sovereign Debt Crisis
The financial crisis which broke out in the
US real estate market in the second half of 2007
became global crisis in 2008 with the bankruptcy
of “Lehman Brothers” in September 2008. The
crisis has brought a serious recession in the
economies of almost all countries worldwide and
finally in Europe. The global crisis resulted in
serious increases in public deficits and debt stocks
in European Union (EU) countries and became a
threat of sustainability of public finances in many
member states.
As a matter of fact, the debt crisis that broke
out in Greece in the second quarter of 2010
threatened the future of other Eurozone countries
and even the economic and monetary union in
a short time. The fact that some member states,
especially Germany, were reluctant to help Greece,
caused panic in the markets and, as a result, the
public finance and banking sector in Ireland,
Portugal, Spain and Italy faced threats to drift
into the debt crisis. Consequently, the debt crisis
in Greece once again revealed the importance
of effective and responsible debt management,
especially for emerging economies. (Yavuz et al,
2013; Oskay, 2010)

Financial Markets & Institutions
important
The high degree of integration of the financial
and real sectors of the EU member states
increased the level and speed of influence of
the 2010 European Sovereign Debt Crisis on
the countries.
Financial crises are associated with four
deadly D (economic downturns, revenues
down, debt, downgrade). They are generally
followed by banking crises, sharp economic
collapses and downturns in public revenues.
Historically, financial crises have been followed
by the debt crises (Hilsenrath, 2010). Decreases in
revenues led to increased budget deficits and huge
budget deficits increased the level of public debt.
The increase in public debt also brings down rating
notes that given by credit rating agencies (Kılıç &
Bayar, 2012; Reinhart, 2009). In this context, the
speculative bubble in the US, which grew rapidly in
the housing market during the second half of 2006,
started to decline in the second half of 2006, and was
transforming into a global financial crisis, affecting
the banking and insurance sectors, investments and
trade since the second half of 2008.
After September 2008, the shock waves spread
all over the world through the channels of trade
and finance, and almost all countries were affected.
Although the most painful period of the crisis was
relatively short, just as a severe heart attack, it lasted
for long enough to cause permanent damage to the
industrialized countries that were at the center of
the crisis. In this framework, the damage was in
three main forms (Dadush et al, 2010:1):
• rising public debts,
• fragile banking sector,
• a great amount of liquidity overhang, which
will need to be withdrawn.
There was a significant capital outflow in
developing and emerging economies with the
withdrawal of liquid investments, which is
supposed to support the financial institutions’
balances. Global export volume decreased by
about 25 percent between April 2008 and January
7
2009, and prices of commodities also fell by at
least 50 percent (Braga & Gallina, 2011, p.1-2).
Public debts also increased significantly in 2008-
2009 as a result of the global financial crisis.
Numerous factors, such as economic stimulus
packages in connection with the financial crisis,
the expropriation of private sector debts and the
decline in tax revenues, have led to an increase in
public debt (Kılıç & Bayar, 2012). In developed
economies, budget deficits, which amounted to
1.1 percent of GDP in 2007, rose to 8.8 percent
in 2009 and in emerging economies which were
fiscally balanced the deficits rose from 0 percent
to 4.9 percent of the GDP in the same period, for
instance. (IMF, 2010, p.8)
When the Eurozone debt crisis is evaluated in
a general sense, it is seen that there are structural
reasons and coordination problems of economic
policies behind the crisis (Kılıç & Bayar, 2012,
p.56). In this context, governments increased
government spending due to their support for
reducing the effects of the global crisis in the EU
countries. On the other hand, tax revenues also
declined due to the stagnation in the markets
in these countries. This led the EU countries
to face serious budget deficits and increases in
the borrowings. The decline in countries’ credit
ratings, the pressure on the stock exchange, the rise
of sovereign state treasuries and credit debt clearing
agreements were among the other reasons for the
European debt crisis (Yavuz et al, 2013: 134).
On the other hand, the fact that the European
Central Bank lowered the government debt interest
rate premiums of Greece, Ireland, Portugal, Italy,
and Spain encouraged these countries to spend
excessively. The borrowing funds used to fund
the current expenditures in these countries were
not canalized into productive areas. The rising
debt stocks caused a decline in credibility of these
countries and as a conclusion, the cost of borrowing
for these countries increased dramatically. (Kılıç &
Bayar, 2012)
The debt crisis that emerged in the second
quarter of 2010 in Greece, Portugal and Ireland,
which are described as European periphery
countries, spread over Italy and Spain. This posed a
major risk in terms of global growth and financial
stability, especially in the Euro Zone countries.
Although Italy did not have a problem of debt
155
7
Financial Crises and Regulations

rollover in the short run and even though Spain has a positive financial performance, the spillover effect of
the debt problem to these two countries raised concerns. (Değerli & Keleş, 2013, 2). In this framework, in
Greece, Iceland, Ireland, Portugal and Ireland the financial markets were under pressure during the crisis.
(Arezki et al, 2011, p.3).
In solving the debt crisis that emerged in the Euro Zone in the spring of 2010 European Monetary
Union’s monetary and fiscal policies were not effective. The debt crisis in the 2010 Euro zone caused
major movements in the yield of bonds and major changes in the euro and other currencies (Von Hagen,
2010). In order to achieve certain goals of the Stability and Growth Pact, which is a part of the Maastricht
Agreement, the budget deficits rose excessively and the governments were held responsible for this situation.
In fact, at the core of the European debt crisis there was foreign debts of the European Countries. The
European Union’s reform proposals included controlling the national governments’ fiscal policies and
increasing bank regulations.
important
When the banking crisis in the private sector took
place, especially in countries such as Ireland and Spain,
The Stability and Growth Pact, the Maastricht governments rescued the private sector by purchasing private
Treaty, and the European Union focused debt in exchange for public debt. Consequently, taxpayers
on the government debt and budget deficit became in a position of debtors to foreign investors. For
ratios ignoring the “excessive” debt ratios in example, the structural budget deficit in Ireland and Spain
the private sector and this situation triggered was relatively low and in fact in these countries the private
crisis in the financial sector. sector was the main cause of the debt crisis. (Stein, 2011)

Learning Outcomes

1 Discuss the reasons and effects of global financial crises.

Self Review 1 Relate Tell/Share

How did the the 2008-

2009 Global Financial and
Economic Crisis influence
the economies of the
developed and developing
countries?
Tell how the behavior of
Associate the usage of
rating agencies affected
derivatives and the 2008-
the 2008-2009 Global
2009 Global Financial and
Financial and Economic
Economic Crisis.
Crisis.

CRISES IN TURKEY
We can classify crises in Turkey as crises prior to 1990 and crises after 1990.

Crises Prior to 1990

In October 1929, a great economic crisis started in the US and affected all the world. During this era
the financial industry did not exist in Turkey yet. Turkish economy was mainly based on the agricultural
sector. Yet, at the advent of the 1929 great depression, the agricultural sector had collapsed due to
taxes, primitiveness and the damage caused by the war. During the crisis, due to the intense imports of
minorities and lowering prices of agricultural products, Turkey had a relatively high level of foreign trade
deficit and the value of the Turkish lira decreased rapidly. Additionally, the first installment payment

156

Financial Markets & Institutions
of the debt inherited from the Ottoman Empire
became due. As a result of these undesirable
developments, an economic crisis broke out in the
country. In this process, the public was encouraged
to use domestic goods. Industry and agriculture
congresses led by Atatürk were organized. Savings
measures were taken. On 30 November 1930, the
“Economic Depression Tax Law” was accepted.
Due to the small number of domestic capitalists
in the country and their insufficiency in private
enterprises, large industrial investments led by
the state were established via state capital without
external loans and aimed to recover in the country.
The country was able to get rid of the negative
repercussions of the 1929 economic crisis with
these actions and decisions.
In this context, between 1930-1939, the
economic policies implemented in Turkey were
based on protectionism and statism. It is also
appropriate to describe these years as the first
industrialization period. Indeed, the crisis of 1929
created an opportunity for industrialization for
undeveloped countries (Boratav, 2015).
1946 was a turning point for Turkish
economy. In 1946, Turkish economy was no
longer protectionist and independent, but it was
an open economy, which depended on foreign
credits (Boratav, 2015: 96). In 1946, the first
big devaluation in the history of Turkey was
carried out. This decision caused cost inflation
to increase. Imports were increasing rapidly, thus
the foreign trade deficit was also rising. There
was a temporary recession and contraction in the
markets. Industrial projects were adjourned. The
Government ruled by Recep Peker resigned and
it was replaced by Hasan Saka on 10 September,
1947. The economy was again in a bad condition
in 1948. In the general elections held in 1950,
the Democrat Party came to power with 53% of
the votes. New lands were opened to agriculture.
Due to the good climatic conditions, productivity
in agriculture also increased export prices. During
this period, foreign aid also increased and the 1946
crisis was overcome. This crisis was largely a result
of World War II.
In the early 1950s, climate conditions in the
country made agriculture unfavorable. Thus,
Turkey’s export ratio decreased because the country
was an agricultural product exporter. The increase
7
in the input prices of the products whose raw
materials came from abroad also increased the
prices in the domestic market. In addition to these
reasons, the unplanned investments, the political
conditions inside, the increase of the foreign debt
burden and the public deficits caused the country
to experience double-digit inflation. Also, the
Korean War increased raw material prices in the
world market. Therefore, the costs of the factories
using imported input also increased. The increasing
inflation with other negative conditions caused
another crisis in 1954. The 1954 crisis was overcome
by temporary measures. In 1958,Turkey’s external
debt due was 256 million dollars. However, Turkey
did not have the resources to pay the foreign debt.
A foreign exchange crisis occurred in the country.
Unemployment, budget deficit and foreign trade
deficit grew. The factories in the country had come
to the point of closure as they could not provide
imported inputs. Turkey in August agreed to
implement a stabilization program with the IMF
practices. OECD, IMF and World Bank provided
loans with suggestions. These suggestions were
implemented immediately. The value of the Turkish
Lira was reduced. The prices of the products of the
state-owned enterprises in the domestic market
were raised. Efficient and short-term investments
were given priority. Efforts to achieve decreased
budget deficits were increased.
In 1964, foreign currency inflows from exports
and transfers from workers’ abroad could not be
realized due to the excessive value of TL. There
was a short-term economic crisis in the country
this year. The government contacted the IMF and
implemented IMF policies. The Arabic countries
agreed to increase the price of oil dramatically in
1973. Foreign trade deficit increased. Additionally,
tourism revenues decreased in that era as well. The
government entered a foreign currency bottleneck.
To overcome this bottleneck, high-interest loans
were borrowed from the outside. With the help
of temporary measures, the crisis was overcome.
Turkey simply tried to postpone the negative
effects of this crisis and achieved it (Boratav, 2015,
p.131). Turkey’s debt, which was 1.8 billion dollars
in 1970, increased to 10 billion dollars in 1977. In
1978, the share of short-term debts in total debt
reached 52 percent. The crisis broke out in 1978.
As a continuation of the above factors, the fact
that OPEC countries increased their oil prices by
157
7
150% completely destroyed the economy. OPEC
members increased oil prices by 150 percent for
the second time in 1979 and 1980. Inflation and
unemployment increased.
As a result of all these developments, the
1980 transformation took place and a liberal
economy was adopted. In 1986, there was
another crisis because of the factors such as the
economic imbalance due to the increase in public
expenditures and the decrease in export revenues
and workers’ remittances. In this period, tight
monetary policy policies such as convenience
to foreign capital, privatization and freedom in
foreign exchange transactions were implemented.
After these measures, Turkey started to experience
serious financial crises more frequently.
Crises After 1990
Over-regulation policies implemented in the
financial markets in the pre-1980 period left
its place to the financial liberalization process
and deregulation practices in the 1980s. The
globalization trend that emerged as a result of
the technological developments and liberalization
movements caused financial markets to take on a
more sensitive structure. In this context, especially
with the globalization movements in the 1990s,
many financial crises broke out in the international
financial markets.
After 1994, November 2000, and February
2001 crises, Turkey implemented a number of
regulatory programs for the prevention of financial
crisis. The Banking Supervisory Board, the second
financial regulation institution, was established
in 1999 after the Capital Markets Board. With
the establishment of the Banking Supervisory
Board, the management complexity in the
implementation of financial policies disappeared
and policy implementations were collected under
the management of this institution (Bahar &
Erdoğan, 2001, p.2).
1994 and 1997-1998 Crises
The financial liberalization process, which
began with the decisions of January 20, 1980,
caused a major financial crisis in 1994 at the
end of 14 years. There had been an increase in
foreign capital inflows to Turkey together with the
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Financial Crises and Regulations
liberalization of capital movements since 1989.
Short-term foreign trade balance deficits, public
borrowing in need of funds and the increase of
portfolio investments in pre-crisis years exhibited
a significant increase (Seyidoğlu, 2003, p.146).
This increase in hot money inflows led the open
positions of banks to grow. This public sector
financing deficit and current account deficit were
the basis of the 1994 crisis. The Gulf War and the
European Monetary Crisis prior to 1994 put the
external financing conditions in a risky position
(Oktar and Dalyancı, 2010, p.12). This economic
picture carried Turkey to the 1994 Currency crisis.
important
During Turkey’s currency crisis in 1994,
output fell 6 percent, inflation rose to three-
digit levels, the Central Bank lost half of its
reserves, and the exchange rate (against the
U.S. dollar) depreciated by more than half in
the first three months of the year.
Turkey overcame the crises in a short time
thanks to the effects of the 1994 crisis stabilization
programs. Foreign capital inflows recorded an
accelerated increase in the period 1995-1997,
and this increase was replaced by a decline after
the Russian crisis that erupted in 1998 (Bahar &
Erdoğan, 2001, p.2).
Regarding the Asian crisis, the factors such as
the lack of market discipline regarding the financial
sector and the lack of transparency caused the crisis
to deepen and not to be fully understood initially.
This also limited the effects of the measures. While
the 1997 Asian crisis hit Turkish economy through
capital channels, the 1998 Russian crisis hit Turkey
through foreign trade channels.
The main reasons for the 1994 and 1998 crises
were (BDDK, 2010).:
• existence of the unsustainable debt burden
in an economic atmosphere, where there
was high and volatile inflation and unstable
growth performance
• structural problems, especially financial
markets, which could not be resolved
permanently
 7
Financial Markets & Institutions

November 2000 Crisis In this process, Turkey experienced both an

The crisis of November 2000 was a financial
system crisis and the main reason for this crisis
was the banking sector. Banks’ attempts to close
their open positions caused public and private
banks to enter into borrowing rush. Turkey started
to increase the risk premium on the borrowing
rate in the external market, which made foreign
borrowing difficult.
In addition to the problems of the banking
sector, the lack of trust in the stability program,
which was implemented under the standby treaty
signed with the IMF in 1999 with the main goal of
reducing inflation, accelerated the process towards
the November crisis (Bahar & Erdoğan, 2001, p.12).
economic and financial crisis at the same time
facing the due date of the debt rollover problems.
The payments system collapsed and the securities
and money markets transactions stopped,
especially because the state banks could not fulfill
their obligations in the money markets (BDDK,
2009, p.3).
The crisis that started in the banking sector
on November 22, 2000 turned into a
currency crisis on February 19, 2001 and
took on the character of twin crises.

With the crisis of February 21, 2001, the

February 2001 Crisis
The markets, which were already sensitive due
to the November 2000 crisis, turned upside down
with the speculative effects of the political crisis
between the President and the Prime Minister.
The pressure on the exchange rates increased
because of the people attacking the TL positions
in the November crisis. There was a severe foreign
currency attack in February, and a 40 percent
increase was observed in the dollar exchange rate
of the first 10 days of the crisis (Ongun, 2002,
p.73). The Central Bank intervened in the market
at the expense of melting its reserves for the two
days following the crisis. Yet on February 22, it
was forced to declare that the exchange rate anchor
was abolished and the floating rate was adopted
(Güloğlu and Altunoğlu, 2002, p.25).
program dated December 9,1999 completely
disappeared. A loss of 6 billion dollars was declared
from the Central Bank, overnight interest rates in
the Interbank market exceeded 6000 percent. On
average, it was realized as high as 4000 percent. In
the face of these developments, the exchange rate
was left to fluctuate.
important
The 21 February 2001 crisis, which was also
a foreign currency crisis, was mainly caused
by high increases in the current account
deficit.

Learning Outcomes

2 Identify financial crises in Turkey.

Self Review 2 Relate Tell/Share

Discuss the importance

What was the main reason
behind the November 2000
crises?
Associate political crises and
of the banking sector’s
financial crises considering
financial strength to avoid
the February 2001 crises.
financial crises.

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Financial Crises and Regulations

REGULATIONS IN THE
FINANCIAL INDUSTRY
Regulation, in general, is a form of government
intervention in economic activity and interference
with the working of the free-market system (Moosa,
2015). The regulation of financial institutions has
been growing rapidly in many countries due to the
two main reasons.
The first one is the expanding freedom of
financial markets (including the progressive
relaxation of restrictions on the types of business,
which financial institutions can undertake).
In this sense, boundaries between commercial,
saving and investment banks, between the banks
and the securities houses and between the banks
and the insurance companies were dissolving.
Furthermore, new financial instruments and
services have developed. At this point, it should
be noted that extending an institution’s range
of activities reduces its riskiness where the
correlation between the returns on different
activities is not strong.
The second cause of the proliferation of
financial regulations is the regulation itself. If
a regulation is imposed on a particular financial
sector, sooner or later, there will be a necessity
for regulation to be applied to other types of
institutions whose activities compete with it in one
way or another. The pressure for a so-called ‘level
playing field’ is also seen in the attempt to impose
common standards internationally, irrespective of
whether uniformity is appropriate to institutions
and economies with different degrees of riskiness.
Moreover, the failure of existing forms of
regulation to prevent institutional collapse, fraud
or other abuse tends to generate a demand for still
tighter control (Rose, 1995).
Governments and central banks have tended
to act on the assumption that the increasing
freedom of financial markets must be
accompanied by an increasing supervision of
financial institutions.
Financial Regulations
Since we are faced with asymmetric information
problems in financial markets, regulations became a
fact of life. Regulation is concerned with changing
the behaviour of regulated institutions. Regulatory
frameworks in regarding financial institutions utilize:
• Disclosure requirements (disclosure
of financial statements and relevant
information)
• Deposit insurance
• Capital requirements
• Supervision
• Assessment of risk management
• Restrictions on competition
The main objectives of imposing financial
regulations are as follows (Llewellyn, 1999):
• to sustain systemic stability,
• to maintain the safety and soundness of
financial institutions,
• to protect the consumers.
International Financial Regulations
The Basel Committee - initially named
the Committee on Banking Regulations and
Supervisory Practices - was established by the
central banks Governors of the Group of Ten
countries at the end of 1974 in the aftermath of
serious disturbances in international currency and
banking markets (notably the failure of Bankhaus
Herstatt in West Germany). Basel Committee,
headquartered at the Bank for International
Settlements in Basel, was established to enhance
financial stability by improving the quality of
banking supervision worldwide, and to serve as a
forum for regular cooperation between its member
countries on banking supervisory matters.

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Financial Markets & Institutions
Since its inception, the Basel Committee has
expanded its membership from the G10 to 45
institutions from 28 jurisdiction. Starting with the
Basel Concordat, first issued in 1975 and revised
several times, the Committee has established a series
of international standards for bank regulation, most
notably its landmark publications of the accords on
capital adequacy which are commonly known as
Basel I, Basel II and, most recently, Basel III.
The Committee’s first meeting took place in
February 1975, and meetings were held regularly
three or four times a year since. The Basel
Committee consists of senior representatives of
bank supervisory authorities and central banks from
Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, Netherlands, Sweden, Switzerland,
United Kingdom and the United States.
The Basel Committee on Banking
Supervision (BCBS) is the primary global
standard setter for the prudential regulation
of banks and provides a forum for regular
cooperation on banking supervisory matters.
important
Bank for International Settlement (BIS)
was established on 17 May 1930, which is
the world’s oldest international financial
organization. From its inception to the
present day, the BIS has played a number of
key roles in the global economy, from settling
reparation payments imposed on Germany
following the First World War, to serving
central banks in their pursuit of monetary
and financial stability.
Basel I
The 1988 Basel Capital Accord was a milestone.
For the first time, supervisors in the main banking
markets agreed on a definition of capital and a
minimum requirement (Caruana, 2008). The
original Basel Accord, which was ultimately
adopted by more than 120 countries around the
world, attempted to subject all internationally
active banks to a common set of minimum capital
requirements by setting out risk-weights for assets
and off-balance sheet positions, defining two kinds
7
of capital and establishing risk weighted asset ratios
that all banks were required to meet. This is often
summarized in two ratios: Tier 1 capital must be at
least 4% of risk-weighted assets and Tier 1 + Tier
2 capital must be at least 8% of risk-weighted assets
(Herring, 2010).
Tier 1: A term used to describe the capital
adequacy of a bank. Tier I capital is core
capital; this includes equity capital and
disclosed reserves.
Tier 2: A term used to describe the capital
adequacy of a bank. Tier II capital is
secondary bank capital that includes items
such as undisclosed reserves, general loss
reserves, subordinated debt of five years.
Basel II
In response to the criticism of Basel I, to address
the changes in the banking environment that the
1988 accord could not deal with effectively, and
in response to the view that Basel I was becoming
outdated, the BCBS decided to design and
implement a new capital accord, Basel II.
In its introduction of the first set of proposals
that gave birth to Basel II, the BCBS proclaimed
a critical need to redesign the 1988 Accord in the
light of market innovations and a fundamental shift
towards more complexity in the banking industry.
important
The main objective behind the introduction
of the Basel II Accord was to narrow the gap
between regulatory capital requirements and
the economic capital produced by the banks’
own internal models.
Unlike Basel I, which had one pillar (minimum
capital requirements or capital adequacy), Basel II
has three pillars:
• Minimum regulatory capital requirements;
• The supervisory review process;
• Market discipline through disclosure.
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Financial Crises and Regulations

The proclaimed features of Basel II and its differences

from Basel I are the following (Moosa, 2015).:
The Basel II regulatory framework was unable
• Basel II includes a “more sophisticated” measurement to maintain the adequate capital to absorb
framework for evaluating capital adequacy; additional levels of risks in the banking
• Basel II is not only about capital adequacy, but system. These shortcomings triggered a wave
also about improving risk management in the of reforms in the aftermath of the crisis to
finance industry by providing the correct incentives introduce tighter capital adequacy and
for better corporate governance and fostering liquidity guidelines in the Basel regulatory
transparency; provisions.
• In Basel II, an explicit weight is assigned to
operational risk;
• Basel II is more risk-sensitive than Basel 1;
• Basel II allows a greater use of internal models for risk assessment and the calculation of regulatory
capital
Despite all of the proclaimed benefits and novelties of Basel II, the accord has been subject to a
barrage of criticism from academics, practitioners and even some regulators (those who are not directly
associated with the Basel Committee). Some bankers think that it is complex and dangerous. Basel II
shares many of the shortcomings of Basel 1, but it has more of its own (Moosa, 2015).

Basel III
The global financial crisis of 2008 revealed very serious deficiencies not only in financial markets, but
also the supervisory and regulatory environment at international level (Giovanali and Devos, 2015). That
is why, despite its comprehensive structure and sensitivity to risks, the Basel II Accord failed to withstand
the recent turmoil in the banking industry and maintain stability in financial markets.
There was a transitional step with the so-called Basel 2.5. At this stage, the global regulatory institution
strengthened market risk capital for the trading book, introduced stress testing in Value at Risk, and revised
the treatment of securitizations. Following this step, the Basel regulators went further to achieve thorough
amendments in order to supplement the existing global regulatory framework with new provisions. This
led to the Basel III Accord, which is considered as an extension to address the weaknesses of the Basel II and
provide concrete and innovative solutions to the emerging challenges in the global banking industry and
financial system as well. Basel III Accord released in December 2010, the new Basel Accord is expected to
be a stringent reference in prudential regulation in the global banking system. Unlike the previous accords,
Basel III introduced macro-prudential norms in banking regulation to handle systemic risk (Vassiliadis,
Baboukardos and Kotsovolos, 2012).

Learning Outcomes

3 Explain the main objectives for regulations in the financial industry.

Self Review 3 Relate Tell/Share

What was the main objective Associate the 2008 global What are the main
behind the introduction of financial crises and the objectives of financial
the Basel II Accord? release of Basel III. regulations?

162

Financial Markets & Institutions
In Practice
FINANCIAL SECTOR ASSESSMENT
PROGRAM (FSAP)
The Financial Sector Assessment Program
(FSAP), established in 1999, is a comprehensive
and in-depth assessment of a country’s financial
sector. FSAPs analyze the resilience of the
financial sector, the quality of the regulatory
and supervisory framework, and the capacity to
manage and resolve financial crises. Based on its
findings, FSAPs produce recommendations of a
micro- and macro-prudential nature, tailored to
country-specific circumstances.
The global financial crisis showed that the
health and functioning of a country’s financial
sector has far-reaching implications for its own
and other economies. The Financial Sector
Assessment Program (FSAP) is a comprehensive
and in-depth analysis of a country’s financial
sector. FSAP assessments are the joint
responsibility of the IMF and World Bank in
developing economies and emerging markets and
of the IMF alone in advanced economies. The
FSAP includes two major components: a financial
stability assessment, which is the responsibility of
the IMF, and a financial development assessment,
the responsibility of the World Bank. To date,
more than three-quarters of the institutions’
member countries have undergone assessments.
The FSAP is a key instrument of the Fund’s
surveillance and provides input to the Article
IV consultation. In jurisdiction with financial
sectors deemed by the Fund to be systemically
important, financial stability assessments under
7
the FSAP are a mandatory part of Article IV
surveillance, and are supposed to take place every
five years; for all other jurisdiction, participation
in the program is voluntary. In developing
and emerging market countries, FSAPs are
conducted jointly with the World Bank. In
these countries, FSAP assessments include two
components: a financial stability assessment,
which is the responsibility of the Fund, and a
financial development assessment, which is the
responsibility of the World Bank.
At the end of each FSAP mission, teams leave
a detailed and comprehensive Aide Memoire
with national authorities, which is confidential.
FSAPs conclude with the preparation of a
Financial System Stability Assessment (FSSA),
which focuses on issues of relevance to IMF
surveillance and is discussed at the IMF Executive
Board together with the country’s Article IV
report. Publication of FSSAs is not mandatory.
In addition to the main document (listed below
if published), individual country’s FSAPs may
bring forward additional supporting documents
(International Monetary Fund (IMF)).
* Aide-mémoire is a French loanword meaning
“a memory-aid; a reminder or memorandum,
especially a book or document serving this
purpose”.
Kaynak: https://www.imf.org/external/np/fsap/
fssa.aspx
163
7
Further Reading
Lehman Brothers Collapse: A Race to the
Bottom
Before its demise, Lehman Brothers was
one of titans of Wall Street. It was the fourth
biggest investment bank behind Goldman Sachs,
Morgan Stanley and Merrill Lynch leading into
the global financial crisis.
It still holds the record for the largest
bankruptcy in US history. At the time Lehman
Brothers shut down on September 15, 2008 it
had $US639 billion in assets and $US619 billion
in debt.
It traced its history back to the 1850s when
German brothers Henry, Emanuel and Mayer
Lehman, transformed their small store in the
deep south of Alabama into a bank.
From the late 1990s Lehman Brothers
sought to capitalise on the US housing boom,
acquiring five big mortgage lenders, including
BNC Mortgage and Aurora Loan Services.
BNC and Aurora were pioneers in sub-prime
lending, selling high-risk mortgages with little
documentation.
It was a punt that would ultimately destroy
Lehman Brothers, leave Wall Street teetering
above the abyss and help spark a global recession.
Real estate hedge fund
The shift into property financing catapulted
Lehman Brothers from being just another bond-
trader to a massive, full service investment bank.
It specialised in highly risky and highly
rewarding bridging finance in big real estate
deals.
In 2006, the year before things started
unravelling, the property unit was responsible for
around 20 per cent of banks’ $US4 billion profit.
Many argued it was not really a bank
anymore, but a real estate hedge fund.
Cracks appear
By February 2007 Lehman Brothers’ shares
hit a record high of $86, giving it a market
capitalisation of around $US60bn. It was all
downhill from there.
A month later the company conceded that
defaults in its roughly $US150 billion worth of
securitised mortgages could impact the profits, a
comment that turned out to be one of the larger
understatements in US corporate history.
Nonetheless, it continued to write more
mortgage-backed securities than any other bank.
164
Financial Crises and Regulations
The beginning of the end
While an exact starting point of the global
financial crisis is hard to pinpoint, August 9,
2007 is as good a date as any.
It was the day big French bank BNP Paribas
froze a number of investment funds loaded with
US mortgage-backed securities, and collateralized
debt obligations (CDOs) as defaults on sub-prime
loans started mounting up at an alarming rate.
BNP simply could not work out what
they were worth, or indeed if they were worth
anything.
It was the same month Lehman Brothers
closed BNC Mortgage, sacking 1,200 employees.
At that stage the damage appeared limited to a
$US50 million impairment charge.
Bear Stearns collapses
The second biggest underwriter of sub-prime
loans, and Lehman Brothers’ arch rival, Bear
Stearns finally capitulated to its toxic load of debt
on March 14, 2008.
After the New York Federal Reserve back-
tracked on a planned bail out, Bearn Stearns
was sold to JP Morgan Chase for $2 a share, a
fraction of the value of its pre-crisis highs.
The market bet Lehman Brothers would be
the next big bank to fall and its share price was
cut in half almost overnight.
Too big to fail
Lehman Brothers’ demise prompted a full-
blown bank crisis in the US, Europe and large
parts of Asia.
The Bush administration hurriedly came up
with the Troubled Assets Relief Program (TARP),
a $US700 billion slush fund to buy toxic assets
from the banks that had engineered them.
It helped stem the outright panic. Ultimately
the banks chewed through more than $400
billion of TARP money stumped up by taxpayers,
although the government ended up making a
small profit on the salvage operation.
Lehman Brothers was the only big bank that
was allowed to collapse.
Its legacy for the survivors, or what are
now known as systemically important banks, is
taxpayers will have to stand behind them with
the “too big to fail” guarantee.
Kaynak: https://www.abc.net.au/news/2018-
09-14/lehman-brothers-timeline-a-race-to-the-
bottom/10242912
 7
Financial Markets & Institutions

Discuss the reasons and effects of

LO 1 global financial crises.

Financial crises are usually caused by the following factors :

• Mismanagement of financial liberalization
• Asset Price bubbles or booms, meaning market prices of assets realized above economic values
• High uncertainty, usually following economic downturns or stock market crashes
• Current account deficits

Summary
• Budget deficits
• Excessive borrowing of government
• Excessive borrowing of businesses
• Vulnerability or fragility of banking industry

The effects of the financial crisis, in general, may include:

• Economic downturn
• Deterioration of cash flows
• Decline of lending
• Deterioration in the balance sheets of financial institutions
• Deterioration in the balance sheets of businesses
• Currency crises
• Rises in debt burdens
• Bank failures
• Company failures
• Increased volatility in financial markets
• Rises in inflation and interest rates
• Rises in unemployment

LO 2 Identify financial crises in Turkey.

We can classify crises in Turkey as crises before 1990 and crises after 1990. Crises after 1990 are:
• 1994 and 1997-1998 Crises
• November 2000 Crisis
• February 2001 Crisis

Explain the main objectives of regulations

LO 3 in the financial industry.

The main objectives of imposing financial regulations are as follows (Llewellyn, 1999):
(1) to sustain systemic stability,
(2) to maintain the safety and soundness of financial institutions,
(3) to protect the consumers.

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Financial Crises and Regulations

1 I. The money crisis 6 I. The collapse of US real estate market

II. The banking crisis II. Lack of transparency
III. The systemic financial crisis III. Biased assessments of the credit rating
Which of the crises mentioned above are among agencies
the main types of financial and/or economic crises?
Test Yourself

Which of the premises mentioned above are among

A. Only I
the reasons for the 2008/2009 global financial and
B. I and II
C. I and III economic crisis?
D. II and III A. Only I
E. I, II and III B. I and II
C. I and III
2 “…………………. crises are defined as D. II and III
financial distortions that have significant effects
on the real economy by preventing the efficient E. I, II and III
functioning of financial markets.”
Fill in the blank above correctly with one of the 7 In what year was there NO crisis in Turkey?
choices below.
A. Money crisis A. 1994
B. Banking crisis B. 1998
C. Systemic financial crisis C. 2000
D. External debt crisis D. 2001
E. Internal debt crisis E. 2005

3 What is the first recorded speculative balloon 8

Which of the following choices below are
in history?
NOT among the main reasons for financial
A. The Tulip Madness regulations?
B. The bankruptcy of the South Sea Company
C. The 1796-1797 panic A. Market failure
D. The Long (Great) Depression B. Free banking system
E. The Great Depression C. Asymmetric information
D. Systemic risk and contagion
4 When did “the great depression” that E. Fiscal rules
originated in the USA break out?
A. 1921 9 When was the Basel Committee established?
B. 1924
C. 1929 A. in 1974
D. 1931 B. in 1979
E. 1933
C. in 1981
5 I. Baker’s Plan D. in 1989
II. Brady Plan E. in 1990
III. New York Club
10 Whatis the world’s oldest international
Which of the premises mentioned above are among
the solution proposals for the 1980 Global Debt Crisis? financial organization?
A. Only I A. Bank for International Settlement
B. I and II B. Basel Capital Accord
C. I and III C. The Financial Sector Assessment Program
D. II and III
D. World Trade Organization
E. I, II and III
E. World Bank

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Financial Markets & Institutions

1. E If your answer is wrong, please review the 6. E If your answer is wrong, please review the
“Global Crises” section. “Global Crises” section.

2. C If your answer is wrong, please review the 7. E If your answer is wrong, please review the

Answer Key for “Test Yourself”

“Global Crises” section. “Crises in Turkey” section.

If your answer is wrong, please review the

3. A If your answer is wrong, please review the 8. E
“Regulations in the Financial Industry”
“Global Crises” section.
section.

If your answer is wrong, please review the

4. C If your answer is wrong, please review the 9. A
“Regulations in the Financial Industry”
“Global Crises” section.
section.

If your answer is wrong, please review the

5. B If your answer is wrong, please review the 10. A
“Regulations in the Financial Industry”
“Global Crises” section.
section.

How did the the 2008-2009 Global Financial and

Suggested answers for “Self Review”

Economic Crisis influence the economies of the
developed and developing countries?

The US fell into economic stagnation in December 2007. Growth rates in

self review 1 both the developed world and developing countries also decreased. The global
crisis significantly affected the unemployment rates. Especially in the US and
developed economies, the upward trend was striking.

What was the main reason behind the November 2000

crises?

The main reason for this crisis was the banking sector’s attempts to close their
self review 2 open positions. These attempts caused public and private banks to enter into
borrowing rush.

What was the main objective behind the

introduction of the Basel II Accord?

The main objective behind the introduction of the Basel II Accord was to
self review 3 narrow the gap between regulatory capital requirements and the economic
capital produced by the banks’ own internal models.

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Financial Crises and Regulations

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