Financial Institutions and Markets Notes

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Financial Institutions and Markets Notes
Financial Institutions and Markets (James Cook University)
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Financial Institutions and Markets Notes
Topic 1 (week 1) – An overview of the financial System
The Financial System and Financial Institutions
- A financial system comprises a range of financial institutions, financial instruments and

financial markets facilitating the flow of funds.
- Under the supervision of the central bank and the prudential supervisor.
Surplus units
- Savers of funds available for lending
Deficit units
- Borrowers of funds for capital investment and consumption
Attributes of financial assets
- Return, risk, liquidity and timing of cash flows
Facilitation of portfolio restructuring

- The combination of assets and liabilities comprising the desired attributes of return,
risk, liquidity and timing of cash flows
Implementation of monetary policy
- Actions of a central bank taken to influence interest rate levels to achieve certain
economic outcomes
- Primary target is inflation
Financial institutions may specialize in:
- Taking deposits, providing advice to corporate and government clients or offering
financial contracts such as insurance.
- Financial institutions are essential to the operation of the modern financial system.
- Financial institutions permit the flow of funds between borrowers and lenders by facilitating
financial transactions.
- Institutions may be categorized by differences in the sources and uses of funds.
Categories of financial institutions

– Depository financial institutions
– Investment banks
– Contractual savings institutions
– Finance companies and general financiers
– Unit trusts
Financial Institutions
Equity
- Ownership interest in an asset
- Residual claim on earnings and assets
• Dividend
• Liquidation
Types
- Ordinary share
- Hybrid (or quasi-equity) security
• Preference shares
• Convertible notes

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Debt
Contractual claim to:
- Periodic interest payments
- repayment of principal.
– Ranks ahead of equity
– Can be:
• short term (money market instrument) or medium to long term (capital market
instrument)
• secured or unsecured
• negotiable (ownership transferable; e.g. commercial bills and promissory notes)
or non-negotiable (e.g. term loan obtained from a bank).
Derivatives
– A synthetic security providing specific future rights that derives its price from:
• A physical market commodity
• Gold and oil
• Financial security
• Interest-rate-sensitive debt instruments, currencies and equities.
– Used mainly to manage price risk exposure and to speculate
- Four Basic derivative contracts
1. Futures Contract
2. Forward Contract
3. Option Contract
4. Swap Contract
Financial Markets
Includes:
- Matching principle
- Primary and secondary market transactions
- Direct and intermediated finance
- Wholesale and retail markets
- Money markets
- Capital markets
Matching principle
- Short-term assets should be funded with short-term (money market) liabilities; e.g. seasonal
inventory needs funded by overdraft.
- Longer term assets should be funded with equity or longer term (capital market) liabilities;
e.g.:
- Equipment funded by debentures
- Lack of adherence to this principle accentuated effects of frozen money markets with the ‘sub-
prime’ market collapse.
• Primary market transaction

- The issue of a new financial instrument to raise funds to purchase goods, services or assets by:
- Businesses (Company shares or debentures)
- Governments (Treasury notes or bonds)
- Individuals (Mortgage)
– Funds are obtained by the issuer.

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Secondary market transaction

- The buying and selling of existing financial securities
- No new funds raised and therefore no direct impact on original issuer of security
- Transfer of ownership from one saver to another saver
- Provides liquidity, which facilitates the restructuring of portfolios of security owners
Direct finance
– Users of funds obtain finance through primary market via direct relationship with
providers (savers)
• Advantages
– Avoids costs of intermediation
– Increases access to diverse range of markets
– Greater flexibility in range of securities users can issue for different
financing needs
• Disadvantages
– Matching of preferences
– Liquidity and marketability of a security
– Search and transaction costs
– Assessment of risk, especially default risk
• Intermediated financial flow markets

– A financing arrangement involving two separate contractual agreements whereby the
saver provides funds to an intermediary and the intermediary provides funding to the
ultimate user of the funds
• Intermediated finance
– Advantages
• Asset transformation
– Borrowers and savers are offered a range of products
• Maturity transformation
– Borrowers and savers are offered products with a range of terms to
maturity
• Credit risk diversification and transformation
– Saver’s credit risk limited to the intermediary, which has expertise and
information
• Liquidity transformation
– Ability to convert financial assets into cash
• Economies of scale
– Financial and operational benefits of organisational size and business
volume

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Wholesale and retail markets

Wholesale markets
• Direct financial flow transactions between institutional investors and borrowers
– Involves larger transactions
Retail markets
• Transactions conducted primarily with financial intermediaries by the household
and small- to medium-sized business sectors
– Involves smaller transactions
• Money markets
– Wholesale markets in which short-term securities are issued (primary market
transaction) and traded (secondary market transaction)
• Securities highly liquid
– Term to maturity of one year or less
– Highly standardized form
– Deep secondary market
• No specific infrastructure or trading place
• Enable participants to manage liquidity

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– Money market submarkets exist for:

• Central bank—system liquidity and monetary policy
• Inter-bank market
• Bills market
• Commercial paper market
• Negotiable certificates of deposit (CDs) market
Capital markets
– Markets in which longer term securities are issued and traded with original term-to-
maturity in excess of one year
• Equity market
• Corporate debt market
• Government debt market
– Also incorporate use of foreign exchange markets and derivatives markets
– Participants include individuals, business, government and overseas sectors
Flows of funds and Market relationship
Sectorial flow of funds

- The flow of funds between deficit and surplus units is an important contributor to
economic growth.
- For these benefits to be fully realised, the flow of funds must be characterised by relative
stability.
- The GFC interrupted the functioning of the financial system and inflicted serious damage
on the ‘real’ economy in many countries.
- The role of regulators is to balance the benefits of a free financial system against the costs
of instability.
- The flow of funds between business, financial institutions, government and household
sectors and the rest of the world
- Net borrowing and net lending of these sectors of an economy vary between countries
- Influenced by:
- the impact of fiscal and monetary policy on savings and investment decisions
- policy decisions like compulsory superannuation
- The GFC has significantly impacted on flow of funds
-

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Financial Crises and the Real Economy
- Greed, irrationality, fraud, instability of capitalism, shadow banking, lax lending standards,
deregulation and free-market policies, the over-reliance on badly designed risk models,
inappropriate incentives structures within financial institutions, leniency of rating
agencies, out-of-control financial innovation and misguided government or central bank
policy
- The disproportionate size of the financial sector compared to the manufacturing or ‘real’
sector of the economy
- Ease to access credit
- Unprecedented Government actions
- US: $700 billion bailout plan (quantitative easing: $US 80B per month)
- Australia
- Government guaranteed deposits with banks, building societies and credit unions to
prevent ‘runs’ on these institutions by their customers
- Two stimulus packages ($50 billion)
- Basel III – review of regulatory framework for soundness and stability of a financial system
Lessons learnt
- Stability of the financial sector is vital
- Regulators can make mistakes
- Financial product innovations present challenges to regulators (see CDOs and CDSs)
- Governance of financial institutions
- Risk exposures
Summary
• The financial system is composed of financial institutions, instruments and markets facilitating
transactions for goods and services and financial transactions.
• Financial instruments may be equity, debt or hybrid.
• Financial markets may be classified according to:
– Primary and secondary transactions
– Direct and intermediated flows
– Wholesale and retail markets
– Money markets and capital markets
– Financial institutions.
• GFC had a significant impact on financial systems.
Roles of RBA – Reserve Bank of Australia

- Price Stability – inflation (within 2-3%)
- Target Cash Rate
- Full employment target
- Target for best interest for Australian citizens

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Topic 2 (week 2) – Commercial banks
Main activities of commercial Banks
Asset management (before the 1980s)

– Loans portfolio is tailored to match the available deposit base
Liability management (1980s onwards)
– Deposit base and other funding sources are managed to meet loan demand
• Borrow directly from domestic and international capital markets
• Provision of other financial services
• Off-balance-sheet (OBS) business
Sources of funds
- Sources of funds appear in the balance sheet as either liabilities or shareholders’ funds.
- Banks offer a range of deposit and investment products with different mixes of liquidity, return,
maturity and cash flow structure to attract the savings of surplus entities.
Current account deposits
- Funds held in a cheque account
- Highly liquid
- May be interest or non-interest bearing
Call or demand deposits
- Funds held in savings accounts that can be withdrawn on demand
- E.g. passbook account, electronic statement account with ATM and EFTPOS
Term deposits
- Funds lodged in an account for a predetermined period at a specified interest rate
Negotiable certificates of deposit (CDs)
- Paper issued by a bank in its own name
- Issued at a discount to face value
- Specifies repayment of the face value of the CD at maturity
- Highly negotiable security
- Short term (30 to 180 days)
Bill acceptance liabilities
Bill of exchange
- A security issued into the money market at a discount to the face value. The face value is
repaid to the holder at maturity.
Acceptance
- Bank accepts primary liability to repay face value of bill to holder.
- Issuer of bill agrees to pay bank face value of bill, plus a fee, at maturity date.
- Acceptance by bank guarantees flow of funds to its customers without using its own funds.
Debt liabilities
- Medium- to longer-term debt instruments issued by a bank
Debenture
- A bond supported by a form of security, being a charge over the assets of the issuer (e.g.
collateralised floating charge).
Unsecured note
- A bond issued with no supporting security.

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Foreign currency liabilities

- Debt instruments issued into the international capital markets that are denominated in a
foreign currency
- Allows diversification of funding sources into international markets
- Meets demand of corporate customers for foreign exchange products
Loan capital and shareholders’ equity

– Sources of funds that have characteristics of both debt and equity (e.g. subordinated
debentures and subordinated notes)
• Subordinated means the holder of the security has a claim on interest payments
or the assets of the issuer, after all other creditors have been paid (excluding
ordinary shareholders)
Uses of Funds
Personal and housing finance

– Housing finance
• Mortgage
• Amortised loan
– Investment property
– Fixed-term loan
– Credit card
Commercial lending
– Involves bank assets invested in the business sector and lending to other financial
institutions
– Fixed-term loan
• A loan with negotiated terms and conditions
– Overdraft
• A facility allowing a business to take its operating account into debit up to an
agreed limit
– Bills of exchange
• Bank bills held
– Commercial bills
• Bills of exchange issued directly by business to raise finance
– Rollover facility
• Bank agrees to discount new bills over a specified period as existing bills mature
– Leasing
Off- Balance-sheet Business
• OBS transactions are a significant part of a bank’s business

• OBS transactions include:
• Direct credit substitutes
• An undertaking by a bank to support the financial obligations of a client (e.g. ‘stand-by
letter of credit’)
• The bank acts as guarantor on behalf of a client for a fee
• Client has a financial obligation to a third party
• Bank is required to make a payment only if the client defaults on a payment to a
third party
• Trade- and performance-related items
• A form of guarantee provided by a bank to a third party, promising financial
compensation for non-performance of commercial contract by a bank client, e.g.:
• documentary letters of credit

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• performance guarantees.
• Commitments
• The contractual financial obligations of a bank that are yet to be completed or delivered
• Bank undertakes to advance funds or make a purchase of assets at some time in
the future, e.g.:
• forward purchases
• underwriting.
• To the extent that these OBS activities involve risk-taking and positions in derivative securities,
OBS activities raise some concerns about bank regulation.
• This is a particularly important concern when the size of off-balance-sheet activities is
considered.
• The notional value of such activities is more than five times the total value of assets held by the
banks.
Regulation and Prudential Supervision
• Reasons for regulation of banks

– Importance of the banking sector for health of the economy
• Prudential supervision
– Imposition and monitoring of standards designed to ensure the soundness and stability
of a financial system
Background to Capital adequacy standards
• The evolution of the international financial system led to development of international capital
adequacy standards
– 1988 Basel I capital accord and Basel II capital adequacy guidelines
– Basel III enhanced capital, leverage and liquidity standards.
Topic 3 (week 3): Non-Bank Financial Institutions
- Financial deregulation in Australia began in the early 1970s

- “At that time, there were wide-ranging controls on the financial system. The aims of those
controls were to:
– Provide the authorities with the mechanism to manage the monetary side of the
economy;
– Create a captive market for government securities, so as to allow the Government to
fund itself;
– Limit the risks that banks could take – i.e. they were a de facto form of prudential
supervision;
– Allocate credit to areas of the economy that authorities thought should get priority.
Housing and farming were particularly favored; and
– Maintain a stable exchange rate and prevent the flow of domestic savings offshore.”

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Investment Banks
- Evolved under regulation

- Are not authorised banks (i.e. not ADIs) and are officially classified as ‘money market
corporations’ in Australia
- Share of total financial institution assets declined from 7.2% in 1990 to 1.4% in 2010
- Today, there is very little difference between a ‘merchant’ bank and an ‘investment’ bank
Chinese Wall
Ethical barrier between different divisions to avoid conflict of interest
- E.g. between the corporate-advisory area and the brokering department of a financial services
firm to separate those giving corporate takeover advice from those advising clients about buying
shares.
- Ideally prevents leaks of corporate inside information.
Sources of funds
- Mainly securities issued into international money markets and capital markets
Uses of funds
- Limited lending to clients, usually on short-term basis

- These loans tend to be sold into the secondary market
- Primarily focused on off-balance-sheet and advisory services
Off-balance-sheet business
Innovative products and services in provision of advice, management and funding services,
generating their main income from fees e.g. FOREX dealers, underwriting equity/debt issues,
advice on funds etc.
IBs and Underwriting
- Advise clients on where and how to raise funds in the domestic & international capital markets
- Assist with prospectus and book-building/roadshow activities for new issues (IPOs (initial public
offerings) - Debt and Equity)
- Have large corporate client list and also have access to institutional investors for private
placements (such as managed funds)
- Underwriting implies that IBs will agree to buy and hold in their inventory any securities not
bought by investors

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Managed Funds
Investment vehicle for investing the pooled savings of individuals in various asset classes in domestic
and international money and capital markets by fund managers
Mutual fund (USA)
- Managed funds established under a corporate structure
- Investors purchase shares in the fund
Trust fund (Australia and UK)
- Managed funds established under a trust deed, managed by a trustee or responsible entity
- Investors in the fund obtain a right to the assets of the fund and a share of the income and capital
gains (losses) derived
Open-end funds
- Floating amount of units which vary in price in direct proportion to the variation in value of the
fund's total net asset value
- Trustee stands ready to buy and sell units at net asset value per unit
Examples: exchange-traded funds (ETFs), listed investment companies (LICs
Closed-end funds
- Fixed amount of units issued, price determined by demand and supply for units
- The price per share often is less than the NAV(net asset value) per share
- Differences may be explained by factors associated with the fund manager performance, operating
efficiencies, unrealized taxes, etc. that provide “real value discount” arguments
- Has implications for liquidity
Main categories of managed funds

- Cash management trusts
- Public unit trusts
- Superannuation funds
- Statutory funds of life offices
- Hedge funds
- Common funds
Friendly Societies
- Mutual organisations that provide members with investment and other services (insurance,
sickness, unemployment benefits)
- Investment products include the issue of bonds that invest in asset classes like cash, fixed-
interest, equities and property
Categorisation of managed funds by investment risk profile:
Capital guaranteed funds

- Aims to provide investors with positive returns while protecting their investment from downside
loss.
- Despite being ‘capital guaranteed’, the investor’s capital is at risk.
- Products may include, dynamic hedging strategies, bonds, etc.
Capital stable funds

- Contributions are mostly protected by investments in low risk and return securities.
Balanced growth funds

- Investments in longer term income streams supported by limited capital growth
- Investments include domestic and foreign equities

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Managed growth (or capital growth) funds

- Invest for greater return through capital growth and less through income streams
- Investments include a greater proportion of domestic and foreign equities
Trusts
Cash Management Trusts
- A mutual investment fund, often managed by a financial intermediary, established under a trust
deed, specifying the trust’s investments
- Generally invest in short-term money-market instruments
- Provide high liquidity for the investor
- Provide retail investors with access to the wholesale market
Public Union Trusts
- Investment fund established under trust deed

- Investors purchase a share in the trust called a ‘unit’
- The trustee invests the pooled funds received from investors
- Unit holders receive a return in the form of income and/ or capital gain
Types of unit trusts and share of public unit trusts assets:

- Property trusts
- Equity trusts
- Mortgage trusts
- Fixed-interest trusts
Listed trusts
- Units quoted and sold on the ASX (more liquid)—mainly property trusts
Unlisted trusts
- Units sold back to trustee after giving the required notice (less liquid)—mainly equity trusts
Superannuation Funds
- The largest part of the managed funds industry is the superannuation sector.
- Indeed, superannuation funds account for almost one-fifth of the assets held by financial
institutions in Australia.
- Most surprisingly, self-managed superannuation funds hold the largest amount of assets within
the superannuation sector.
- There are more than 500 000 SMSFs holding a total of more than $500 billion in assets.
APRA classifies superannuation funds as:

- Entities with more than four members
- Pooled superannuation trusts (PSTs)
- Small APRA funds
- Balance of life office statutory funds
- Self-managed funds.
Compulsory superannuation funds

• Legislation requiring employers to contribute a defined amount to employees’
superannuation accounts
• Australian employers not paying the mandatory 9.5% (not 9%) into employees’
superannuation funds must pay the superannuation guarantee charge (SGC)

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Retail superannuation funds

• Run “for profit” by FIs who charge a fee on capital invested and take percentage
of investment earnings
Self-managed superannuation funds
• 30% of Australia’s super savings; regulated by ATO; not risk-free; Trustees are
middle age and above
Rollover funds
vehicle for which job changers park funds until retirement
Defined benefit funds and accumulation funds
– Defined benefit funds

• Amount paid to employee on retirement is based on a defined formula
• Risk lies with employer, who must make good any shortfall
– Accumulation funds
• Amount of funds available at retirement consists of contributions plus earnings
less taxes and expenses
General Insurance Offices
• Insurer pays the insured a predetermined amount if some pre-specified event (peril) occurs
• Sources of funds
– Contractual premiums paid in advance for:
• House and contents
– co-insurance, public liability insurance
• Motor vehicle insurance
– Comprehensive; third party, fire and theft; third party; compulsory third
party
• Other risk insurance policies to individuals in retail market and businesses in the
commercial market.
– Inflow of funds not as stable as life offices
• Uses of funds
– Generally shorter term, highly marketable securities, owing to the less predictable
nature of the risks underwritten
– Examples
• Money market securities, such as bills of exchange, commercial paper and
certificates of deposit
Hedge Funds
- Hedge funds operate in a relatively unregulated environment.

- Often, hedge funds are open to ‘high net worth’ individuals who will be required to invest a
relatively large sum.
- Because the strategies and operations of hedge funds are neither transparent nor straightforward,
hedge funds are often the target of criticism when markets experience significant levels of
volatility.
This was certainly the case during the GFC where the short selling activities of the hedge funds
attracted much scrutiny
Use sophisticated investment strategies and products mainly for high-net-worth individuals and
institutions to achieve higher and positive returns in both an upward and a downward moving market
• Sources of funds mainly from superannuation and life offices, and high-net-worth individuals
• May leverage investments through debt financing and/or use of derivative products

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• A hedge fund may choose to list on a stock exchange, thus providing a secondary market that
will allow investors to buy and sell units in the fund.
Finance Companies and General Financiers
• Borrow in domestic and international financial markets and make loans to small business and
individuals
• Issue of debentures and unsecured notes
• Borrowings from related corporations and banks
• Borrowing direct from domestic and international money and capital markets
• Uses of funds
• Loans to individuals, possibly higher risk
• Lease financing
• Loans to small- and medium-sized businesses (e.g. bills finance, term loans, floor plan
financing, factoring and accounts receivable financing)
Building Societies and Credit Unions
Building Societies
• Authorised deposit-taking institutions (ADIs – as with commercial banks) mainly lending for
residential property
• During period of regulation building societies gained market share at the expense of savings
banks
• Since deregulation the sector share of total assets declined from 3.1% in 1990 to 0.5% in 2010.
In response some building societies have:
– Merged to rationalise costs
– Become banks, e.g. Challenge Bank, Advance Bank and Heritage Bank
– Improved technology for service and cost reasons
– Diversified activities and products offered to savers and borrowers
– Mainly deposits from customers
• Uses of funds
– Personal finance to individual borrowers
• Mainly housing finance
• Term loans and credit card finance
Credit Unions
• Common bond of association often exists between members owing to employment, industry or
community (e.g. Shell Employees’ Credit Union)
Sources of funds
• Mainly deposits from members (payroll deductions)
• Other credit unions and the issue of promissory notes and other securities
Uses of funds
• Primarily personal finance to members
• Residential housing loans
• Personal loans and credit card facilities
• Limited commercial lending
Export Finance Corporations
• Export finance companies support the export activities of domestic firms.

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Topic 4 (week 4) – International Banking
The Euromarkets
International Debt Markets
Are used by:

- financial institutions, who are the largest borrowers
- governments and corporations
Attract investors as they:
- provide a deep and liquid market
- allow higher investment returns
- are a form of portfolio diversification
Have grown in importance owing to deregulation of FX markets

Accessible to borrowers with a strong financial reputation and a very good credit rating
Consist of large unregulated money and capital markets
Major centres in London, the Middle East and Asia
USD is the dominant currency
Eurozone is the domestic market for countries adopting the euro currency.
Debt securities denominated in euros have grown as the predictability, liquidity and volatility of the
euro consolidate.
Initially evolved to enable countries to hold USD outside of the US, e.g. USSR.
Although euromarkets originated in Europe, euromarket transactions can occur in any nation-state of
the world
‘Euro’ means ‘outside’.
A euromarket transaction is conducted in a foreign country but not in its currency.
Growth in euromarket transactions is driven mainly by interest rate factors; i.e. lower borrowing and
higher lending rates.
Euromarkets provide intermediated and direct finance over a range of terms to maturity and are
categorised as follows:
Eurocurrency markets
Provide intermediated bank finance
Euronote markets
Provide short-term direct finance
Eurobond markets
Provide medium- to long-term direct finance.
Eurocurrency Markets – Major forms
Short-term bank advances

- Similar to term loans or fully drawn advances
- Term determined and full amount drawn down on approval
- Commitment fee may be charged if advance not drawn down immediately after approval
- May be extended by ‘revolving credit’, where a mixture of currencies can be chosen at each
rollover (to match borrower’s currency inflows)
- LIBOR typically used as indicator or reference rate

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Eurocurrency standby facilities

- A source of ‘back-up’ funds to meet short-term cash shortfalls
- Funds more likely to be available offshore in periods of tight domestic liquidity
- Short-term finance (up to two years)
- Interest charge and commitment fee apply
Medium- to long-term Eurocurrency bank loans

- Loan size about USD3–100 million
- Larger loans may involve a syndicate of banks
- Term is typically five to 10 years
- Loans usually fully drawn down at commencement of loan unless an availability period is
arranged, which attracts a commitment fee
- Interest rate normally above LIBOR and fixed for a period of one to 12 months, plus other fees
apply
Euronote Markets
- Direct wholesale finance

- Active market for short-term promissory notes or commercial paper
Euronotes take several forms, two of which are:
1. euronote issuance facility (NIF)
2. eurocommercial paper (ECP).
- Demystified in that these secb gurities are fundamentally the same as domestic money-market
and capital-market securities
Euronote issuance facility (NIF)

- A short-term unconditional bearer promissory note drawn by the borrower in borrower’s
name
- Underwriting banks guarantee funds at issue and convert funding into medium term through a
rollover facility
- The instrument
- Discount security
- Maturity usually 30 to 180 days
- Bearer securities in denominations of USD 100 000 to
500 000
Structure
- A syndicate of banks underwrite the facility to a specified amount and discount rate, thus
providing certainty for borrower
Selling procedures
- Usually sold by a tender process, inviting members of a tender panel to tender prices for the
notes
- Tender panel composed of up to 25 financial institutions, including some of the underwriters
- Issuer may specify a rate (posted rate), which is the yield at which the issuer is willing to sell a
security
Parties involved in NIF issue
- Arranger, lead manger, co-managers and senior managers, facility agent, tender panel agent,
issuing and paying agent
Fees
- Additional to NIF issue and rollover fees: include establishment fees for the arranger, managers
and underwriter; commitment fee and take-up fees to underwriters; and agency fees for
administration
- Approximately 50 basis points (0.50%) in equivalent annual costs

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Eurocommercial paper (ECP)

- Arrangement where P-notes are issued into euromarkets that are not underwritten
- Developed owing to changes in needs of:
- borrowers—high credit ratings and a history of successful issues, sought cheaper funds
by dispensing with underwriters
- financial institutions—underwriting NIF issues sought to avoid imposed capital adequacy
requirements of off-balance-sheet exposures
- Typically more than USD250 million
- Issued in tranches to test market’s reaction and to match borrower’s cash needs
- Usually less than six dealing institutions (spread geographically and involving different
institutional forms) to avoid fragmentation of facility
Calculating security price of NIF and ECP:
Eurobond Market
Eurobond market is the equivalent of a domestic capital market.

Two main long-term coupon debt securities issued in the euromarket considered here are:
1. euro medium-term notes
2. eurobonds, including straight bonds and floating rate notes.
Emerged from the US equivalent market

Unsecured, non-homogenous bearer securities paying periodic coupon, issued in tranches
Bond markets consist of three broad market groups

1. Domestic bonds
- Bonds issued into a local market, in the local currency, by a local company
2. Foreign bonds
- Bonds issued into a foreign market, in the local currency of that market
3. Eurobonds
- Bonds issued into a foreign market, but not in the currency of that market
- Traded on global markets and may escape local market listing and trading regulations
- Underwritten by a multinational syndicate of banks
Issue and trading of eurobonds

- Eurobonds are sold in a multistage process organised by an international bank called the lead
manager.
- Lead manager creates a management group by inviting five to 30 banks to be co-managers

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Types of Eurobonds
Two classes of bonds considered here:

1. straight (fixed coupon)
2. floating rate notes.
Straight (fixed coupon)

- A fixed-interest bond paying periodic coupons; principal repayable at maturity
- Issuers and investors
Issuers—high credit rating and a household name
Investors include retail and institutional investors
- Amount and currency of denomination
Fixed costs of issue constrain minimum size of issue to at least USD50 million, average about
USD500 million
Main currency USD, but also yen, euro and pound sterling
Floating rate notes (FRNs)

A bearer bond with a variable coupon rate based on an indicator interest rate, generally LIBOR (6-
month)
Price of Fixed- Interest eromarket secruties:
Markets in the USA
US markets accessible to more international borrowers than euromarkets because of the lower
required investment grade credit rating, i.e. BBB and AA respectively
Important available US securities
Commercial paper (USCP)
US foreign (Yankee) bonds
American depository receipts (ADRs)
The US market is highly innovative and has other products not discussed here.

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Commercial paper (USCP)

- Short-term promissory note; i.e. discount security
- Average maturity less than 45 days
- Denominations of USD100 000
- Some issues are supported by credit enhancements such as a bank letter of credit, or security
over the assets of the issuer
- Issue by public offer or private placement without requirement for official SEC registration
US foreign (Yankee) bonds

- A debt security issued by a foreign borrower into the US market
- Denominated in USD
- Issued for up to 20 years
- Straight bond—fixed interest periodic coupon, principal repayable at maturity
American depository receipts (ADRs)

- A security issued by a US depository bank and supported by a depository share
- The depository share represents one or more ordinary shares of a foreign issuer listed on the
foreign company’s home stock exchange
- Allows foreign companies to raise capital in US market without needing to meet SEC listing
requirements
Credit Rating Agencies
- An organisation specialising in assessing the credit quality associated with financial

obligations, e.g. S&P (Standard & Poor’s), Moody’s, Fitch.
- The rating methodology develops a profile balancing business risk, financial risk and
environmental risk factors.
S&P provide:
- Long-term credit ratings (AAA to D), with BBB and above being ‘investment grade’
- Short-term credit ratings (A-1 to D)
- A rating of a corporation overall.
Topic 5 (week 5) – Islamic Banking
What is Islamic Banking?
- Banking conducted in accordance with the beliefs of Islam.

- Under Islam both paying interest and charging interest are forbidden.
- This makes the conventional ‘Western way’ of banking and providing financial services
unsuitable.
- Riba is the common word used to describe ‘interest’.
- It means any fixed or guaranteed interest payment on loans or deposits.
- Only kind of loan permitted under Islam:
‘a qard-el-hassan’ (good loan).
- A good loan entails no direct or indirect benefit for the lender.
Speculation, Risk and Risk Management
Problem:
Conventional banking addresses risk by incorporating it into the interest rate paid/received.
Islamic banking approach:
In Islamic banking, the lender must share in the profits and losses generated by the company.

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The users of capital must share risk equally.

The use of capital should result in shared benefit for the wider community.
Gharar describes risk, uncertainty or speculation.

In Islam gharar is subject to God’s will.
Risk should be treated in a way that reflects a legitimate risk-sharing between borrower and lender.
Speculation is not allowed.
The use of derivatives to hedge risks is problematic as the valuation of derivatives depends on interest
rates.
The use of derivatives is further problematic because of speculative elements.
Derivatives can only be used for halal (compliant with Islam) transactions.
If the counterparty is haram (unacceptable under Islam), the transaction is no longer halal.
Contracts not regarded as gharar:
Sales with advance payments (bai’ bithaman ajil),
Contracts to manufacture (istisna),
Hire contracts (ijara).
Islamic Banking Products
Deposits and Products
Current account (alwadiah):

No interest payments,
Standard features: funds available on demand, debit card use for ATMs and EFTPOS transactions,
Some ‘no-fee accounts’.
Savings account:
No guaranteed interest, but share of bank profits,
Bank losses are absorbed by reserves,
Compared to alwadiah, less flexibility regarding withdrawals.
Investment account:
Term deposit,
Return = share of bank profit,
Profit = a proportion of bank’s total profits, or
Profit = a proportion of profits generated by a specific part of bank’s portfolio (e.g. car loans).
Providing returns compliant with Islamic belief:
Prizes and bonuses
Controversial because of gambling element.
‘Gifts’
Monetary or non-monetary,
At discretion of bank.
Lending
Musharaka
- Lender takes a direct equity stake in a project or business (direct equity participation).
- Financier = ‘shareholder’ in borrowing company.
- Increased risk compared to holding debt (Western approach).
- Risk issue can be addressed through the creation of separate legal entities (joint venture
approach)

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Mudaraba (shirka)
- Funding is made available to an entrepreneur (mudarib) who invests funds in the project.
- Profits are shared on a pre-arranged basis.
- Entrepreneur = investor (rabbulmal) only and thus responsible for all losses from investment.
- This approach is comparable to Western non-recourse finance.
Islamic Mortgages
Three different approaches to enable Muslims to ‘finance’ their own homes.
1. Murubaha:
Concept of ‘mark-up’ over original purchase price.
Halal, as selling for profit, is acceptable for trade to flourish.
Vendor sells house to bank.
Bank sells house immediately to borrower at a higher price.
2. Ijara
Bank pays for the house and leases it to borrower.
The borrower ‘rents’ the house for installments equal to the original price plus a ‘mark up’.
At maturity the borrower makes a final payment to the bank, often $1.
3. Diminishing Partnership Approach

Local community acts as a type of banker to provide finance.
Model akin to Western concept of credit unions.
Steps in diminishing partnership approach:
Prospective buyer pays money into a partnership fund, administered by local community.
If partnership has sufficient funds, the house is bought in the name of the partnership.
Partner (buyer) has liability to partnership.
Buyer ‘rents’ house from partnership until liability is repaid.
Potential problems:
Loan concentration in real estate.
Loan concentration in certain geographical areas.
Small portfolios compared to banks.
Corporate governance issues.
Poor lending practices.
Bonds
Sukuk
The sukuk is issued like a conventional bond.
Payments on sukuk may reflect musharaka or other lending approaches.
Despite pricing issues due to uncertain cash flows, sukuk are straightforward products.
Topic 6: Government Debt, Monetary Policy and the Payments System
The Commonwealth Government Requirement
Full Financial Year
- Borrow to finance budget deficits

- Roll over existing bonds that mature
- Retire debt at/prior to maturity if budget in surplus
- Instruments issued are Treasury bonds and they are bought mainly by commercial banks, other
financial institutions and portfolio managers for:

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 Liquidity management
 Portfolio investments
 Risk management
 Payments system requirements
 Prudential requirements.
- Budget surpluses and debt reduction policies have limited the supply of government securities
- Long-dated bonds are now issued every two years, ensuring sufficient securities to support 10-
year bond futures contracts
- Government intends to issue about $55 billion of Treasury bonds to ensure a deep and liquid
market
- Crowding-out effect:
 Government demand for debt financing reduces amount of funds available for investment
in private sector
 Minimized in times of strong fiscal management
Within financial year

- Borrow to finance short-term mismatches between receipts and payments; i.e. manage day-to-
day liquidity
- Roll over existing debt
- Instruments issued for intra-year budgetary purposes are short term; i.e. Treasury notes (T-
notes)
Commonwealth Government securities
- Like the private sector, the Commonwealth Government issues both coupon and discount
securities
- Treasury bonds (or T-bonds) for full-financial-year financing
- Treasury notes (or T-notes) for within-year or intra-year financing.
Treasury bonds
Main features:
- Coupon instrument (coupons normally paid each six months)
- Coupon payment = coupon rate x face value of bond
- Face value of bond redeemed at maturity date or may be sold in secondary market for early
redemption
- Until 1984 either bearer bond or inscribed stock
- Since 1984 inscribed stock, which has the following advantages:
- Less costly to maintain register of bond holders
- Ownership of bearer bonds not registered, facilitating tax evasion and money laundering
- Protected from risk of theft, destruction and misplacement.
Primary market transactions
- Issued by Commonwealth Treasury through RBA
- Issued through the tender system
- Removes rate setting from political arena
- Bids submitted through Yieldbroker DEBTS System
- Minimum $1 million, thereafter multiples of $1 million
- Bids made in terms of yield to maturity, not price
- Bids are accepted in ascending order of yield, i.e. lowest-yield bid (highest price) first, until
issue fully subscribed

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Pricing
Treasury notes
- T-notes are short-term discount securities issued by the Commonwealth Government through
the Australian Office of Financial Management (AOFM).
- T-note issues have a variable term-to-maturity in order to coincide with the government’s
revenue receipt dates.
- T-notes may be redeemed at maturity date or by sale in the secondary market.
Tendering process
- Tenders held periodically on a competitive basis to meet funding needs in the primary market
- Minimum parcel of $1 million face value, thereafter multiples of $1 million via the AOFM tender
system in terms of yield to maturity
- Bids accepted in ascending order of yield, i.e. lowest-yield bid (highest price) first, until issue is
fully subscribed
- T-note purchases settled through Austraclear settlement system
Pricing
State Government Securities (SEMIS)
Benefits of central borrowing authorities

- Maximize economies of scale
- Access international markets
- Better manage the timing of debt issues and associated cash flows
- Remove potential for competition between different issuers within the same state and achieve
a lower average cost of funds
- Size of the single debt issues larger than the borrowings of individual state authorities
- More effective use of tender and dealer panels
- Encourages a secondary market

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Debt issues may be:

- Public—prospectus, advertising and marketing
- Private—information memorandum, quicker, cheaper
- Underwritten—tender and dealer panels place issues and create a secondary market by
quoting bid and offer prices
- Non-underwritten—issue attractive to institutional investors owing to investment-grade credit
rating.
Monetary Policy
Actions of the RBA that influence interest rates in order to achieve the following economic objectives:
- Stability of the currency
- Maintain inflation within a 2–3% range over the business cycle.
- Maintenance of full employment
- Economic prosperity and welfare of the Australian people
By impacting on the cash rate (overnight interbank rate), the RBA can affect rates of longer term
securities, e.g.:
- RBA tightens monetary policy by selling Commonwealth Government securities (CGSs) and
reducing the money supply.
- This causes investment and household spending to decrease.
Open market operations

Conducted primarily by:
- Repurchase agreements (repos) on nominated debt securities
- Outright or direct transactions in short-dated CGSs
- Sales of CGSs reduce supply of cash in money market
- Purchases of CGSs inject additional cash
- Foreign exchange swap.
The RBA holds and manages a portfolio of CGSs to maintain system liquidity and effect monetary
policy
- The RBA achieves this by purchasing CGSs in the secondary market and occasionally taking an
allotment at tender in a primary issue.
Topic 7 (week 8) – The Mathematics of Finance
Simple Interest
Simple interest is interest paid on the original principal amount borrowed or invested.
- The principal is the initial, or outstanding, amount borrowed or invested.
- With simple interest, interest is not paid on previous interest.

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The amount of interest paid on debt, or earned on a deposit is:
Example 1: If $10 000 is borrowed for one year, and simple interest of 8% per annum is charged, the
total amount of interest paid on the loan would be:
Example 2: Had the same loan been for two years the total amount of interest paid would be:
The market convention (common practice occurring in a particular financial market) is for the number
of days in the year to be 365 in Australia and 360 in the US and the euromarkets.
Example 3: If the amount is borrowed at the same rate of interest but for a 90-day term, the total
amount of interest paid would be:
The final amount payable (S) on the borrowing is the sum of the principal plus the interest amount.
Alternatively, the final amount payable can be calculated in a single equation:
The final amounts payable in the three previous examples are:

Example 1:
S = 10 000 [1 + ( 1 x 0.08)] = 10 800
Example 2:
S = 10 000 [1 + ( 2 x 0.08)] = 11 600
Example 3:
S = 10 000 [1 + ( (90/365) x 0.08)] = 10 197.26
Present Value with Simple Interest

The present value is the current value of a future cash flow, or series of cash flows, discounted by the
required rate of return.
Alternatively, the present value of an amount of money is the necessary amount invested today to yield
a particular value in the future.
The yield is the effective rate of return received.

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Example
A company discounts (sells) a commercial bill with a face value of $500 000, a term to maturity of
180 days and a yield of 8.75% per annum. How much will the company raise on the issue?
Briefly, a bill is a security issued by a company to raise funds.
A bill is a discount security, i.e. it is issued with a face value payable at a date in the future, but in order
to raise the funds today, the company sells the bill today for less than the face value. The investor who
buys the bill will receive face value at the maturity date.
The price of the bill will be:
The simple interest equation may be rewritten to facilitate its application to calculating the price (i.e.
present value) of another discount security, the Treasury note (T-note):
Example
What price per $100 of face value would a funds manager be prepared to pay to purchase 180-day T-
notes if the current yield on these instruments was 5.82% per annum?
Calculation of yields
In the previous examples, the return on the instrument or yield was given.
However, in other situations it is necessary to calculate the yield on an instrument (or cost of
borrowing).
Notice that we are multiplying the amount of interest received over d days as a proportion of principal
amount invested by 365/d to get annual yield

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Example: What is the yield (annual rate of return) earned on a deposit of $50 000 with a maturity
value of $50 975 in 93 days? That is, this potential investment has a principal (A) of $50 000, interest
(I) of $975 and an interest period (d) of 93 days.
HPY is the yield on securities sold in the secondary market prior to maturity
Short-term money market securities (e.g. T-notes) may be sold prior to maturity because:
- Investment was intended as short-term management of surplus cash held by investor
- The investor’s cash flow position has unexpectedly changed and cash is needed
- A better rate of return can be earned in an alternative investment.
The yield to maturity is the yield obtained by holding the security to maturity.
The HPY is likely to be different from the yield to maturity.
- A discount security pays no interest but is sold today for less than its face value, which is
payable at maturity, e.g. T-note.
The HPY will be:
- Greater than the yield to maturity when the market yield declines from the yield at purchase,
i.e. interest rates have decreased and the price of the security increases
- Less than the yield to maturity when the market yield increases from the yield at purchase, i.e.
interest rates have increased and the price of the security decreases.
Compounding Interest
Compound interest (unlike simple interest) is paid on both:

- The initial principal
- The accumulated previous interest entitlements.
The general form of the compounding interest formula is:
Accumulated Amount or FV = S = A(1 + i)^n
- On many investments and loans, interest will accumulate more frequently than once a year; e.g.
daily, monthly, quarterly
- Thus, it is necessary to recognize the effect of the compounding frequency on the inputs i
(annual interest rate) and n (total number of periods).
- If interest had accumulated monthly on the previous loan, then:
i = 0.15/12 = 0.0125
n = 3 * 12 = 36
Example
The effect of compounding can be further understood by considering a deposit of $8000 paying 12%
per annum, but where interest accumulates quarterly for four years:
I = 12.00 % p.a. / 4 = 3% per quarter = 0.03
And:
n = 4 * 4 = 16 periods
so:
S = 8000 * (1 + 0.03)^16

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= 8000(1.604706)
= $12 837.65
Present Value with Compound Interest
The present value of a future amount is the future value divided by the interest factor (referred to as
the discount factor) and is expressed in equation form as:
This may also be written as:
Example
What is the present value of $18 500 received at the end of three years, if funds could currently be
invested at 7.25% per annum, compounded annually?
- An annuity is a series of periodic cash flows of the same amount

- An ordinary annuity is a series of periodic cash flows occur at end of each period
- An ordinary annuity is valued by multiplying the periodic payment, C, by the Present Value
Annuity Interest Factor (PVAIF):
Example: The present value of an annuity of $200, received at the end of each quarter for 10 years,
where the required rate of return is 6.00% per annum, compounded quarterly, would be:
C = $200
i = 6.00%/4 = 1.50% or 0.015
n = 4 x 10 = 40
Therefore:
A = $200 * [ 1 – (1 + 0.015)-40 ]
0.015
= $200 * [ 29.9158452 ]
= $5983.17

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An annuity due is an annuity where the cash flows occur at the beginning of each period (as opposed
to an ordinary annuity where they are paid at the end of the period)
An annuity due is valued similarly to an annuity, but is adjusted by the term (1 + i) as follows:
Calculating the present value (i.e. price) of a bond is simply the sum of:
(i) the present value of the future coupon payments (valued as an annuity)
(ii) the present value of the final principal payment at maturity:
Future Value with Compound Interest
The accumulated (or future) value of an annuity is given by:
Example
A university student is planning to invest the sum of $200 per month for the next three years in order
to accumulate sufficient funds to pay for a trip overseas once she has graduated. Current rates of
return are 6% per annum, compounding monthly. How much will the student have available when she
graduates?
C = $200
i = 6.00%/12 = 0.50% or 0.005
n= 3 x 12 = 36
Therefore:
A = $200 * [ (1 + 0.005)36 - 1 ]
0.005
= $200 * [ 39.3361 ]
= $7867.22
Effective Rates of Interest
- The nominal rate of interest is the annual rate of interest, which does not take into account the
frequency of compounding.
- The effective rate of interest is the rate of interest after taking into account the frequency of
compounding.
- The formula for converting a nominal rate into an effective rate is:

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What is the effective rate of interest if you are quoted:

a) 10% per annum, compounded annually?
b) 10% per annum, compounded semi-annually?
c) 10% per annum, compounded monthly?
Week 9 –Topic 8 – Short Term Debts
Trade Credit
Short-term debt is a financing arrangement for a period of less than one year with various
characteristics to suit borrowers’ particular needs
- Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds.
- Matching principle
- Short-term assets should be funded with short-term liabilities.
- The importance of this principle was highlighted by the GFC.
A supplier provides goods or services to a purchaser with an arrangement for payment at a later date.
Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days).
From provider’s perspective
- Advantages include increased sales
- Disadvantages include costs of discount and increased discount period, increased total credit
period and accounts receivable, increased collection and bad debt costs.
The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is:
If the purchaser can obtain funds at a rate of less than 16.03% p.a. they should borrow to pay the
account within 7 days.
Similarly, if the company has surplus cash that has alternate uses but cannot earn 16.03%, it should
use that cash to pay the account within 7 days.
Bank Overdrafts
The cash flows within a business will rarely be matched

- At times a business will incur cash outflows to meet operating expenses and at other times will
receive cash inflows from the sale of goods and services.
The primary purpose of an overdraft facility is to allow the management of liquidity and working
capital needs.

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The fluctuating nature of credit available through an overdraft facility enables the mismatch in cash
flows to be managed
- When expenses need to be paid the business can draw-down on the overdraft facility and when
income is received the business can reduce or place the facility back into credit.
Major source of short-term finance.

Allows a firm to place its cheque (operating) account into deficit, to an agreed limit.
Generally operated on a fully fluctuating basis:
- It is placed in deficit when expenses are paid and brought back into credit when revenues are
received.
Lender also imposes an establishment fee, monthly account service fee and a fee on the unused
overdraft limit.
Interest rates negotiated with bank at a margin above an indicator rate, reflecting the borrower’s
credit risk:
- Financial performance and future cash flows;
- Length of mismatch between cash inflows and outflows;
- Adequacy of collateral.
Indicator rate typically a floating rate based on a published market rate, e.g. BBSW.
In some countries overdraft borrower may be required to hold a credit average balance or
compensating credit balance.
Prior to granting an overdraft to a customer, and also with periodic reviews, the bank will look at a
number of liquidity-related issues, including:
- Its overall banking relationship with the customer;
- The historic and forecast performance of the business (bottom-up approach) and any impacts
forecast changes might have on cash flows and liquidity requirements;
- Forecasts for the industry in which the business operates (top-down approach) and the impact
of changes in economic activity might have on the business;
- How the business has managed its cash flow and liquidity positions, in particular, its accounts
receivables and accounts payable.
Commercial Bills
A bill of exchange is a discount security issued with a face value payable at a future date.
A commercial bill is a bill of exchange issued to raise funds for general business purposes.
- Trade bills issued to finance specific international trade transactions;
- Commercial bills may not relate to any specific transaction or use of funds.
A bank-accepted bill is a bill that is issued by a corporation and incorporates the name of a bank as
acceptor (thus often referred to as “two-name paper”).
Features of bank Accepted Bills – Parties Involved
Drawer
Issuer of the bill;
Secondary liability for repayment of the bill (after the acceptor).
Acceptor
Undertakes to repay the face value to the holder of the bill at maturity;
Acceptor is usually a bank or merchant bank.
Payee
The specified party to whom the bill is to be paid, i.e. the party who receives the funds
Usually the drawer, but the drawer can specify some other party as payee
Discounter
The party that discounts the face value and purchases the bill

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The provider or lender of the funds

May also be the acceptor of the bill
Endorser
The party that was previously a holder of the bill;
Signs the reverse side of the bill when selling, or discounting, the bill;
Order of liability for payment of the bill runs from acceptor to drawer and then to endorser.
The flow of funds (non-bank bills)

- Alternatively, a bill can be drawn by the bank and accepted by the borrower.
- The bank is both drawer and discounter of the bill.
- If the bank rediscounts a bill (sells to a third party), the bank becomes the endorser, creating a
bank-endorsed bill.
- Funds are lent to borrower as payee.
- At maturity date the borrower, as acceptor of the bill, is liable to pay face value to the holder of
the bill.
Establishing a bill financing facility:

- Borrower approaches bank or merchant bank;
- Assessment made of borrower’s credit risk;
- Credit rating of borrower affects size of discount;
- Maturity usually 30, 60, 90, 120 or 180 days;
- Minimum face value usually $100 000.
Bank will indicate whether it is willing to discount the bill and the discount rate
- thus providing both a bill acceptance facility as well as a bill discount facility.
Advantages of commercial bill financing

- Lower cost than other short-term borrowing forms, i.e. overdraft, fully-drawn advances;
- Borrowing cost (yield) determined at issue date (not affected by subsequent changes in
interest rates).
- A bill line:
- Arrangement with a bank where it agrees to discount bills progressively up to an agreed
amount.
- Term of loan extended by ‘rollover’ at maturity.
Discount Security Calculations
Calculating Price
Alternatively:

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Example: Calculating price—yield known:

A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with
a face value of $500 000. Having approached two prospective discounters, the company has been
quoted yields of 9.52% per annum and 9.48% per annum. Which quote should the company accept,
and what amount will the company raise?
Calculating Face Value—issue price and yield known:
Example:
A company needs to raise additional funding of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank
has agreed to discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn?
Calculating yield:
Example:
A company issued a 30-day bank-accepted bill with a face value of $500 000. The bill was discounted
at a yield of 9.48% per annum, representing a price of $496 134.23. After seven days the discounter
sells the bill in the short-term money market for $497 057.36. The bill is not traded again in the
market. Calculate the yield to the original discounter and to the holder at maturity.
Yield to original discounter:
Yield to holder at maturity:
Calculating price—discount rate known:

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Example:
The price of a 180-day bill, with a face value of $100 000, selling at a discount of 14.75%, would be:
The discount in this formula is effectively the rate of return to the buyer of the bill (or the cost of funds
to the drawer of the bill), expressed as a percentage per annum, in relation to the face value of the bill.
Calculating discount rate:
Example:
A 180-day bill with a face value of $100 000 and selling currently at $92 000, with a full 180 days to
run to maturity, has a discount rate of:
Note if issued in the US, the number of days will be 360 days and the answer will be 16.00%.
Promissory Notes
- Also called P-notes or commercial paper, they are discount securities, issued in the money
market with a face value payable at maturity but sold today by the issuer for less than face
value.
- Typically available to companies with an excellent credit reputation because:
- There is no acceptor or endorser
- They are unsecured instruments.
- Calculations—use discount securities formulae.
- Issue programs:
- Usually arranged by major commercial banks and money market corporations;
- Standardized documentation;
- Revolving facility;
- Most P-notes are issued for 90 days;
- By tender, tap issuance or dealer bids.
Underwritten P-Note issues:

- Underwriting guarantees the full issue of notes is purchased and typical fee is 0.1% per annum.
- Underwriter is usually a commercial bank or investment bank.
- The underwritten issue can incorporate a rollover facility, effectively extending the borrower’s
line of credit beyond the short-term life of the P-note issue.
- Credit rating.

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Issues may also be non-underwritten

- Issuer may approach money market directly.
- Commercial bank or investment bank may be retained as lead manager and receive fees.
Negotiable Certificates of Deposit
- CDs are a short-term discount security issued by banks to manage their liabilities and
liquidity.
- Maturities range up to 180 days.
- Issued to institutional investors in the wholesale money market.
- The short-term money market has an active secondary market in CDs.
- Calculations—use discount securities formulae.
Inventory Finance, Accounts Receivable Financing, and Factoring
Inventory finance
- Most common form is ‘floor plan finance’.
- Particularly designed for the needs of motor vehicle dealers to finance their inventory of
vehicles
- Bailment common—finance company holds title to dealership’s stock.
- Dealer is expected to promote financier’s financial products.
Accounts receivable financing

- A loan to a business secured against its accounts receivable (debtors);
- Mainly supplied by finance companies;
- Lending company takes charge of a company’s accounts receivable; however, the borrowing
company is still responsible for the debtor book and bad debts.
Factoring
- Company sells its accounts receivable to a factoring company
- Converting a future cash flow (receivables) into a current cash flow.
- Factoring provides immediate cash to the vendor; plus it removes administration costs of
accounts receivable.
- Main providers of factor finance are the finance companies.
- Factor is responsible for collection of receivables.
- Notification basis: vendor is required to notify its (accounts receivables) customers that
payment is to be made to the factor.
- Recourse arrangement
- Factor has a claim against the vendor if a receivable is not paid.
- Non-recourse arrangement
- Factor has no claim against Vendor Company.
Topic 9 – Medium – to long – term debt
Term loans or fully drawn advances
Term loan
- A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and equipment.
- Secured by mortgage over asset purchased or other assets of the firm.
Fully drawn advance
- A term loan where the full amount is provided at the start of the loan.
- Provided by:
- mainly commercial banks and finance companies

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- to a lesser degree, investment banks, insurance offices and credit unions.
Term loan Structures
Interest only during term of loan and principal repayment on maturity.

Amortised or credit foncier loan
- Periodic loan instalments consisting of interest due and reduction of principal.
Deferred repayment loan
- Loan instalments commence after a specified period related to project cash flows and the debt
is amortised over the remaining term of the loan.
Interest may be fixed (for a specified period of time; e.g.
two years) or variable.
Interest rate charged on term loan is based on an indicator rate (e.g. BBSW or a bank’s own prime
lending rate)
- influenced by:
- credit risk of borrower—risk that borrower may default on loan commitment, giving rise to a
risk premium;
- term of the loan—usually longer term attracts a higher interest rate;
- repayment schedule—frequency of loan repayments (e.g. monthly or quarterly) and form of
the repayment (e.g. amortised or interest-only loan).
Other fees include:
- establishment fee
- service fee
- commitment fee
- line fee
- bill option clause fee.
Loan Covenants
- Restrict the business and financial activities of the borrowing firm:

- Positive prospectus
• Requires borrower to take prescribed actions; e.g. maintain a minimum level of working
capital.
- Negative prospectus Fixed Assets Ltd
• Restricts the activities and financial structure of borrower; e.g. maximum D/E ratio,
minimum working-capital ratio, unaudited periodic financial statements.
- Breach of covenant results in default of the loan contract, entitling lender to act.
Calculating the loan instalment—ordinary annuity

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Example:
Kitcheware Limited has approached Mega Bank to obtain a term loan to finance the purchase of a new
high-speed CD burner. The bank offers a $150 000 loan, amortised over five years at 8% per annum,
payable monthly. Calculate the monthly loan instalments.
Calculating the loan instalment— annuity due
Example:
A company is purchasing a computer system for the business at a cost of $21 500. A finance company
has offered a term loan over seven years at a rate of 12% per annum. The loan will be repaid by equal
monthly instalments at the beginning of each month. Calculate the amount of each loan instalments.

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Mortgage finance and introduction to securitisation
Mortgage finance
A mortgage is a form of security for a loan.

- The borrower (mortgagor) conveys an interest in the land and property to the lender
(mortgagee).
The mortgage is discharged when the loan is repaid.
If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on the property, i.e. take
possession of assets and realise any amount owing on the loan.
Use of mortgage finance:
- Mainly retail home loans
- Up to 30-year terms.
- To a lesser degree commercial property loans
- Up to 10 years as businesses generate cash flows enabling earlier repayment.
Providers (lenders) of mortgage finance
- Commercial banks, building societies,
life insurance offices, superannuation funds, trustee institutions, finance companies and
mortgage originators.
Interest rates:
- Both variable and fixed interest rate loans are available to borrowers.
- With fixed interest loans, interest rates reset every five years or less.
- With interest-only mortgage loans, interest-only period is normally a maximum of five years.
Mortgagee (lender) may reduce their risk exposure to borrower default by:
- Requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value.
Calculating the loan instalment— mortgage (i.e. ordinary annuity)
Example:
A company is seeking a fully amortised commercial mortgage loan of $650 000 from its bank. The
conditions attached to the loan include an interest rate of 8% per annum, payable over five years by
equal end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment
amount.

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A $650 000
0.08
i 0.02
4
n 5 4 20
$650 000
R
1 (1  0.02)  20
[ ]
0.02
$39 751.87 monthly instalmnnt
Introduction to Securitisation
Mortgage originators, commercial banks and other institutions use securitisation to manage their
mortgage loan portfolios.
Involves conversion of non-liquid assets into new asset-backed securities that are serviced with cash
flows from the original assets.
Original lender sells bundled mortgage loans to a special-purpose vehicle.
- That is, a trust set up to hold securitised assets and issue asset-backed securities like bonds,
providing investors with security and payments of interest and principal.
The securitisation of mortgage finance suffered a large contraction during the GFC.
- Securitised mortgage assets in 2007: $215 billion;
- Securitised mortgage assets in 2013: $106 billion.
These falls were recorded in Australia despite the much lower default rates experienced on mortgages
compared to other parts of the world.
International investors were the major investors in this product and after the GFC they created an
aversion to the securitisation market.
The bond market: debentures, unsecured notes and subordinated debt
These securities are issued in the corporate bond market:

Markets for the direct issue of longer-term debt securities.
Lenders attract higher:
- Risk compared with lending indirectly through intermediaries
- Yield owing to sharing in the profit margin usually taken by intermediaries.
Debentures and unsecured notes:

- Are corporate bonds;
- Specify that the lender will receive regular interest payments (coupon) during the term of the
bond and receive repayment of the face value at maturity.
Unsecured notes are bonds with no underlying security attached.
Debentures:
- Are secured by either a fixed or floating charge over the issuer’s unpledged assets;
- Are listed and traded on the stock exchange;
- Have a higher claim over a company’s assets (e.g. on liquidation) than unsecured note holders.
Issuing debentures and notes:

There are three principal issue methods
1. Public issue—issued to the public at large, by prospectus.
2. Family issue—issued to existing shareholders and investors, by prospectus.
3. Private placement—issued to institutional investors, by information
memorandum.
Usually issued at face value, but may be issued at a discount or with deferred or zero interest.
A prospectus contains detailed information about the business.
Subordinated debt

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- More like equity than debt, i.e. quasi-equity.

- Claims of debt holders are ‘subordinated’ to all other company liabilities.
- Agreement may specify that the debt not be presented for redemption until after a certain
period has elapsed.
- May be regarded as equity in the balance sheet, improving the credit rating of the issuer.
Calculations: Fixed – interest securities
Price of a fixed-interest bond at coupon date.

- The price of a fixed-interest security is the sum of the present value of the face value and the
present value of the coupon stream.
Example: Price of a fixed-interest bond at coupon date

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

Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+ corporate bond
with a face value of $100 000, paying 10% per annum half-yearly coupons, maturing 31 December
2020, would be sold on 20 May 2015 at what price?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
Next coupon date is June 30, 2015. Days expired since last coupon payment on December 31, 2014:
(Jan = 31) + (Feb = 28) + (Mar = 31) + (Apr = 30) + (May = 20) = 140 days
k = (140/181)

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Leasing
Leasing defined
- A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the
right to use the asset for an agreed period of time in return for periodic rental payments.
- Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the
asset.
Advantages of leasing for lessee over ‘borrow and purchase’ alternative:
- conserves capital,
- provides 100% financing,
- matches cash flows (i.e. rental payments with income generated by the asset),
- less likely to breach any existing loan covenants,
- rental payments are tax deductible.
Advantages of leasing for lessor over a straight loan provided to a lessee:
- Leasing has relatively low level of overall risk as asset can be repossessed if lessee defaults.
- Leasing can be administratively cheaper than providing a loan.
- Leasing is an attractive alternative source of finance to both business and government
Operating lease:
- Short-term lease
- Lessor may lease the asset to successive lessees (e.g. short-term use of equipment).
- Lessee can lease asset for a short-term project.
- Full-service lease—maintenance and insurance of the asset is provided by the lessor.
- Minor penalties for lease cancellation.
- Obsolescence risk remains with lessor.
Finance lease:
- Longer term financing.
- Lessor finances the asset.
- Lessor earns a return from a single lease contract.
- Net lease—lessee pays for maintenance and repairs, insurance, taxes and stamp duties
associated with lease.
- Residual amount due at end of lease period.
- Ownership of the asset passes to lessee on payment of the residual amount.
Sale and lease back

- Existing assets owned by a company or government are sold to raise cash; e.g. government car
fleet.
- The assets are then leased back from the new owner.
- This removes expensive assets from the lessee’s balance sheet.
Cross-border lease
- A lessor in one country leases an asset to a lessee in another country.
Direct finance lease:

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- Involves two parties (lessor and lessee).

- Lessor purchases equipment with own funds and leases asset to lessee.
- Lessor retains legal ownership of asset and takes control or possession of asset if lessee
defaults.
- Security of the lessor provided by:
- lease agreement;
- leasing guarantee—an agreement by a third party to meet commitments of the lessee in the
event of default.
Leveraged finance lease:

- Lessor contributes limited equity and borrows the majority of funds required to purchase the
asset.
- Lease manager
- Structures and negotiates the lease and manages it for its life;
- Brings together the lessor (or equity participants), debt parties and lessee.
- Asset then leased to lessee.
- Lessor gains tax advantages from the depreciation of equipment and the interest paid to the
debt parties
When choosing the most appropriate source of medium- to long-term debt, a borrower should
consider the following factors:
- Fixed or variable interest rate
- Term of the financing arrangement
- Repayment schedule
- Loan covenants
- Whether secured by fixed or floating charge, or unsecured
- The merits of leasing an asset as opposed to buying an asset.
Topic 11: Introduction to Risk Management and Derivatives
Understanding Risk
Risk may be defined as the possibility or probability of something occurring that is unexpected or
unanticipated.
Categories of risk:
Operational risk;
Financial risk.
Speculative Risk – The probability/chance that things wont turn out as expected
Pure Risk – Loss or No loss (insurance companies)
Operational risk:
- Exposure that may impact on the normal commercial functions of a business, affecting its
operational and financial performance; e.g.:
- Technology;
- Property and equipment;
- Personnel;
- Competitors;
- Natural disasters;
- Government policy;
- Suppliers and outsourcing.

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Financial risk:
- Exposures that result in unanticipated changes in projected cash flows or the structure and
value of balance-sheet assets and liabilities, e.g.:
- Interest rate risk;
- Foreign exchange risk;
- Liquidity risk;
- Credit risk;
- Capital risk.
-
Relationships between risks can result in one risk impacting on another risk:
Direct risk—the initial risk event that impacts on the operational or financial position of an
organization
Consequential risks—exposures that eventuate as a result of an initial direct risk event.
The Risk Management Process
- Effective management of risk exposures requires a structured risk management process.

- Although the range of risks varies by organization, one such model is:
- Identify operational and financial risk exposures;
- Analyze the impact of the risk exposures;
- Assess the attitude of the organization to each identified risk exposure;
- Select appropriate risk management strategies and products;
- Establish related risk and product controls;
- Implement the risk management strategy;
- Monitor, report, review and audit.
Identify operational and financial risk exposures:

- Requires full understanding of the business, including operations, personnel, competitors,
regulators, legislative requirements, stakeholders, cash flows and balance sheet structure.
- Also need to understand interrelationships and causal links between the above categories.
Analyze the impact of the risk exposures:
- A business impact analysis is used to document each risk exposure and measure the
operational and financial impacts should the risk event occur.
- Need to consider both quantitative and qualitative risks.
Assess the attitude of the organization to each identified risk exposure:
- Not all risks will be mitigated or removed.
- The risks to be avoided, controlled, transferred or retained should be documented.
Select appropriate risk management strategies and products:
- An integrated process to analyze the risk management options available.
- Generally, several risk management strategies available, the choice between them to be subject
to cost–benefit analysis.
- All risk management processes and strategies should be periodically audited.
Establish related risk and product controls
- Ensure adequate controls established, documented and circulated among personnel.
- These include procedural controls and system controls:
- Procedural controls document risk management products that can be used by the
organization.
- System controls cover all electronic product delivery and information systems relating to
the identification, measurement, management and monitoring of risk management.
Implement the risk management strategy:
- Obtain written authority to proceed with implementation.
- Check that time lags between the commencement of this process and the implementation of the
strategy have not impaired the effectiveness of the strategy.

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- Risk strategies are developed for different planning periods.

Monitor, report, review and audit:
- As risk management is ongoing, the strategies must be continuously monitored to ensures they
achieve the expected risk management objectives and outcomes.
Futures Contracts
Futures contracts
- An agreement between two parties to buy, or sell, a specified commodity or financial
instrument at a specified date in the future at a price determined today.
- An exchange-traded contract where standardized contracts are traded in a formal market.
Examples include:
- A fund manager holding shares who is concerned the price may fall before they are sold.
- An investor concerned that share prices may rise before they are purchased.
- Are used for both hedging and speculative purposes.
Strategy involves carrying out an initial transaction in the futures market that corresponds with the
transaction to be conducted in the physical market at a later date.
- Example:
Futures contracts
Relevant terms:
Clearing house
- Records transactions conducted on an exchange and facilitates value settlement and transfer.
Initial margin
- Deposit lodged with clearing house to cover adverse price movements in a futures contract.
Marked-to-market
- The periodic repricing of an existing contract to reflect current market valuations.
Maintenance margin call
- The top-up of an initial margin to cover adverse futures contract price movements.
Forward Contracts

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A financial instrument designed mainly to manage specified risks.

Offered over the counter by financial institutions
- Therefore, more flexible than highly standardized exchange-traded products like futures, as the
terms and conditions of a forward contract, such as amount and timing of the contract, can be
negotiated.
Two main types
1. Forward rate agreements (FRAs);
2. Forward foreign exchange contracts.
(1) Forward rate agreements (FRAs)

- An over-the-counter product used to manage interest rate risk exposures.
- Allows a borrower to manage future interest rate risk exposure by locking in an interest rate
today that will apply at a specified future date.
- Is given effect by one party to the contract compensating the other party if the reference
rate is different from the agreed rate.
(2) Forward foreign exchange contracts

- Also known as a forward exchange contract; locks in an exchange rate today for delivery of
foreign currency at a specified future date.
- Example, an Australian company may be importing goods from overseas and the company will
need to pay USD1 million in three months’ time.
Options Contracts
An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or
financial instrument at a predetermined price (exercise or strike price), on or before a specified date
(expiration date).
Types of options:
Call options
Give the option buyer the right to buy the commodity or instrument at the exercise price
Profit = S – K – C
Profit = S – (K+C)
Put options
Give the buyer the right to sell the commodity or instrument at the exercise price
Payoff = (K-S, 0)

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Profit = K – (S+P)
An option will only be exercised if it is in the buyer’s best interests; i.e.:

- A buyer will not exercise the right to sell if the physical market price is above the exercise price
of the option.
- A buyer will not exercise the right to buy if the physical market price is below the exercise price
of the option contract at expiration date.
Options can be exercised either:
- Only on expiration date (European option);
- Any time up to expiration date (American option).
Relevant terms:
Premium
- The price paid by an option buyer to the writer (seller) of the option.
Exercise price or strike price
- The price specified in an options contract at which the option buyer can buy or sell.
Call option profit and loss payoff profiles
Put option Profit and loss payoff Profiles

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Swap Contracts
An over-the-counter financial product allowing parties to enter into a contractual agreement to

exchange cash flows.
Intermediated swap
- A party enters into a swap with a financial intermediary.
Direct swap
- Two parties enter into a swap with each other without using a financial intermediary.
Two main types of swap contracts:
1. Interest rate swaps;
2. Cross-currency swaps.
(1) Interest rate swaps

- The exchange of interest payments associated with a notional principal amount.
- Notional principal amount—the underlying amount specified in a contract that is used to
calculate the value of the contract.
Vanilla swap
- a swap of a series of fixed interest rate payments for floating interest rate payments.
Basis swap
- a swap of a series of two different reference rate interest payments.
Swap rate
- the fixed interest rate specified in a swap contract.
(2) Cross-currency swaps
- Two parties, such as a bank and a company, exchange debt denominated in different currencies.
- Interest payments are exchanged.

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- Principals exchanged at beginning of agreement and then re-exchanged at conclusion of

agreement, usually at the same exchange rate.

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Financial Institutions and Markets Notes

Financial Institutions and Markets (James Cook University)

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Financial Institutions and Markets Notes

Topic 1 (week 1) – An overview of the financial System

The Financial System and Financial Institutions

- A financial system comprises a range of financial institutions, financial instruments and

Facilitation of portfolio restructuring

Categories of financial institutions

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• Primary market transaction

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Secondary market transaction

• Intermediated financial flow markets

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Wholesale and retail markets

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– Money market submarkets exist for:

Flows of funds and Market relationship

Sectorial flow of funds

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Financial Crises and the Real Economy

Roles of RBA – Reserve Bank of Australia

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Topic 2 (week 2) – Commercial banks

Main activities of commercial Banks

Asset management (before the 1980s)

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Foreign currency liabilities

Loan capital and shareholders’ equity

Personal and housing finance

Off- Balance-sheet Business

• OBS transactions are a significant part of a bank’s business

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Regulation and Prudential Supervision

• Reasons for regulation of banks

Background to Capital adequacy standards

Topic 3 (week 3): Non-Bank Financial Institutions

- Financial deregulation in Australia began in the early 1970s

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- Evolved under regulation

- Limited lending to clients, usually on short-term basis

IBs and Underwriting

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Main categories of managed funds

Categorisation of managed funds by investment risk profile:

Capital guaranteed funds

Capital stable funds

Balanced growth funds

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Managed growth (or capital growth) funds

Cash Management Trusts

Public Union Trusts

- Investment fund established under trust deed

Types of unit trusts and share of public unit trusts assets:

APRA classifies superannuation funds as:

Compulsory superannuation funds

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Retail superannuation funds

Defined benefit funds and accumulation funds

– Defined benefit funds

General Insurance Offices

- Hedge funds operate in a relatively unregulated environment.