Page i FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS Page ii ASSURANCE OF LEARNING Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. This eighth edition of Financial Institutions, Instruments and Markets is specifically created
to support assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by graduates such as: communication, initiative and enterprise, self-management, life-long learning, problem solving, technology, teamwork, planning and organising.1 Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the learning outcomes for your course which may assist instructors in making the collection and presentation of assurance of learning data easier. AACSB STATEMENT McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Financial Institutions, Instruments and Markets 8e has sought to recognise the curriculum guidelines detailed in the AACSB standards for business accreditation. A variety of pedagogical features in chapters are designed to draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities, use of information technology, ethical understanding, reflective thinking, critical analysis and diversity and multicultural understanding.2 The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school and the faculty. While Financial Institutions, Instruments and Markets 8e and the teaching package make no claim of specific AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of the general knowledge and skills areas.
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Viney, Christopher, author. Financial institutions, instruments and markets / Christopher Viney, Peter Phillips. 8th edition 9781743079959 (paperback) Includes index. Financial institutions—Australia. Financial institutions—Australia—Problems, exercises, etc. Financial instruments—Australia. Financial instruments—Australia—Problems, exercises, etc. Money market—Australia. Money market—Australia—Problems, exercises, etc. Phillips, Peter John, author.
Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 2, 82 Waterloo Road, North Ryde NSW 2113 Publisher: Jillian Gibbs Senior product developer: Lisa Coady Production editor: Natalie Crouch Permissions editor: Haidi Bernhardt Copyeditor: Julie Wicks Proofreader: Anne Savage Indexer: Graham Clayton Cover design: Christa Moffit Internal design: David Rosemeyer Typeset in Chaparral Pro 10/12 by SR Nova Printed in China on 70 gsm matt art by CTPS http://textflow.mheducation.com/parser.php?secload=0.3&fake&print
This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry. In this eighth edition, Dr Peter Phillips and myself continue to present a finance text for you that is authoritative and scholarly, which at the same time highlights the dynamic, exciting and global nature of financial institutions, instruments and markets. The recent global financial crisis gradually became apparent from mid-2007 and had a significant adverse effect on the financial markets from 2008. As the crisis then rapidly evolved it led to an extended period of continuing financial market uncertainty and extreme volatility. Major global financial institutions had to be bailed out by government or failed, sovereign debt in a number of countries reached unprecedented levels, economic activity slowed significantly and unemployment rose to very high levels, particularly in the USA and a number of European countries. The nature and contagion effects of this evolving global financial crisis are discussed in detail in various chapters of the book. Within this context, it is important that the eighth edition should encourage new generations of students and industry practitioners to understand, anticipate and challenge the complex and rapidly evolving structure of the financial system. As argued by Nobel Laureate and leading economist Professor Joseph Stiglitz, effective financial market regulation within the context of the integrated global financial markets is required to mitigate future financial crises. Interestingly, the government initiated a review of the Australian financial system in 1997 (the Wallis Report). In part, structural and regulatory change that was implemented as a result of that report ensured the Australian financial system came through the global financial crisis relatively unscathed. The government has currently commissioned a new review of the system (the Murray Report). The final report is due at the end of 2014 and hopefully the government and regulators will act upon its recommendations of the report to ensure the financial system is made even more efficient and robust. One thing is certain, change will occur. As students of the financial system you must keep yourself informed about the structure and operation of financial institutions, instruments and markets. Importantly, you must think about and anticipate future directions and change. When, as a young boy of sixteen I began working in the industry, it was the time of pounds, shillings and pence. I was required to record all transactions using a nib pen dipped in ink. Daily, weekly, monthly and annual statements were added in my head. It was an exciting day when we received a mechanical adding machine—its dimensions were 300×400×200 mm and it could only add, subtract, multiply and divide. I had to pull a large handle to input each entry into the machine. There has been unbelievable change to the insulated environment of those days. In particular, there has been significant deregulation of the financial markets, the development of electronic information and product delivery systems, new and sophisticated financial products, the integration of domestic financial systems into a global financial system and, from time to time, major financial and economic crises. To remain relevant in business and finance you must continue to educate yourself and those for whom you may be responsible in the future. You must read the daily press and periodic financial journals to keep yourself up to date. I suggest you add notations of current and proposed future changes to the financial system to your personal copy of this book. This is not a text that you will sell at the end of a particular unit of study, but rather is an important reference that you should continue to use for further studies and on into your professional career. I have enjoyed my career working in and teaching about the financial system. I encourage you to accept every opportunity that comes your way and I wish you the best of success. CH R I S T O P H E R VI N E Y
C H R I S T O P H E R V I N E Y brings to this book a wealth of industry experience and academic knowledge associated with the international financial markets. His appreciation of the nature of both the theoretic and the applied functions and operations of the global financial system is reflected in the clear and interesting presentation of issues in such a way that the reader is motivated to learn. Prior to moving into academia Chris spent twenty-seven years in the commercial banking industry including retail banking, corporate lending, risk management, personnel, property, policy and administration. His academic career included appointments at Monash University and Deakin University, Melbourne, Australia. He has taught in the areas of financial markets, financial institutions management, corporate finance, treasury management and personal financial planning. Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand. He has received university awards for contributions to the internationalisation of teaching and learning programs. As the director of the finance international study programs at Monash and Deakin Universities, Chris has taken select groups of students overseas as part of their tertiary studies. He has also published research papers on the capital markets, operational risk management, bureau de change, money laundering and education and training. Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future editions of the book and it has now become a principal learning and reference source for undergraduate students, postgraduate students and industry practitioners alike. As the text book continues to evolve, a co-author, Peter Phillips, has joined Chris in writing the seventh and eighth editions.
P E T E R P H I L L I P S has been teaching economics and finance at the University of Southern Queensland (USQ) in Toowoomba, Australia since 1998. Presently, he is an Associate Professor in Finance at USQ. He has taught in the areas of financial markets and institutions, portfolio management and corporate finance as well as several economics courses, including macroeconomics and econometrics. Peter completed a PhD at USQ in financial economics in 2003. Since then he has published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs) in which he and his co-authors explore various aspects of the portfolios chosen by SMSF investors. He has recently completed work on a book that explores SMSFs in more detail.
Acknowledgments The challenge of maintaining the currency and relevancy of a book with the scope of financial institutions, instruments and markets is enormous. This daunting task is tackled at many levels. At one level we are most appreciative of those users of the book, including academics, practitioners and students, who provide ongoing feedback in the form of comment, suggestion and discussion. We value your contributions immensely. The quality of the production of the book is also dependent on the expertise and hard work of the people at McGraw-Hill Education Australia. As authors, we have been very fortunate to have the dedicated editorial support of Jillian Gibbs and Jane Roy. We would also like to acknowledge and thank the team at McGraw-Hill including: Lisa Coady, Natalie Crouch, Marisa Rey Bulen, Haidi Bernhardt and Maryann D'Sa. CH R I S T O P H E R VI N E Y
C H A P T E R 1 A modern financial system: An overview highlights various aspects of the global financial crisis with a special focus on the importance of regulation for ensuring financial markets stability introduces the financial institutions, financial instruments and financial markets that comprise domestic and global financial systems and explains why a stable financial system is important for economic growth provides a concise context that assists the reader to understand the relationships of the material in the following chapters extended learning—globalisation of the financial markets and the drivers of change in the financial system extended learning—the impact of the Asian financial crisis on the financial system C H A P T E R 2 Commercial banks contains a detailed discussion on the commercial bank, including its role, products, off-balance-sheet business, regulation and supervision provides a concise explanation of the capital adequacy and liquidity standards that apply to banks under the Basel II and Basel III Accords outlines aspects of the regulatory response to the global financial crisis extended learning—standardised approach to credit risk extended learning—business continuity risk management extended learning—corporate governance and ethics C H A P T E R 3 Non-bank financial institutions an examination of investment banks, managed funds, superannuation funds, cash management trusts, public unit trusts, life and general insurance offices, hedge funds, finance companies, building societies, credit unions and export finance corporations extended learning—project finance and structured finance C H A P T E R 4 The share market and the corporation considers the management structure of a publicly listed corporation discusses the important roles of a stock exchange in facilitating the listing of a corporation's shares on the exchange (primary market role) and the ongoing trading of existing shares (secondary market role) on the share market examines the managed products and derivative products offered by a stock exchange, including exchange traded funds, contracts for difference, real estate investment trusts, infrastructure funds, options, warrants and futures contracts examines the interest rate market role, the trading and settlements roles, the information role and the regulatory roles of a stock exchange C H A P T E R 5 Corporations issuing equity in the share market introduces the capital budgeting investment decision process; funding issues related to debt and equity; initial public offerings, stock exchange listing rules and alternative forms of equity issues extended learning—Australian Securities Exchange (ASX) listing requirements C H A P T E R 6 Investors in the share market considers the role of the investor in the share market; risks associated with buying and selling shares discusses taxation; financial performance indicators and the pricing of shares introduces share market indices and the interpretation of share market information C H A P T E R 7 Forecasting share price movements examines fundamental analysis and technical analysis approaches to share price forecasting http://textflow.mheducation.com/parser.php?secload=0.7&fake&print
considers the nature and impact of electronic trading on the markets introduces the random walk hypothesis and the efficient markets hypothesis (EMH) within the context of forecasting share price movements introduces behavioural finance as an alternative theoretical framework to the EMH for understanding share price movements C H A P T E R 8 Mathematics of finance: an introduction to basic concepts and calculations introduces the principles of mathematical calculations that underpin financial market instruments, including simple interest, compound interest, present value, future value, yield, annuities and effective rates of interest C H A P T E R 9 Short-term debt examines the main sources and types of short-term intermediated and direct finance available to a business corporation, including trade credit, bank overdrafts, commercial bills, promissory notes, negotiable certificates of deposit, inventory finance, accounts receivable financing and factoring calculation of prices and yields on discount securities C H A P T E R 10 Medium- to long-term debt identifies the main types of longer-term debt available to a corporation, including term loans, fully drawn advances, mortgage finance, debentures, unsecured notes, subordinated debt and leasing calculation of prices and yields on fixed interest securities extended learning—securitisation Page xvii C H A P T E R 11 International debt markets explores the structure of the international debt markets, in particular the euromarkets (eurocurrency, euronote and eurobond markets) and the US money and capital markets. examines the main generic products offered in the international debt markets considers the important role of credit rating agencies in the international debt markets extended learning—novation, subparticipation and transferable loan certificates extended learning—convertible bonds and warrants extended learning—US medium-term notes extended learning—Standard & Poor's credit rating definitions C H A P T E R 12 Government debt, monetary policy and the payments system examines why governments issue short-term and longer-term debt securities, the types of securities and the pricing of those securities. It also considers the purpose and implementation of monetary policy; the operation of the payments system, exchange settlement accounts, real-time gross settlement and repurchase agreements extended learning—fixed-coupon Treasury bonds: price calculation using the Australian Office of Financial Management (AOFM) formula C H A P T E R 13 An introduction to interest rate determination and forecasting examines the macroeconomic context and the loanable funds approach to interest rate determination and the impact of changes in related variables considers the term structure and risk structure of interest rates within the context of the expectations theory, the segmented markets theory and the liquidity premium theory extended learning—the yield curve and expectations theory calculations C H A P T E R 14 Interest rate risk measurement identifies methods used to measure interest rate risk and introduces an exposure management system examines interest rate risk measurement models, including re-pricing gap analysis, duration and convexity considers internal and external interest rate risk management techniques C H A P T E R 15 Foreign exchange: the structure and operation of the FX market examines the structure, participants, operation and conventions in the global FX markets http://textflow.mheducation.com/parser.php?secload=0.7&fake&print
discusses and calculates spot and forward FX quotations considers the impact of the Economic and Monetary Union of the European Union (EMU) C H A P T E R 16 Foreign exchange: factors that influence the exchange rate introduces different exchange rate regimes used by various nation-states in the context of a floating exchange rate, considers factors that affect the determination of an equilibrium exchange rate, including relative inflation rates, national income growth rates, interest rates, expectations and central bank intervention considers the application of regression analysis in the measurement of exchange rate sensitivity extended learning—purchasing power parity C H A P T E R 17 Foreign exchange: risk identification and management recognises FX risk and presents an organisational FX risk policy structure discusses the measurement of transaction FX exposures examines internal and external market-based hedging techniques using derivative products C H A P T E R 18 An introduction to risk management and derivatives introduces the fundamentals of understanding risk and risk management provides a concise introduction to generic derivative products and markets, in particular futures, forwards, option and swap contracts C H A P T E R 19 Futures contracts and forward rate agreements examines the purpose, structure and operation of a futures market, including structuring and calculating risk management strategies considers forward rate agreement contracts and the use of an FRA to manage interest rate risk exposures C H A P T E R 20 Options examines the purpose, structure and operation of options markets introduces option contract strategies that may be applied in a wide range of risk exposure scenarios C H A P T E R 21 Interest rate swaps, cross-currency swaps and credit default swaps examines the purpose of interest rate swaps (including facilitating speculation) and considers the construction of a swap to manage an interest rate risk exposure in the context of international markets, considers the construction of a currency swap to manage both an interest rate exposure and an FX risk exposure introduces the credit default swap and discusses the structure of, and parties to, a CDS.
Page xxii PART INTRODUCTIONS Introducing each of the six parts is a short overview of the material covered in the following chapters. These openers are a helpful introduction to how the key concepts, institutions or instruments work together and how they fit within the larger picture.
CHAPTER OPENERS Each chapter begins with a short overview of the information contained in the chapter, providing not only an introduction to the chapter, but also a useful study reference.
LEARNING OBJECTIVES These numbered points clearly outline what each reader should know and be able to do by the end of the chapter. They will also assist in exam revision. Each learning objective notes the numbered section in which the learning objective appears in the chapter. They are directly linked to the end-of-chapter summary, which systematically works through each learning objective.
KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or concept is highlighted in the text at its first appearance, and the definition provided in the corresponding margin. A boxed list of these key terms appears at the end of each chapter and each entry is followed by the page on which it first appeared (thus linking to the margin definition) as well as providing the context for the definition. A full list with definitions appears in the glossary.
FINANCIAL NEWS CASE STUDY Found at the end of every chapter, each financial news case study contains excerpts from financial articles that provide real-world examples of concepts discussed within the chapter. They are followed by related discussion questions providing the opportunity for self-assessment and putting into practice what you've learned!
Page xix REFLECTION POINTS Located after every major section within each chapter, the reflection points highlight the most significant material covered as well as providing regular summaries and a useful tool for revision, which will help students identify areas requiring further study.
CHAPTER SUMMARIES The chapter summaries comprehensively review the topics covered in each chapter and are linked directly to the learning objectives, listing each learning objective and a summary of the relevant material.
EXTENDED LEARNING The extended learning sections provide an additional resource for self-assessment and a variety of activities designed to address the more complex aspects of the chapter. These sections are accompanied by extended learning questions which test students' understanding of the material.
END OF CHAPTER QUESTIONS Each chapter contains a number of different question types useful to test student recall and understanding of the material covered in the chapter. The True or false questions test your recall and the answers are helpfully contained at the end of the book, an excellent tool for exam revision. These true or false questions can also be used as short answer questions to test students' ability to provide more information. The Essay questions provide the opportunity to put the concepts that have been learnt into practice, highlighting students' ability to analyse and evaluate the material. The Extended learning questions relate to the in-depth extended learning sections and require students to demonstrate a deeper understanding of the concepts and theories presented in the chapter. Page xx EXPLORING FINANCE ON THE WEB This updated resource provides a comprehensive list of useful finance websites including central banks, financial institutions, government sites, exchanges and markets. It also provides online learning tools such as financial newspapers and magazines, currency converters, background reading and suggested databases.
CAREERS IN FINANCE Introduces students to the enormous career opportunities that exist in both local and international economics. A list of web addresses of select employers of finance graduates is a source of organisation-specific career information. A useful guide to preparing on-line application is also presented.
GLOSSARY This useful list of definitions contains all of the key terms and concepts as they appear in the margin notes. FINANCIAL ABBREVIATIONS This comprehensive list covers all the major financial abbreviations used both in the text and in the financial world, providing a quick, easy-to-use reference point. It is helpfully located on the inside front cover to make looking up terms easy! WORLD CURRENCIES Located on the inside back cover for ease of reference, this handy, updated table lists the currencies of all the world's major countries, as well as their common abbreviations.
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The following websites have been selected as useful and interesting sources of information relevant to financial institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this is just the beginning! See your library's subject page on finance/economics/business where there will be listings of search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources available to use/borrow, often with their call numbers and the general call numbers to look for your subject. These pages may also list significant journals in your field as well as databases and newspapers. BACKGROUND
Both Yahoo! and Google provide good entry points for the latest news, facts and figures as well as providing a gateway to other resources. Yahoo! has a specific Australian and New Zealand site, www.yahoo.com.au/finance. Google Finance has an international site, www.google.com/finance. FINANCE
This text includes a glossary of the main financial market words referred to in the book. As you extend your understanding of the financial system further, www.investorwords.com provides online access to over 6000 words and 20 000 links. It is the biggest financial glossary on the web. DATABASES This is a list of some of the suggested databases your library may have access to that contain finance articles and information. If your institution does not have access to all the databases you may be able to get access through another institution, so check with your library about borrowing rights at other universities. Proquest: Academic research library Covers finance, has full text articles. Connect4: Annual report collections Business provides full text annual reports from various Australian companies including some company financial statements. APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to full text. Proquest: Banking Information Sources International database, full text article access. Covers banking and industry and the financial services industry. Expanded Academic ASAP Full text articles available, international. Factiva Full text available, covers most Fairfax publications including Business Review Weekly, The Australian Financial Review and The Age. Science Direct Full text, international. Includes access to journals such as Journal of Financial Markets, Journal of International Money and Finance and Journal of Banking and Finance. You can find these databases by selecting your subject (finance, business, economics) and searching the library subject pages for relevant journal listings. Alternatively, look them up in alphabetical order through the online library catalogue to check for access. You may need a password when accessing them off campus. WORLD
http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member states of the United Nations with their ISO-4217 currency codes and abbreviations listed. www.xe.com/currencyconverter provides a convenient foreign exchange currency converter. Page xxiii FINANCE MEDIA Although not all of these may be available from your library (either in hard copy or through online access with a password) it is worth investigating the possibilities of interlibrary loans. Ask your subject librarian for information about accessing the catalogues of other libraries. Wall Street Journal http://online.wsj.com/public/asia The Wall Street Journal has great information available online without subscription. MSN Money www.money.msn.com http://textflow.mheducation.com/parser.php?secload=0.10&fake&print
A useful site that has good coverage of financial events in the ‘news’ section including video clips. The Financial Times www.ft.com/home/uk Online access to full text articles from either the UK, US or Asian editions of the paper. Fortune Magazine http://www.fortune.com Fortune Magazine home, access to full text articles. AUSTRALIAN
AND INTERNATIONAL INSTITUTIONS AND AUTHORITIES
The Reserve Bank of Australia website www.rba.gov.au/links provides direct link access to the websites of: central banks EMEAP members other international organisations Australian government departments and authorities Australian legislation Australian financial sector organisations AUSTRALIAN
ANZ Banking Group – www.anz.com.au Commonwealth Bank of Australia – www.commbank.com.au National Australia Bank – www.nab.com.au Westpac Banking Corporation – www.westpac.com.au SELECT
INTERNATIONAL FINANCIAL INSTITUTIONS
Allianz – www.allianz.com Citibank – www.citibank.com Credit Suisse – www.credit-suisse.com Goldman Sachs – www.goldmansachs.com ING Bank – www.ing.com JPMorgan Chase & Co – www.jpmorgan.com UBS Investment Bank – www.ibb.ubs.com CREDIT
Fitch Ratings – www.fitchibca.com Moody's Investors Service – www.moodys.com Standard & Poor's – www.standardandpoors.com INFORMATION
Australian Securities Exchange – www.asx.com.au New Zealand Stock Exchange – www.nzx.com http://textflow.mheducation.com/parser.php?secload=0.10&fake&print
CME Group (Chicago Board of Trade and Chicago Mercantile Exchange) – www.cmegroup.com Hong Kong Exchange – www.hkex.com.hk Euronext (formerly London International Financial Futures Exchange) – www.euronext.com London Metal Exchange – www.lme.com London Stock Exchange – www.londonstockexchange.com Lloyds of London – www.lloyds.com NASDAQ – www.nasdaq.com New York Stock Exchange – www.nyse.com Shanghai Stock Exchange – www.sse.com.cn Singapore Exchange – www.sgx.com Sydney Futures Exchange (a part of the Australian Securities Exchange) – www.asx.com.au Tokyo Stock Exchange – www.tse.or.jp/english CLEARING ,
SETTLEMENTS AND CUSTODIAN SERVICES
Austraclear – www.asx.com.au Clearstream – www.clearstream.com Euroclear – www.euroclear.com Reserve Bank Information and Transfer System – www.rba.gov.au/rits SWIFT – www.swift.com
One of my very good friends established his own engineering business after graduating many years ago. The business has grown and is very successful. A few years ago he obtained a copy of this text book and after reading commented that he wished he had been able to study the book as part of his engineering degree before he began in business, as it would have saved him from many of the financial pitfalls he experienced over the years. Within the context of careers in finance, this true story highlights that a career in finance can be established in any country, economic sector, industry sector, business or government. The range of career opportunities is enormous. For example, commercial banking provides an enormous range of options including retail finance, corporate lending, international banking, treasury and information technology, to name but a few. Investment banking also offers specialist finance opportunities including mergers and acquisitions, project finance, securitisation, underwriting and venture capital. Funds management or personal financial planning are also other career opportunities. Small, medium and large businesses all require people skilled in finance to manage their assets, liabilities and cash flows. Government departments and authorities also require finance graduates to assist with the financing of capital or recurrent expenditures. Stock-broking is yet another career opportunity. Finance is a global market and therefore there are possibilities for working in a range of developing and advanced financial markets. In particular, you may wish to work in London or New York. While visiting many of the global financial markets, I have encountered many people from different countries who have made the transition from their local market to the international financial markets. During your studies you may find certain areas of finance that particularly excite and interest you. Research the types of organisations that provide career opportunities in your areas of interest; understand the structure and culture of the organisations and carefully consider the organisation's guidelines for graduate employment. Most large employers include a link to this information on their website. Some examples include: ANZ Banking Group – www.anz.com.au/about-us/careers Commonwealth Bank – www.commbank.com.au/about-us/careers.html National Bank of Australia – www.nab.com.au/about-us/careers Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers Goldman Sachs – www.goldmansachs.com/careers Macquarie Bank – www.macquarie.com.au/careers Reserve Bank of Australia – www.rba.gov.au/careers Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers Telstra Corporation – www.telstra.com.au/careers BHP Billiton Limited – www.bhpbilliton.com/careers KPMG – www.kpmg.com/au/en/careers Ernst & Young – www.ey.com/au/en/careers Tips for online applications Before you start Allow yourself plenty of time as each application can take between two and four hours at a minimum! Read the application instructions carefully, to determine whether you: have the appropriate/minimum software and hardware to undertake this process have the option of downloading a copy of the application form to assist you in preparing all relevant information and in filling out the form have to fill out the form in one sitting, or whether you have the option of saving, exiting out and returning to the form when you are ready Page xxv know what information you will be required to include in the application form (course/unit details, results etc.) so you can have this handy when you are completing the forms http://textflow.mheducation.com/parser.php?secload=0.11&fake&print
know whether additional information (cover letters, etc.) can be attached if desired. Obtain a copy of your academic transcript. Collect all the information you require, for example course/unit details. Also have electronic access to your résumé to cut and paste into the application form. If you need to use computer labs or library computers, book ahead of time. Working on the application Print out the application form to use as a draft. Complete responses offline and cut and paste into the application. Remember to fill out all the fields. Save regularly as you progress through the application form if possible. Proofread your applications—not all online application forms have spell checks. Leave plenty of time to submit the applications electronically. Typically, employer websites experience a huge rush towards the application deadlines. You may experience delays or be unable to submit due to technical problems if sites are overloaded. Make sure your email address and mobile phone numbers are correct! All too often students record these inaccurately —it is vital that you are contactable, particularly if employers wish to schedule you for testing/interviews. If they can't reach you, they won't bother trying again, given the numbers of applications they will be processing. If you don't receive acknowledgment, or you are unsure whether your application has been received, contact the relevant recruitment coordinator to confirm receipt of your application. If you are having any problems with the technology or have questions regarding the form, contact the graduate recruiter in that organisation as soon as possible. Print out a copy of the application for your records (and make a note of any contact you have with the organisation)—it will help if and when you are invited to an interview. In addition to proofreading, reread your application before you hit the ‘send’ button. Does it present you in the best possible way? You will not get another chance to revise it! Distinguish yourself from other applicants Employers advise that the best way to make your application stand out are the simple things: Fill out all the fields. Proper business language should be used as you would for a paper-based application. Just because it is an online form doesn't mean that you should use more informal or text language, or insert symbols, for example smiley faces. Check your spelling, or get others to check it for you—spell checks don't pick up everything. Answers to in-depth questions should be carefully thought out and tailored to each employer, not a generic cut-andpaste answer. Use proper paragraphs, not just a list of dot points. These tips may seem obvious, but you'd be amazed at the number of applications which are not successful because they haven't followed this advice!
Front Matter PART 1.FINANCIAL INSTITUTIONS Chapter 1.A modern financial system: an overview Chapter 2.Commercial banks Chapter 3.Non-bank financial institutions PART 2.EQUITY MARKETS Chapter 4.The share market and the corporation Chapter 5.Corporations issuing equity in the share market Chapter 6.Investors in the share market Chapter 7.Forecasting share price movements PART 3.THE CORPORATE DEBT MARKET Chapter 8.Mathematics of finance: an introduction to basic concepts and calculations Chapter 9.Short-term debt Chapter 10.Medium- to long-term debt Chapter 11.International debt markets PART 4.GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES Chapter 12.Government debt, monetary policy and the payments system Chapter 13.An introduction to interest rate determination and forecasting Chapter 14.Interest rate risk measurement PART 5.THE FOREIGN EXCHANGE MARKET Chapter 15.Foreign exchange: the structure and operation of the FX market Chapter 16.Foreign exchange: factors that influence the exchange rate Chapter 17.Foreign exchange: risk identification and management PART 6.DERIVATIVE MARKETS AND RISK MANAGEMENT Chapter 18.An introduction to risk management and derivatives Chapter 19.Futures contracts and forward rate agreements Chapter 20.Options Chapter 21.Interest rate swaps, cross-currency swaps and credit default swaps End Matter
Financial institutions Chapter 1 A modern financial system: an overview Chapter 2 Commercial banks Chapter 3 Non-bank financial institutions Page 2 Part 1 FINANCIAL INSTITUTIONS Career opportunities in finance are enormous and they are available to you if you dedicate yourself to learning and understanding how the financial institutions, instruments and markets work. You should be excited that one day you may, for example, work in a commercial bank in Hong Kong or Sydney, or an investment bank in London or New York, or a multilateral government organisation in Paris or Washington, or a multinational corporation anywhere in the world. Further, it does not matter where you live or study; financial institutions, instruments and markets are essentially the same in all developed countries. What you learn from this textbook will be relevant in the world of finance no matter where your travels take you. This textbook discusses the structure, functions and operations of a modern financial system; that is, you are going to learn about financial institutions, financial instruments and financial markets. Each nation-state is responsible for the structure and operation of its own financial system; however, they form an integrated global financial system. Although institutions, instruments and markets are fundamentally alike, they may be differentiated by size, terminology, the level of government regulation and prudential supervision. For example, in the UK the main type of financial instrument issued on the stock exchange is called an ordinary share, whereas the same instrument issued in the USA is known as common stock. Internationalisation of the financial markets has, in part, occurred because of the development of sophisticated technology-based information systems and product delivery systems. This has allowed new products and markets to evolve, and an enormous increase in the volume and speed of the flow of funds through the international financial markets. As will be seen, the combination of globalisation, deregulation, technology and competition has encouraged enormous innovation and change within financial institutions, instruments and markets. Much of what you will learn from this text is international in nature, but it will be necessary at times to focus on the financial system of a particular nation-state. It is not possible to look at the variations that occur in the financial systems of all nation-states. Therefore, when necessary, reference will be made to the Australian financial system as it has a modern, efficient and stable financial system that operates effectively within the global financial system. Page 3 Think of a financial system as being a number of financial institutions and markets through which funds move between lenders and borrowers. The institutions and markets that facilitate this flow of funds develop the financial instruments and techniques that encourage savings and investment. The financial system also provides the framework through which central banks and prudential regulators influence the operations of participants in the financial system. Most importantly, a central bank, through its monetary policy initiatives, affects the level of interest rates, economic activity and business performance. A financial system is essential in facilitating economic growth and future productive capacity in a country. The provision of finance to business allows economic growth to occur, which should lead to increased productivity, increased employment and a higher standard of living. A modern, sound and efficient financial system encourages the accumulation of savings that are then available for investment in productive capital within an economy. Chapter 1 presents an overview of a modern financial system and provides a context for the more detailed studies that occur throughout the textbook. It introduces the main categories of financial institutions, discusses the functions of financial markets and provides an overview of the types of instruments that are created within the markets. At the end of Chapter 1, two extended learning sections are provided: ‘Globalisation of the financial markets’ and ‘The impact of the Asian financial crisis on the financial system’. Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks. Commercial banks are the largest financial institutions providing savings, lending and a wide range of other financial services for their customers. The assets, liabilities and off-balance-sheet business of commercial banks are analysed in detail. At the end of the chapter three extended learning sections are provided: ‘The standardised approach to credit risk’, ‘Business continuity risk management’, and ‘Corporate governance and ethics’. Chapter 3 extends the discussion of financial institutions further and looks at the operations and significance of other types of financial institutions. In particular the chapter considers investment banks, managed funds, superannuation funds, cash management trusts, public unit trusts, life insurance offices, general insurance offices, hedge funds, finance companies, general financiers, building societies, credit unions and export finance corporations. At the end of http://textflow.mheducation.com/parser.php?secload=1&fake&print
the chapter an extended learning section is provided: ‘Project finance and structured finance’.
Page 4 Chapter 1 A modern financial system: an overview Chapter Outline 1.1 Financial crises and the real economy 1.2 The financial system and financial institutions 1.3 Financial instruments 1.4 Financial markets 1.5 Flow of funds, market relationships and stability Learning objectives 1. LO 1.1 Understand the effects and consequences of a financial crisis on a financial system and a real economy. 2. LO 1.2 Explain the functions of a modern financial system and categorise the main types of financial institutions, including depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts. 3. LO 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt, hybrids and derivatives. 4. LO 1.4 Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets, direct finance and intermediated finance. 5. LO 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, and money markets and capital markets. 6. LO 1.6 Analyse the flow of funds through the financial system and the economy and briefly discuss the importance of ‘stability’ in relation to the flow of funds. Extended learning 1. LO 1.7 Appreciate the importance of globalisation of the international financial markets. 2. LO 1.8 Appreciate the effects, consequences and relevance of the Asian financial crisis. Page 5 Introduction The real economy where goods and services are exchanged is connected to the financial markets where financial securities are exchanged. Each affects the other. The development of financial markets has made the exchange of value for goods and services much easier. The introduction of money into the exchange process increases the speed and efficiency with which transactions take place. The use of monetary value also makes it easier to save surplus funds. In order to attract these surplus funds for use in capital projects or consumption spending, businesses and governments issue financial securities such as shares and bonds that entitle investors to a share of business profits or periodic interest payments. These securities change hands on the financial markets at prices that reflect the prevailing business conditions, risk and uncertainty and expectations of future returns. Ups and downs are to be expected in the normal course of the business cycle. However, financial markets are sometimes characterised by high levels of volatility. These periodic bursts of volatility send market participants running for cover as the capital values of investments suddenly appear to have been overestimated. The ensuing liquidation and crisis is the market's remedial action to correct the miscalculations of the preceding economic boom. In the modern financial system, this liquidation can take place at terrifying speed. Although the particular circumstances of each crisis are unique, we can be sure that at the depths of a crisis there will be calls for a review of the ways in which the financial system is regulated. We start our study of the financial system with a discussion of the ways in which financial markets and the real economy interact during periods of financial crisis.
LEARNING OBJECTIVE 1.1 Understand the effects and consequences of a financial crisis on a financial system and a real economy The most recent crisis was the global financial crisis (GFC). The GFC has been described as the most significant economic crisis since the Great Depression in the 1930s. In 2007, realisation that house prices in America had begun to fall and mortgage defaults were increasing, particularly in sub-prime mortgages which had been issued to low-income individuals who were sometimes without a documented ability to meet the monthly repayments, initiated a liquidation of trading positions in the mortgage markets which quickly evolved into a banking crisis. Uncertainty about the value of assets posted as collateral and the solvency of counterparties significantly disrupted the financing arrangements upon which financial institutions relied to fund their activities. Uncertainty about the solvency of financial institutions flowed through the financial system. Unable to fund their activities through the usual channels, some financial institutions were forced to seek equity capital injections from investors or obtain emergency funding from central banks. Some were bailed out by their sovereign government. Others were forced to sell themselves to stronger financial institutions. Many others were forced to file for bankruptcy. GLOBAL FINANCIAL CRISIS (GFC) the global financial crisis (GFC) refers to the financial crisis of 2008 that has been traced to the collapse of the housing market in the United States and the consequences of that collapse for the market for mortgage-related securities SUB-PRIME MORTGAGES loans to borrowers that under normal credit assessment standards would not have the capacity to repay The effects of the crisis flowed into the ‘real’ economy. Economic growth in the USA slowed considerably. According to the Bureau of Economic Analysis (www.bea.gov), from the second half of 2008 through the first half of 2009, the USA experienced four consecutive quarters of negative economic growth (falling gross domestic product or GDP). Contributing to this were severe declines in private investment, including back-to-back declines of 36 per cent and 42 per cent in 2009. The Bureau of Labor Statistics (www.bls.gov) recorded a steep increase in the unemployment rate in the USA, which doubled from 5 per cent in 2007 to just over 10 per cent in 2009. Amid the uncertainty and economic turmoil, financial markets continued to reel. Share markets in most of the advanced economies experienced precipitous falls and at the depths of the crisis had recorded losses of more than 50 per cent. The American stock market alone experienced losses in 2008 of $8 trillion. Currency markets were not immune from the volatility. The Australian dollar experienced depreciations of more than 30 per cent against the major currencies. During the crisis, a number of prestigious Wall Street firms lost their independence or failed completely. Bear Stearns was purchased by JPMorgan Chase & Co. for just $10 per share in March 2008, after trading at $150 per share a year earlier. In July, the mortgage broker IndyMac was placed in ‘conservatorship’ by the US government. In September, two government-chartered mortgage lenders, Freddie Mac and Fannie Mae, were similarly placed in the care of the US government. Lehman Brothers collapsed in mid-September. At the same time that Lehman Brothers tried in vain to arrange a bailout or takeover, Merrill Lynch sold itself to Bank of America to avoid a Lehman-style collapse. Lehman Brothers' collapse created enormous market volatility as market participants struggled to predict the effects of the investment bank's failure on the intertwined network of trades that characterises the financial markets. Governments and central banks desperately tried to stabilise the markets. Meanwhile, other financial institutions found themselves under tremendous pressure. Washington Mutual was placed in receivership. Wachovia was purchased by Wells Fargo. AIG was effectively taken over by the Federal Reserve. Page 6 FEDERAL RESERVE the central bank of the USA Banks and other financial institutions are always vulnerable to ‘runs’. These are situations where all at once many customers demand their money back from a financial institution. Financial institutions do not operate with 100 per cent reserves and cannot possibly meet all of these demands. Before the GFC, financial institutions became more vulnerable because of maturity mismatching in their financing arrangements. Most financial institutions had become reliant on very short-term or overnight financing to finance their operations. Repurchase agreements or ‘repos’ are very short-term funding arrangements and financial institutions had come to rely heavily on overnight repo financing in the decade before the crisis. During the crisis, when financial institutions became wary about the solvency of their counterparties (and themselves), repo financing became either increasingly expensive or impossible to secure. Without the overnight repo markets, financial institutions did not have the capital to sustain their operations for any length of time. This was exacerbated by the redemption and withdrawal requests being received from investors and depositors. Bear Stearns, for example, found that it was unable to secure repo financing once doubts surfaced about its solvency. Although Bear Stearns had more than $18 billion in capital, this fell far short of what was required to finance its day-to-day operations. Bear Stearns was taken over by JPMorgan Chase & Co. just a few days after its repo financing evaporated. With Bear Stearns gone, the financial markets awaited the next ‘domino’ to fall. When the crisis hit, information about the market value of the securities traded among financial institutions and the magnitude of financial obligations of particular institutions was difficult or impossible to obtain. Collateralised debt obligations (CDOs), which are portfolios of mortgages and other loans arranged into ‘tranches’ according to levels of risk, are complex by nature because it is very difficult to determine the quality of the numerous individual loans in each of the tranches. This complexity and the absence of liquid secondary markets for the securities led to large writedowns in the estimated values of these securities when financial institutions realised that there were no buyers willing to engage in transactions at prices even close to the previously recorded selling prices. With prices falling, writedowns in the value of positions in these markets spiralled downwards. Uncertainty about which institutions held the riskiest CDO tranches contributed to financial institutions' unwillingness to extend financing to their counterparties. http://textflow.mheducation.com/parser.php?secload=3.2&fake&print
To make matters even worse, buyers of CDOs had usually entered into credit default swaps (CDSs) with other financial institutions. CDSs were designed to insure their buyers against default on bonds, tranches or by institutions. As CDOs fell rapidly in value and financial institutions reeled, the large outstanding liabilities potentially facing the ‘sellers’ of CDSs and the uncertainty over how much insurance had been sold by which institutions contributed further to the spiral in valuations, balance sheet write-downs and the viability of financial institutions. Although most of the drama and many of the popular accounts of the crisis focused on Wall Street and its ‘blue-blood’ banking establishments, as time has passed the GFC has come to be thought of as having two main parts. The first, which we have just described, was the initial liquidation of assets due to the trouble emanating from and engulfing the Wall Street banks. The second was what has come to be known as the eurozone crisis or the sovereign debt crisis. This second instalment of the GFC emanated from and engulfed the central banks of a number of European countries. That is, in ‘part two’ it was country or government debt, otherwise known as sovereign debt, that became ground zero as the crisis evolved. EUROZONE CRISIS or SOVEREIGN DEBT CRISIS the economic and international financial crisis that followed the GFC, which saw multiple European governments seek bailouts from the European Central Bank (ECB) and other stronger European countries The eurozone crisis can be traced to late 2009 when the new Greek government announced that its deficit, understood by the world financial community to already be an astronomical 113 per cent of the country's national income, was actually twice as large, or more than 220 per cent of the country's gross domestic product. There was a very great possibility that Greece would fail to meet its obligations to investors in Greek sovereign debt (Greek government bonds). This immediately precipitated panic in the international bond markets. Like any market, investors need to have confidence that they will receive the cash flows they are entitled to and the issuer of the debt, whether it is a corporation or a government, will not default on its obligations. It looked like Greece might do just that. The panic in the international bond markets led to a collapse in bond prices and a spike in the cost of borrowing for governments suspected of being in a similar position to Greece, especially Ireland, Spain, Portugal and Italy. Government services and welfare programs became the victims of harsh austerity measures. As the government sector of these economies was curtailed, national incomes fell rapidly and other economic indicators deteriorated. The economic booms in these now troubled countries had been fuelled by money coming from banks in other European countries, particularly in northern Europe. These banks held trillions of dollars in Greek, Irish, Spanish and Italian debt, which were consequently trading at substantially lower prices. The trouble had spread north and west, like a virus. This had disastrous and far-reaching economic consequences. National incomes fell precipitously in the worst affected countries and unemployment soared. Most of the Eurozone, including relatively strong economies such as France and Germany, soon found itself amid an economic malaise that has shown no real signs of abating. And so, the GFC continues to ripple through the global economic and financial system. Page 7 A number of explanations for the GFC have been proposed. These include greed, irrationality, fraud, the inherent instability of capitalism, the disproportionate size of the financial sector compared to the manufacturing or ‘real’ sector of the economy, shadow banking, lax lending standards, deregulation and free-market policies, over-reliance on badly designed mathematical models for measuring risk, inappropriate incentives structures within financial institutions, ‘captured’ ratings agencies that were too lenient in rating mortgage debt, out-of-control financial innovation and misguided government or central bank policy. There are many different points of view and strong and convincing arguments can be made for each of the possible explanations for the GFC. Whatever role each of these factors might have played, the fundamental explanation for the GFC is quite straightforward. Throughout the early 2000s, central banks, particularly the US Federal Reserve, set interest rates at very low levels. This created a boom in consumption, housing and other asset prices driven by easy credit available throughout the economic system. In the absence of increasingly intense credit expansion, sooner or later the credit-driven boom had to come to an end. The larger and longer the boom, the more catastrophic must be the ensuing recession or depression. Despite the unique circumstances of each individual case, all economic crises can be traced to this same root cause. Following the onset of the crisis, governments and central banks around the world undertook unprecedented interventions in the financial and economic systems. In America, for example, the federal government arranged a $700 billion bailout plan and, as we have seen, even took ownership of some financial institutions. In Australia, the federal government implemented a guarantee on deposits with banks, building societies and credit unions to prevent ‘runs’ on these institutions by their customers. As the banking crisis gave way to concerns about economic growth, governments turned their attention to fiscal stimulus to encourage economic activity and prevent recession. In Australia, the government implemented two stimulus packages totalling more than $50 billion in late 2008 and early 2009. Various factors contributed to greater stability in Australia during the crisis and a mitigation of its effects on the real economy. However, the effects of the GFC continue to be felt in most parts of the developed world and, although Australia managed to navigate the crisis better than other countries, dealing with the legacy of the GFC will present a challenge for many years to come. Many lessons might be learned from the GFC. A stable financial sector is vital to the health of the overall economy. Perceived mistakes by regulators, including allowing interest rates to remain at very low levels for long periods of time, as well as perceptions that the crisis was caused by a financial sector that is out of control, have sparked calls for strong regulatory reforms. Innovative financial products and securities, such as CDOs and CDSs, present a challenge to regulators. New products do not always fall within the scope of existing regulations. The incentive arrangements and governance within financial institutions is another factor that attracted the attention of critics before, during and after the GFC. Regulations that limit compensation packages within the financial sector or realign incentive structures such that they do not encourage large amounts of risk taking represent attractive options to those who are critical of perceived excesses within the financial sector. Finally, the way that risk is managed within financial institutions has emerged as a very prominent subject. Risk is intertwined and interrelated. The existence of one risk will change the dynamics of other risk exposures. With the GFC, it appears that there was a lack of understanding of who was ultimately http://textflow.mheducation.com/parser.php?secload=3.2&fake&print