LEONARDO DA VINCI

Transfer of Innovation

VALDONĖ DARŠKUVIENĖ

Vytautas Magnus University

Financial Markets

Leonardo da Vinci programme project

„Development and Approbation of Applied Courses

Based on the Transfer of Teaching Innovations
in Finance and Management for Further Education
of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria”

2010

TABLE OF CONTENTS

Table of contents............................................................................................................... 2
Introduction ...................................................................................................................... 5 1.
FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL
SYSTEM.......................................................................................................................... 6
1.1. Financial system structure and functions............................................................ 6
1.2. Financial markets and their economic functions................................................. 7
 1.3. Financial intermediaries and their functions....................................................... 9
1.4. Financial markets structure .............................................................................. 11
1.4.1. Financial instruments............................................................................... 11 1.4.2.
Classification of financial markets ........................................................... 13 1.5. Financial
market regulation ............................................................................. 14 1.6.
Summary......................................................................................................... 15 Key
terms.................................................................................................................... 15 Further
readings.......................................................................................................... 16 Review
questions and problems .................................................................................. 16 2.
INTEREST RATES DETERMINATION AND STRUCTURE............................... 17 2.1.
Interest rate determination ............................................................................... 17 2.1.1. The
rate of interest ................................................................................... 17 2.1.2. Interest rate
theories: loanable funds theory ............................................. 19 2.1.3. Interest rate theories:
liquidity preference theory...................................... 20 2.2. The structure of interest
rates........................................................................... 20 2.3. Term structure of interest
rates......................................................................... 22 2.4. Theories of term structure of
interest rates....................................................... 22 2.4.1. Expectations
theory.................................................................................. 23 2.4.2. Liquidity premium
theory ........................................................................ 25 2.4.3. Market segmentation
theory..................................................................... 26 2.4.4. The preferred habitat
theory..................................................................... 26 2.5. Forward interest rates and yield
curve.............................................................. 26 2.6.
Summary......................................................................................................... 29 Key
terms.................................................................................................................... 29 Further
readings.......................................................................................................... 30 Relevant
websites........................................................................................................ 30 Review
questions and problems .................................................................................. 30 3. MONEY
MARKETS .............................................................................................. 33 3.1. Money
market purpose and structure ............................................................... 33 3.1.1. The role of
money markets....................................................................... 33 3.1.2. Money market
segments .......................................................................... 34 3.1.3. Money market
participants....................................................................... 36 3.2. Money market instruments
.............................................................................. 37 3.2.1. Treasury bills and other
government securities......................................... 37 3.2.2. The interbank market
loans...................................................................... 42 3.2.3. Commercial papers
.................................................................................. 43 3.2.4. Certificates of deposit
.............................................................................. 45 3.2.5. Repurchase
agreements............................................................................ 46 3.2.6. International money
market securities...................................................... 49 3.3. Money market interest rates and
yields ............................................................ 51 3.4.
Summary......................................................................................................... 54 Key
terms.................................................................................................................... 54

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Further readings.......................................................................................................... 54
Relevant websites........................................................................................................ 55
Review questions and problems .................................................................................. 55
4. DEBT MARKETS .................................................................................................. 57 4.1.
Debt market instrument characteristics ............................................................ 57 4.2.
Bond market.................................................................................................... 59
 4.2.1. Bond market characteristics ..................................................................... 59 4.2.2.
Bond market yields.................................................................................. 60 4.3. Bond
valuation ................................................................................................ 61 4.3.1.
Discounted models................................................................................... 61 4.3.2. Bond
duration and risk............................................................................. 63 4.3.3. Bond price
volatility ................................................................................ 63 4.3.4. Behavior of
Macaulay’s duration ............................................................. 65 4.3.5.
Immunization........................................................................................... 65 4.3.6. Bond
convexity........................................................................................ 65 4.4. Bond analysis
.................................................................................................. 67 4.4.1. Inverse floaters and
floating rate notes..................................................... 67 4.4.2. Callable bonds
......................................................................................... 67 4.4.3. Convertible
bonds.................................................................................... 69 4.5.
Summary......................................................................................................... 70 Key
terms.................................................................................................................... 71 Further
readings.......................................................................................................... 71 Review
questions and problems .................................................................................. 71 5. EQUITY
MARKET ................................................................................................ 73 5.1. Equity
instruments........................................................................................... 74 5.1.1. Common
shares ....................................................................................... 74 5.1.2. Preferred shares
....................................................................................... 75 5.1.3. Private
equity........................................................................................... 77 5.1.4. Global shares and
American Depository Receipts (ADR)......................... 78 5.2. Primary equity market
..................................................................................... 80 5.2.1. Primary public
market.............................................................................. 80 5.3. Secondary equity market
................................................................................. 83 5.3.1. Organized
exchanges............................................................................... 84 5.3.2. Over-the-counter
(OTC) market............................................................... 86 5.3.3. Electronic stock
markets.......................................................................... 87 5.4. Secondary equity market
structure ................................................................... 88 5.4.1. Cash vs forward
markets.......................................................................... 89 5.4.2. Continuous markets and
auction markets ................................................. 89 5.4.3. Order-driven markets and
quote-driven markets....................................... 89 5.4.4. Hybrid
markets........................................................................................ 91 5.5. Equity market
transactions............................................................................... 91 5.5.1. Bid-ask spread
......................................................................................... 91 5.5.2. Placing
order............................................................................................ 93 5.5.3. Margin trading
......................................................................................... 95 5.5.4. Short
selling............................................................................................. 97 5.5.5. Stock trading
regulations.......................................................................... 98 5.6. Equity market
characteristics......................................................................... 100 5.6.1. Stock indicators
..................................................................................... 100 5.6.2. Stock market
indexes............................................................................. 100 5.6.3. Stock market
indicators.......................................................................... 103 5.6.4. Transaction execution
costs.................................................................... 104 5.7. Stock market efficiency
................................................................................. 106

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5.8. Stock valuation.............................................................................................. 109
5.8.1. Fundamental analysis............................................................................. 109
 5.8.2. Technical analysis.................................................................................. 110
5.9. Processes of consolidation of stock exchanges............................................... 114
5.10. Summary ................................................................................................... 115 Key
terms.................................................................................................................. 116
Further readings........................................................................................................ 116
Relevant websites...................................................................................................... 117
Review questions and problems ................................................................................ 118
6. DERIVATIVES MARKETS................................................................................. 120 6.1.
Hedging against risk ...................................................................................... 120 6.2.
Description of derivatives markets................................................................. 120 6.3.
Forward and futures contracts........................................................................ 122
6.3.1. Principles of forward and futures contracts............................................. 122
6.3.2. Forward and futures valuation................................................................ 124
6.3.3. Use of forwards and futures ................................................................... 127
6.3.4. Futures contracts: stock index futures..................................................... 129
6.3.5. Contracts for difference (CFD) .............................................................. 130
6.4. Swaps............................................................................................................ 131 6.5.
Options.......................................................................................................... 132 6.5.1.
Options definition .................................................................................. 132 6.5.2.
Components of the Option Price ............................................................ 135 6.5.3.
Determinants of the Option Price ........................................................... 136 6.5.4.
Option pricing models............................................................................ 138 6.5.5. Mixed
strategies in options trading......................................................... 139 6.6.
Summary....................................................................................................... 139 Key
terms.................................................................................................................. 140
Review questions and problems ................................................................................ 140

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INTRODUCTION

Motivation for developing the course

Research by the members of the project consortium Employers’ Confederation of Latvia

and Bulgarian Chamber of Commerce and Industry indicated the need for further
education courses in the field of finance and managerial decision making.

Innovative content of the course

The course has been developed to include the following innovative content: ∙ Key concepts
of financial markets, which are explained from an applied perspective, including with
examples and problems from current financial markets practices from EU integration
and development perspective;
∙ Analytical techniques to be applied in financial markets provide with understanding
and tools to decision makers in the firm;
∙ Applied exercises, which cover topics such as money market, debt market, equity
market instruments, as well as decision making rules in the financial markets; ∙
Summaries are provided at the end of every chapter, which aid revision and control of
knowledge acquisition during self-study;

Innovative teaching methods of the course

The course is developed to utilise the following innovative teaching methods: ∙ Availability
on the electronic platform with interactive learning and interactive evaluation methods;
∙ Active use of case studies and participant centred learning;
∙ Availability in modular form;
∙ Utilising two forms of learning - self-study and tutorial consultations; ∙
Availability in several languages simultaneously.

Target audience for the course

The target audience are: entrepreneurs, finance and management specialists from Latvia,
Lithuania and Bulgaria and, in the longer term, similar groups in any other European
country.
The course assumes little prior applied knowledge in the area of financial and operation
analysis.
The course is intended for 32 academic hours (2 credit points).

Course objective

The objective of the course is to provide entrepreneurs with the knowledge in the area of
financial markets, specific financial market instruments, behavior in order to enable them
to understand the financial markets processes and their factors, and to make successfully
financial decisions on the individual as well as company level.
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1. FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL
SYSTEM

Mini contents ∙ The structure of a financial system

∙ Functions of a financial system
∙ The structure and key features of financial markets
∙ The key features of financial intermediaries
∙ Major financial market participants

1.1. Financial system structure and functions

The financial system plays the key role in the economy by stimulating economic growth,
influencing economic performance of the actors, affecting economic welfare. This is
achieved by financial infrastructure, in which entities with funds allocate those funds to
those who have potentially more productive ways to invest those funds. A financial system
makes it possible a more efficient transfer of funds. As one party of the transaction may
possess superior information than the other party, it can lead to the information asymmetry
problem and inefficient allocation of financial resources. By overcoming the information
asymmetry problem the financial system facilitates balance between those with funds to
invest and those needing funds.
According to the structural approach, the financial system of an economy consists of
three main components:
1) financial markets;
2) financial intermediaries (institutions);
3) financial regulators.
Each of the components plays a specific role in the economy.
According to the functional approach, financial markets facilitate the flow of funds in
order to finance investments by corporations, governments and individuals. Financial
institutions are the key players in the financial markets as they perform the function of
intermediation and thus determine the flow of funds. The financial regulators perform the
role of monitoring and regulating the participants in the financial system.
market Figure 1. The
Bond market

Short term fixed securities

structure of financial
Firms
Stock market
 system Banking sector Governments

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Financial markets studies, based on capital market theory, focus on the financial system,
the structure of interest rates, and the pricing of financial assets.
An asset is any resource that is expected to provide future benefits, and thus possesses
economic value. Assets are divided into two categories: tangible assets with physical
properties and intangible assets. An intangible asset represents a legal claim to some future
economic benefits. The value of an intangible asset bears no relation to the form, physical
or otherwise, in which the claims are recorded.
Financial assets, often called financial instruments, are intangible assets, which are
expected to provide future benefits in the form of a claim to future cash. Some financial
instruments are called securities and generally include stocks and bonds.
Any transaction related to financial instrument includes at least two parties: 1) the
party that has agreed to make future cash payments and is called the issuer;
2) the party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the investor.
Financial assets provide the following key economic functions.
∙ they allow the transfer of funds from those entities, who have surplus funds to
invest to those who need funds to invest in tangible assets;
∙ they redistribute the unavoidable risk related to cash generation among deficit
and surplus economic units.
The claims held by the final wealth holders generally differ from the liabilities issued by
those entities who demand those funds. They role is performed by the specific entities
operating in financial systems, called financial intermediaries. The latter ones transform
the final liabilities into different financial assets preferred by the public.

1.2. Financial markets and their economic functions

A financial market is a market where financial instruments are exchanged or traded.
Financial markets provide the following three major economic functions:
1) Price discovery
2) Liquidity
3) Reduction of transaction costs
1) Price discovery function means that transactions between buyers and sellers of
financial instruments in a financial market determine the price of the traded asset. At the
same time the required return from the investment of funds is determined by the
participants in a financial market. The motivation for those seeking funds (deficit units)
depends on the required return that investors demand. It is these functions of financial
markets that signal how the funds available from those who want to lend or invest funds
will be allocated among those needing funds and raise those funds by issuing financial
instruments.
2) Liquidity function provides an opportunity for investors to sell a financial instrument,
since it is referred to as a measure of the ability to sell an asset at its fair market value at
any time. Without liquidity, an investor would be forced to hold a financial instrument
until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt
instrument is liquidated when it matures, and equity instrument is until the company is

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either voluntarily or involuntarily liquidated. All financial markets provide some form of
liquidity. However, different financial markets are characterized by the degree of liquidity.
3) The function of reduction of transaction costs is performed, when financial market
participants are charged and/or bear the costs of trading a financial instrument. In market
economies the economic rationale for the existence of institutions and instruments is
related to transaction costs, thus the surviving institutions and instruments are those that
have the lowest transaction costs.
The key attributes determining transaction costs are
∙ asset specificity,
∙ uncertainty,
∙ frequency of occurrence.
Asset specificity is related to the way transaction is organized and executed. It is lower
when an asset can be easily put to alternative use, can be deployed for different tasks
without significant costs.
Transactions are also related to uncertainty, which has (1) external sources (when events
change beyond control of the contracting parties), and (2) depends on opportunistic
behavior of the contracting parties. If changes in external events are readily verifiable, then
it is possible to make adaptations to original contracts, taking into account problems
caused by external uncertainty. In this case there is a possibility to control transaction
costs. However, when circumstances are not easily observable, opportunism creates
incentives for contracting parties to review the initial contract and creates moral hazard
problems. The higher the uncertainty, the more opportunistic behavior may be observed,
and the higher transaction costs may be born.
Frequency of occurrence plays an important role in determining if a transaction should
take place within the market or within the firm. A one-time transaction may reduce costs
when it is executed in the market. Conversely, frequent transactions require detailed
contracting and should take place within a firm in order to reduce the costs.
When assets are specific, transactions are frequent, and there are significant uncertainties
intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific,
transactions are infrequent, and there are no significant uncertainties least costly may be
market transactions.
The mentioned attributes of transactions and the underlying incentive problems are related
to behavioural assumptions about the transacting parties. The economists (Coase (1932,
1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to
transactions costs economics by analyzing behaviour of the human beings, assumed
generally self-serving and rational in their conduct, and also behaving opportunistically.
Opportunistic behaviour was understood as involving actions with incomplete and
distorted information that may intentionally mislead the other party. This type of behavior
requires efforts of ex ante screening of transaction parties, and ex post safeguards as well
as mutual restraint among the parties, which leads to specific transaction costs.
Transaction costs are classified into:
1) costs of search and information,
2) costs of contracting and monitoring,
3) costs of incentive problems between buyers and sellers of financial assets.
1) Costs of search and information are defined in the following way:

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∙ search costs fall into categories of explicit costs and implicit costs.
Explicit costs include expenses that may be needed to advertise one’s intention to sell
or purchase a financial instrument. Implicit costs include the value of time spent in
locating counterparty to the transaction. The presence of an organized financial market
reduces search costs.
∙ information costs are associated with assessing a financial instrument’s investment
attributes. In a price efficient market, prices reflect the aggregate information
collected by all market participants.
2) Costs of contracting and monitoring are related to the costs necessary to resolve
information asymmetry problems, when the two parties entering into the transaction
possess limited information on each other and seek to ensure that the transaction
obligations are fulfilled.
3) Costs of incentive problems between buyers and sellers arise, when there are conflicts
of interest between the two parties, having different incentives for the transactions
involving financial assets.
The functions of a market are performed by its diverse participants. The participants in
financial markets can be also classified into various groups, according to their motive for
trading:
∙ Public investors, who ultimately own the securities and who are motivated by the
returns from holding the securities. Public investors include private individuals and
institutional investors, such as pension funds and mutual funds.
∙ Brokers, who act as agents for public investors and who are motivated by the
remuneration received (typically in the form of commission fees) for the services
they provide. Brokers thus trade for others and not on their own account.
∙ Dealers, who do trade on their own account but whose primary motive is to profit
from trading rather than from holding securities. Typically, dealers obtain their
return from the differences between the prices at which they buy and sell the
security over short intervals of time.
∙ Credit rating agencies (CRAs) that assess the credit risk of borrowers.
In reality three groups are not mutually exclusive. Some public investors may occasionally
act on behalf of others; brokers may act as dealers and hold securities on their own, while
dealers often hold securities in excess of the inventories needed to facilitate their trading
activities. The role of these three groups differs according to the trading mechanism
adopted by a financial market.

1.3. Financial intermediaries and their functions

Financial intermediary is a special financial entity, which performs the role of efficient
allocation of funds, when there are conditions that make it difficult for lenders or investors
of funds to deal directly with borrowers of funds in financial markets. Financial
intermediaries include depository institutions, insurance companies, regulated investment
companies, investment banks, pension funds.
The role of financial intermediaries is to create more favourable transaction terms than
could be realized by lenders/investors and borrowers dealing directly with each other in
the financial market.
The financial intermediaries are engaged in:

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∙ obtaining funds from lenders or investors and
∙ lending or investing the funds that they borrow to those who need funds.
The funds that a financial intermediary acquires become, depending on the financial claim,
either the liability of the financial intermediary or equity participants of the financial
intermediary. The funds that a financial intermediary lends or invests become the asset of
the financial intermediary.
Financial intermediaries are engaged in transformation of financial assets, which are less
desirable for a large part of the investing public into other financial assets—their own
liabilities—which are more widely preferred by the public.
Asset transformation provides at least one of three economic
functions: ∙ Maturity intermediation.
∙ Risk reduction via diversification.
∙ Cost reduction for contracting and information processing.

Depository
Deposits
Employee Contributions
Institutions
Purchase (Commercial
Securities
Surplus Units Banks, Savings
Institutions, Credit
Unions)
Policyholders
Purchase Shares
Finance Companies
Employers and
Employees Premium s
 Mutual Funds
Pension funds

Deficit Units (Firms,

Government,
Agencies, Some
Individuals)
Insurance
Companies

Figure 2. Comparison of roles among financial institutions

Source: Madura J. (2008). Financial Institutions and Markets, Eight Edition
These economic functions are performed by financial market participants while providing
the special financial services (e.g. the first and second functions can be performed by
brokers, dealers and market makers. The third function is related to the service of
underwriting of securities).
Other services that can be provided by financial intermediaries include:
∙ Facilitating the trading of financial assets for the financial intermediary’s
customers through brokering arrangements.

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∙ Facilitating the trading of financial assets by using its own capital to take a position
in a financial asset the financial intermediary’s customer want to transact in.
∙ Assisting in the creation of financial assets for its customers and then either
distributing those financial assets to other market participants.
∙ Providing investment advice to customers.
∙ Manage the financial assets of customers.
∙ Providing a payment mechanism.

1.4. Financial markets structure

1.4.1. Financial instruments
There is a great variety of financial instrument in the financial marketplace. The use of
these instruments by major market participants depends upon their offered risk and return
characteristics, as well as availability in retail or wholesale markets. The general view on
the financial instrument categories is provided in Table 1.
Table 1. Financial instrument categories
Category Risk determinants Expected returns Main participants

Non In wholesale money In wholesale In wholesale

tradables markets: transaction money money markets:
and non volumes markets: low banks
transferable
s In retail markets: low In credit In retail markets:
transparency, lack of markets: low banks and non-bank
standardisation, low firms and
creditworthiness households

In foreign exchange In foreign In foreign

markets: high exchange exchange
volatility, change of markets: high markets: financial
currency institutions, companies

Securities Market volatility, Comparably high Banks and

individual risks and non-bank firms,
failures individuals

Derivatives Market volatility, leverage Very high Banks and

non-bank firms,
individuals

Source: Reszat B. (2008). European Financial Systems in the Global Economy

A financial instrument can be classified by the type of claims that the investor has on the
issuer. A financial instrument in which the issuer agrees to pay the investor interest plus
repay the amount borrowed is a debt instrument. A debt instrument also referred to as an
instrument of indebtedness, can be in the form of a note, bond, or loan. The interest
payments that must be made by the issuer are fixed contractually. For example, in the case
of a debt instrument that is required to make payments in Euros, the amount can be a fixed
Euro amount or it can vary depending upon some benchmark. The investor in a debt
instrument can realize no more than the contractual amount. For this reason, debt
instruments are often called fixed income instruments.

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Fixed income instruments forma a wide and diversified fixed income market. The key
characteristics of it is provided in Table 2.

Table 2.Fixed-income market

 Market Features Issuers

Bonds Long-term obligations to make Governments,

Long a series of fixed payments firms
term
Bonds that can be swapped for Firms
Convertibles equity at pre-specified
conditions
Asset-backed
securities Securitised “receivables” Financial
presenting future streams institutions,
of payments firms
Preferred stock,
subordinated debt Debt and equity hybrids Firms

Notes Medium-term obligations Governments

Medium
term Medium-term instruments with Firms
Floating-rate notes interest rates based on LIBOR
or another index

Bills Short-term obligations Governments

Short
term Short-term debt instruments Firms
Commercial paper
Short-term debt instruments Banks
Certificates of
deposit

Source: Reszat B. (2008). European Financial Systems in the Global Economy

In contrast to a debt obligation, an equity instrument specifies that the issuer pays the
investor an amount based on earnings, if any, after the obligations that the issuer is
required to make to investors of the firm’s debt instruments have been paid.
Common stock is an example of equity instruments. Some financial instruments due to
their characteristics can be viewed as a mix of debt and equity.
Preferred stock is a financial instrument, which has the attribute of a debt because
typically the investor is only entitled to receive a fixed contractual amount. However, it is
similar to an equity instrument because the payment is only made after payments to the
investors in the firm’s debt instruments are satisfied.
Another “combination” instrument is a convertible bond, which allows the investor to
convert debt into equity under certain circumstances. Because preferred stockholders
typically are entitled to a fixed contractual amount, preferred stock is referred to as a fixed
income instrument.
Hence, fixed income instruments include debt instruments and preferred stock.
The features of debt and equity instruments are contrasted in Table 3.
The classification of debt and equity is especially important for two legal reasons. First, in
the case of a bankruptcy of the issuer, investor in debt instruments has a priority on the
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claim on the issuer’s assets over equity investors. Second, the tax treatment of the
payments by the issuer can differ depending on the type of financial instrument class.
Table 3. Debt versus equity
Debt Equity

Characteristic Borrower-lender Ownership, no time limit

relation, fixed
maturities

Advantages:

✔ for the firm Predictability, Flexibility, low cost of

independence from finance, reputation
shareholders’ influence

✔ for the investor Low risk High expected return

Disadvantages:

✔ for the firm Debt servicing obligation Shareholder dependence,

short sightedness, market
volatility influencing
management
decisions

✔ for the investor Low returns High risk

Source: Reszat B. (2008). European Financial Systems in the Global Economy

1.4.2. Classification of financial markets

There different ways to classify financial markets. They are classified according to the
financial instruments they are trading, features of services they provide, trading
procedures, key market participants, as well as the origin of the markets.
The generalized financial market classification is given in Table 4.
Table 4. Financial market classification
Criterion Features Examples

Products Tradability, Equity, debt instruments, derivatives

transferability,
ownership, maturity,
denomination, substance
 Services Technical, advisory, IT support, research and
information and analysis, custody
knowledge based,
administrative

Ways of Physical, electronic, virtual Over the counter, exchange, internet

trading

Participants Professionals, non Banks, central banks, non-bank

professionals, financial companies, institutional
institutions, officials investors, business firms, households

Origin Domestic, cross-border, National markets, regionally

regional, international integrated markets, Euromarkets,
domestic/foreign currency markets,
onshore/offshore markets

Source: Reszat B. (2008). European Financial Systems in the Global Economy.

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From the perspective of country origin, its financial market can be broken down into an
internal market and an external market.
The internal market, also called the national market, consists of two parts: the domestic
market and the foreign market. The domestic market is where issuers domiciled in the
country issue securities and where those securities are subsequently traded.
The foreign market is where securities are sold and traded outside the country of issuers.
External market is the market where securities with the following two distinguishing
features are trading: 1) at issuance they are offered simultaneously to investors in a number
of countries; and 2) they are issued outside the jurisdiction of any single country. The
external market is also referred to as the international market, offshore market, and the
Euromarket (despite the fact that this market is not limited to Europe).
Money market is the sector of the financial market that includes financial instruments that
have a maturity or redemption date that is one year or less at the time of issuance. These
are mainly wholesale markets.
The capital market is the sector of the financial market where long-term financial
instruments issued by corporations and governments trade. Here “long-term” refers to a
financial instrument with an original maturity greater than one year and perpetual
securities (those with no maturity). There are two types of capital market securities: those
that represent shares of ownership interest, also called equity, issued by corporations, and
those that represent indebtedness, or debt issued by corporations and by the state and local
governments.
Financial markets can be classified in terms of cash market and derivative markets.
The cash market, also referred to as the spot market, is the market for the immediate
purchase and sale of a financial instrument.
In contrast, some financial instruments are contracts that specify that the contract holder
has either the obligation or the choice to buy or sell another something at or by some
future date. The “something” that is the subject of the contract is called the underlying
(asset). The underlying asset is a stock, a bond, a financial index, an interest rate, a
currency, or a commodity. Because the price of such contracts derive their value from the
value of the underlying assets, these contracts are called derivative instruments and the
market where they are traded is called the derivatives market.
When a financial instrument is first issued, it is sold in the primary market. A secondary
market is such in which financial instruments are resold among investors. No new capital
is raised by the issuer of the security. Trading takes place among investors.
Secondary markets are also classified in terms of organized stock exchanges and over-the
counter (OTC) markets.
Stock exchanges are central trading locations where financial instruments are traded. In
contrast, an OTC market is generally where unlisted financial instruments are traded.

1.5. Financial market regulation

In general, financial market regulation is aimed to ensure the fair treatment of participants.
Many regulations have been enacted in response to fraudulent practices. One of the key
aims of regulation is to ensure business disclosure of accurate information for investment
decision making. When information is disclosed only to limited set of investors, those
have major advantages over other groups of investors. Thus regulatory framework has to
provide the equal access to disclosures by companies. The recent regulations were passed

14
in response to large bankruptcies, overhauled corporate governance, in order to strengthen
the role of auditors in overseeing accounting procedures. The Sorbanes-Oxley Act of 2002
in US was designed particularly to tighten companies’ governance after dotcom bust and
Enron’s Bankruptcy. It had direct consequences internationally, first of all through global
companies. The US Wall Street Reform and Consumer Protection Act (Dodd-Frank) of
2010 aims at imposing tighter financial regulation for the financial markets and financial
intermediaries in US, in order to ensure consumer protection. This is in tune with major
financial regulation system development in EU and other parts of the world.

1.6. Summary
The financial system of an economy consists of three components: (1) Financial markets;
(2) financial intermediaries; and (3) financial regulators.
The main function of the system is to channel funds between the two groups of end users
of the system: from lenders (‘surplus units’) to borrowers (‘deficit units’). Besides, a
financial system provides payments facilities, a variety of services such as insurance,
pensions and foreign exchange, together with facilities which allow people to adjust their
existing wealth portfolios.
Apart from direct borrowing and lending between end-users, borrowing and lending
through intermediaries and organized markets have important advantages. These include
transforming the maturity of short-term savings into longer-term loans, reduction of risk
and controlling transaction costs.
The field of financial markets and its theoretical foundations is based on the study of the
financial system, the structure of interest rates, and the pricing of risky assets.
The major market players are households, governments, nonfinancial corporations,
depository institutions, insurance companies, asset management firms, investment banks,
nonprofit organizations, and foreign investors.
Financial markets are classified into internal versus external markets, capital markets
versus money markets, cash versus derivative markets, primary versus secondary markets,
private placement versus public markets, exchange-traded versus over-the-counter
markets.
The financial markets and intermediaries are subject to financial regulators. The recent
changes in the regulatory system are happening in response to the problems in the credit
markets and financial crisis that struck 2008.

Key terms
∙ Financial system
∙ Financial markets
∙ Money markets
∙ Capital markets
∙ Debt markets
∙ Derivative markets

15
Further readings
1. European Commission (2007). European Financial Integration Report 2007, EC,
Brussels.
2. Fabozzi F. J., Modigliani F., (2007). Capital Markets: Institutions and
Instruments. Prentice-Hall International.
3. Financial Stability Forum (2008). Report on Enhancing Market and Institutional
Resilience, FSF, Basel.
4. Howells P., Bain K. (2008). Financial Markets and Institutions. Financial Times,
Prentice Hall.
5. Madura J. (2008). Financial Markets and Institutions. Prentice-Hall International.
6. Mishkin F. S., Eakins S. G. (2006). Financial Markets and Institutions.
Addison-Wesley.
7. Seifert, W.G., Schleitner, A.K., Mattern, F., Streit, C.C., Voth, H.J. (2000).
European Capital Markets, Macmillan.
8. Valdez, S. (2006). Introduction to Global Financial Markets, Palgrave
Macmillan.
 Review questions and problems

1. What are the functions of a financial system?

2. Distinguish the difference between deficit and surplus units.
3. What is the difference between ‘saving’ and a ‘financial surplus’?
4. Discuss the advantages to deficit and surplus units of using organized financial
markets and financial intermediaries.
5. How are financial intermediaries able to engage in maturity transformation?
6. Explain briefly the difference between deposit-taking and non-deposit-taking
intermediaries.
7. Why do people simultaneously hold financial assets and liabilities?
8. Why is the average size of broker/ dealer operations in general smaller than that
of asset transformers?

16
2. INTEREST RATES DETERMINATION AND STRUCTURE

Mini contents ∙ Interest rate determination

∙ Loanable funds theory
∙ Liquidity preference theory
∙ Level of interest rates in the economy
∙ Understanding of the term structure of interest rates
∙ Theories of term structure of interest rates
∙ Spot rates and forwards rates
∙ Yield curves

For financing and investing decision making in a dynamic financial environment of market
participants, it is crucial to understand interest rates as one of the key aspects of the
financial environment. Several economic theories explain determinants of the level of
interest rates. Another group of theories explain the variety of interest rates and their term
structure, i.e. relationship between interest rates and the maturity of debt instruments.

2.1. Interest rate determination

2.1.1. The rate of interest
Interest rate is a rate of return paid by a borrower of funds to a lender of them, or a price
paid by a borrower for a service, the right to make use of funds for a specified period. Thus
it is one form of yield on financial instruments. Two questions are being raised by market
participants:
∙ What determines the average rate of interest in an economy?
∙ Why do interest rates differ on different types and lengths of loans and debt
instruments?
Interest rates vary depending on borrowing or lending decision. There is interest rate at
which banks are lending (the offer rate) and interest rate they are paying for deposits (the
bid rate). The difference between them is called a spread. Such a spread also exists
between selling and buying rates in local and international money and capital markets. The
spread between offer and bid rates provides a cover for administrative costs of the
financial intermediaries and includes their profit. The spread is influenced by the degree of
competition among financial institutions. In the short-term international money markets
the spread is lower if there is considerable competition. Conversely, the spread between
banks borrowing and lending rates to their retail customers is larger in general due to
considerably larger degree of loan default risk. Thus the lending rate (offer or ask rate)
always includes a risk premium.
Concept Risk premium is an addition to the interest rate demanded by a lender
to take into account the risk that the borrower
might default on the loan entirely or may not repay on time
(default risk).

17
There are several factors that determine the risk premium for a non- Government security,
as compared with the Government security of the same maturity. These are (1) the
perceived creditworthiness of the issuer, (2) provisions of securities such as conversion
provision, call provision, put provision, (3) interest taxes, and (4) expected liquidity of a
security’s issue.
In order to explain the determinants of interest rates in general, the economic theory
assumes there is some particular interest rate, as a representative of all interest rates in an
economy. Such an interest rate usually depends upon the topic considered, and can
represented by e.g. interest rate on government short-term or long-term debt, or the base
interest rate of the commercial banks, or a short-term money market rate (EURIBOR). In
such a case it is assumed that the interest rate structure is stable and that all interest rates in
the economy are likely to move in the same direction.
Concept Interest rate structure is the relationships between the various rates of
interest in an economy on financial
instruments of different lengths (terms) or of different
 degrees of risk.
The rates of interest quoted by financial institutions are nominal rates, and are used to
calculate interest payments to borrowers and lenders. However, the loan repayments
remain the same in money terms and make up a smaller and smaller proportion of the
borrower’s income. The real cost of the interest payments declines over time. Therefore
there is a real interest rate, i.e. the rate of interest adjusted to take into account the rate of
inflation. Since the real rate of return to the lender can be also falling over time, the lender
determines interest rates to take into account the expected rate of inflation over the period
of a loan. When there is uncertainty about the real rate of return to be received by the
lender, he will be inclined to lend at fixed interest rates for short-term.
The loan can be ‘rolled over’ at a newly set rate of interest to reflect changes in the
expected rate of inflation. On the other hand, lenders can set a floating interest rate, which
is adjusted to the inflation rate changes.
Concept Real interest rate is the difference between the nominal rate of interest
and the expected rate of inflation. It is a measure
of the anticipated opportunity cost of borrowing in terms of
goods and services forgone.
The dependence between the real and nominal interest rates is expressed using the
following equation:
i =(1+ r)(1+ ie) - 1
where i is the nominal rate of interest, r is the real rate of interest and ie e is the expected
rate of inflation.
Example Assume that a bank is providing a company with a loan of 1000 thous.
Euro for one year at a real rate of interest of 3
per cent. At the end of the year it expects to receive back
1030 thous. Euro of purchasing power at current prices.
However, if the bank expects a 10 per cent rate of inflation
over the next year, it will want 1133 thous. Euro back (10 per
cent above 1030 thous. Euro). The interest rate required by
the bank would be 13.3 per cent
i =(1+ 0,03)(1 + 0,1) - 1 = (1,03)(1,1) - 1 = 1,133 - 1=0,133
or 13,3 per cent

18
When simplified, the equation becomes: i = r + ie
In the example, this would give 3 per cent plus 10 per cent = 13 per cent.
The real rate of return is thus: r = i - ie
When assumption is made that r is stable over time, the equation provides the Fisher
effect. It suggests that changes in short-term interest rates occur because of changes in the
expected rate of inflation. If a further assumption is made that expectations about the rate
of inflation of market participants are correct, then the key reason for changes in interest
rates is the changes in the current rate of inflation.
Borrowers and lenders think mostly in terms of real interest rates. There are two economic
theories explaining the level of real interest rates in an economy:
 ∙ The loanable funds theory
∙ Liquidity preference theory

2.1.2. Interest rate theories: loanable funds theory

In an economy, there is a supply loanable funds (i.e., credit) in the capital market by
households, business, and governments. The higher the level of interest rates, the more
such entities are willing to supply loan funds; the lower the level of interest, the less they
are willing to supply. These same entities demand loanable funds, demanding more when
the level of interest rates is low and less when interest rates are higher.
The extent to which people are willing to postpone consumption depends upon their time
preference.
Concept Time preference describes the extent to which a person is willing to
give up the satisfaction obtained from present
consumption in return for increased consumption in the
future.
The term ‘loanable funds’ simply refers to the sums of money offered for lending and
demanded by consumers and investors during a given period. The interest rate in the
model is determined by the interaction between potential borrowers and potential savers.

Concept Loanable funds are funds borrowed and lent in an economy during a
specified period of time – the flow of money from
surplus to deficit units in the economy.
The loanable funds theory was formulated by the Swedish economist Knut Wicksell in
the 1900s. According to him, the level of interest rates is determined by the supply and
demand of loanable funds available in an economy’s credit market (i.e., the sector of the
capital markets for long-term debt instruments). This theory suggests that investment and
savings in the economy determine the level of long-term interest rates. Short-term interest
rates, however, are determined by an economy’s financial and monetary conditions.
According to the loanable funds theory for the economy as a whole:
Demand for loanable funds = net investment + net additions to liquid reserves
Supply of loanable funds = net savings + increase in the money supply
Given the importance of loanable funds and that the major suppliers of loanable funds are
commercial banks, the key role of this financial intermediary in the determination of

19
interest rates is vivid. The central bank is implementing specific monetary policy, therefore
it influences the supply of loanable funds from commercial banks and thereby changes the
level of interest rates. As central bank increases (decreases) the supply of credit available
from commercial banks, it decreases (increases) the level of interest rates.

2.1.3. Interest rate theories: liquidity preference theory

Saving and investment of market participants under economic uncertainty may be much
more influenced by expectations and by exogenous shocks than by underlying real forces.
A possible response of risk-averse savers is to vary the form in which they hold their
financial wealth depending on their expectations about asset prices. Since they are
concerned about the risk of loss in the value of assets, they are likely to vary the average
liquidity of their portfolios.

Concept A liquid asset is the one that can be turned into money quickly, cheaply
and for a known monetary value.

Liquidity preference theory is another one aimed at explaining interest rates. J. M.

Keynes has proposed (back in 1936) a simple model, which explains how interest rates are
determined based on the preferences of households to hold money balances rather than
spending or investing those funds.
Money balances can be held in the form of currency or checking accounts, however it does
earn a very low interest rate or no interest at all. A key element in the theory is the
motivation for individuals to hold money balance despite the loss of interest income.
Money is the most liquid of all financial assets and, of course, can easily be utilized to
consume or to invest. The quantity of money held by individuals depends on their level of
income and, consequently, for an economy the demand for money is directly related to an
economy’s income. There is a trade-off between holding money balance for purposes of
maintaining liquidity and investing or lending funds in less liquid debt instruments in order
to earn a competitive market interest rate. The difference in the interest rate that can be
earned by investing in interest-bearing debt instruments and money balances represents an
opportunity cost for maintaining liquidity. The lower the opportunity cost, the greater the
demand for money balances; the higher the opportunity cost, the lower the demand for
money balance.
Concept Liquidity preference is preference for holding financial wealth in the
form of short-term, highly liquid assets rather
than long-term illiquid assets, based principally on the fear
that long-term assets will lose capital value over time.
According to the liquidity preference theory, the level of interest rates is determined by the
supply and demand for money balances. The money supply is controlled by the policy
tools available to the country’s Central Bank. Conversely, in the loan funds theory the level
of interest rates is determined by supply and demand, however it is in the credit market.

2.2. The structure of interest rates

The variety of interest rates that exist in the economy and the structure of interest rates is
subject to considerable change due to different factors. Such changes are important to the
operation of monetary policy. Interest rates vary because of differences in the time period,

20
the degree of risk, and the transactions costs associated with different financial
instruments. Figure 3 provides an overview of the factors influencing interest rates and

Future State of
 Expansion Household
Demand for
Future Volume of Funds
Business

Future Volume of
Government Future Business
Revenues Demand for
Funds
Future Government Future
Expenditures
Demand for
Loanable Funds
Future
Future Level of
Government Demand
Household income
for
Funds
Future State of the Fed’s Future
Economy (Economic Policies on Money
Growth, Supply Growth
Unemployment,
Inflation) Forecast of Interest
Foreign Economies and Future Savings by Rates
Future State of Foreign
Expectations of Households and
Economies and
Exchange Rate Others
Expectations of
Movements
Exchange Rate
Movements

Future Level of Future Foreign Demand

Household Income for
Funds Future
Future Foreign
Supply of Demand for
Household Plans to Loanable Funds Loanable Funds
Borrow
Future
Future Plans for

Figure 3. Framework for Forecasting Interest Rates

Source: Madura J. (2008). Financial Institutions and Markets.
thus the general framework for forecasting them.
The greater the risk of default associated with an asset, the higher must be the interest rate
paid upon it as compensation for the risk. This explains why some borrowers pay higher
rates of interest than others.

21
The degree of risk associated with a request for a loan may be determined based upona
company’s size, profitability or past performance; or, it may be determined more formally
by credit rating agencies. Borrowers with high credit ratings will be able to have
commercial bills accepted by banks, find willing takers for their commercial paper or
borrow directly from banks at lower rates of interest. Such borrowers are often referred to
as prime borrowers. Those less favored may have to borrow from other sources at higher
rates.
The same principle applies to the comparison between interest rates on sound risk-free
loans (such as government bonds) and expected yields on equities. The more risky a
company is thought to be, the lower will be its share price in relation to its expected
average dividend payment – that is, the higher will be its dividend yield and the more
expensive it will be for the company to raise equity capital.

2.3. Term structure of interest rates

The relationship between the yields on comparable securities but different maturities is
called the term structure of interest rates. The primary focus here is the Treasury market.
The graphic that depicts the relationship between the yield on Treasury securities with
different maturities is known as the yield curve and, therefore, the maturity spread is also
referred to as the yield curve spread.
Concept Yield curve: Shows the relationships between the interest rates payable
on bonds with different lengths of time to
maturity. That is, it shows the term structure of interest rates.
The focus on the Treasury yield curve functions is due mainly because of its role as a
benchmark for setting yields in many other sectors of the debt market. However, a
Treasury yield curve based on observed yields on the Treasury market is an unsatisfactory
measure of the relation between required yield and maturity. The key reason is that
securities with the same maturity may actually provide different yields.
Hence, it is necessary to develop more accurate and reliable estimates of the Treasury yield
curve. It is important to estimate the theoretical interest rate that the Treasury would have
to pay assuming that the security it issued is a zero-coupon security.
If the term structure is plotted at a given point in time, based on the yield to maturity, or
the spot rate, at successive maturities against maturity, one of the three shapes of the yield
curve would be observed. The type of yield curve, when the yield increases with maturity,
is referred to as an upward-sloping yield curve or a positively sloped yield curve. A
distinction is made for upward sloping yield curves based on the steepness of the yield
curve. The steepness of the yield curve is typically measured in terms of the maturity
spread between the long-term and short-term yields.
A downward-sloping or inverted yield curve is the one, where yields in general decline
as maturity increases.
A variant of the flat yield is the one in which the yield on short-term and long-term
Treasuries are similar but the yield on intermediate-term Treasuries are much lower than,
for example, the six-month and 30-year yields. Such a yield curve is referred to as a
humped yield curve.

2.4. Theories of term structure of interest rates

There are several major economic theories that explain the observed shapes of the yield
curve:

22
∙ Expectations theory
∙ Liquidity premium theory
∙ Market segmentation theory
∙ Preferred habitat theory

2.4.1. Expectations theory

The pure expectations theory assumes that investors are indifferent between investing for a
long period on the one hand and investing for a shorter period with a view to reinvesting
the principal plus interest on the other hand. For example an investor would have no
preference between making a 12-month deposit and making a 6-month deposit with a view
to reinvesting the proceeds for a further six months so long as the expected interest
receipts are the same. This is equivalent to saying that the pure expectations theory
assumes that investors treat alternative maturities as perfect substitutes for one another.
The pure expectations theory assumes that investors are risk-neutral. A risk-neutral
investor is not concerned about the possibility that interest rate expectations will prove to
be incorrect, so long as potential favourable deviations from expectations are as likely as
unfavourable ones. Risk is not regarded negatively.
However, most investors are risk-averse, i.e. they are prepared to forgo some investment
return in order to achieve greater certainty about return and value of their investments. As
a result of risk-aversion, investors may not be indifferent between alternative maturities.
Attitudes to risk may generate preferences for either short or long maturities. If such is the
case, the term structure of interest rates (the yield curve) would reflect risk premiums.
Question How a yield curve would shift in response to sudden expectations of
rising interest rates according to pure
expectations theory?
If an investment is close to maturity, there is little risk of capital loss arising from interest
rate changes. A bond with a distant maturity (long duration) would suffer considerable
capital loss in the event of a large rise in interest rates. The risk of such losses is known as
capital risk.
To compensate for the risk that capital loss might be realised on long-term investments,
investors may require a risk premium on such investments. A risk premium is an addition
to the interest or yield to compensate investors for accepting risk. This results in an upward
slope to a yield curve. This tendency towards an upward slope is likely to be reinforced by
the preference of many borrowers to borrow for long periods (rather than borrowing for a
succession of short periods).
Some investors may prefer long maturity investments because they provide greater
certainty of income flows. This uncertainty is income risk. If investors have a preference
 for predictability of interest receipts, they may require a higher rate of interest on short
term investments to compensate for income risk. This would tend to cause the yield curve
to be inverted (downward sloping).
The effects on the slope of the yield curve from factors such as capital risk and income risk
are in addition to the effect of expectations of future short-term interest rates. If money
market participants expect short-term interest rates to rise, the yield curve would tend to be
upward sloping. If the effect of capital risk were greater than the effect of income risk, the
upward slope would be steeper. If market expectations were that short-term interest rates
would fall in the future, the yield curve would tend to be downward sloping. A dominance

23
of capital-risk aversion over income-risk aversion would render the downward slope less
steep (or possibly turn a downward slope into an upward slope).

Panel A: Impact of a Sudden Expectation of Higher Interest Rates

Market for 3-Month Market for 3-Month Risk-free Debt
(Short term) (Short term)
Risk-free Debt Risk-free Debt
Market for 3-Month i S2
i (Short term) Yield
S1
D1

Quantity of Funds
i1 i2
S1 3 Months 10 Years
D1 YC2 Term to
S2
D2 Maturity
D2
Quantity of Funds
YC1
i2 i1
E(↑i) → Supply of funds provided by investors ↑ in short-term (such as 3-month) markets, and ↓ in long
term (such as 10-year) markets. Demand for funds by borrowers ↑ in long-term markets and ↓ in short
term markets. Therefore, the yield curve becomes upward sloping as shown here.

Panel B: Impact of a Sudden Expectation of Lower Interest Rates

i2 D2
i S2 D2 Yield
i
S1 D1

i2 S1
i1 S2 YC1

YC2

i1 D1
 Quantity of Funds Maturity
3 Months 10 Years Term
Quantity of Funds to
E(↓i) → Supply of funds provided by investors ↑ in long-term (such as 10-year) markets, and ↓ in short
term (such as 3-month) markets. Demand for funds by borrowers ↑ in short-term markets and ↓ in long
term markets. Therefore, the yield curve becomes downward sloping as shown here.

Figure 4. How Interest Rate Expectations Affect the Yield Curve

Source: Madura J. (2008). Financial Institutions and Markets

24
The Figure 4 provides a graphical explanation, how interest rate expectations affect the
yield curve.
Question Why interest rates tend to decrease during recessionary periods?

Question What is the relationship between yield and liquidity of the securities?

2.4.2. Liquidity premium theory

Some investors may prefer to own shorter rather than longer term securities because a
shorter maturity represents greater liquidity. In such case they will be willing to hold long
term securities only if compensated with a premium for the lower degree of liquidity.
Though long-term securities may be liquidated prior to maturity, their prices are more
sensitive to interest rate movements. Short-term securities are usually considered to be
more liquid because they are more likely to be converted to cash without a loss in value.
Thus there is a liquidity premium for less liquid securities which changes over time. The
impact of liquidity premium on interest rates is explained by liquidity premium theory.
Market expects Maturity an interest
stable interest increase in
rates interest rates

dl

Inclusion of
Inclusion of
e

Liquidity
dl
i

Inclusion of e

Liquidity Premium
Y
i

dl

Liquidity Y
Premium d

Premium
e
e
i
d
z

Y e i

z
l

Liquidity
Liquidity
a

Liquidity
d i

e
l
u
Premium
Premium Premium
a

Removed
z
n
i u

Removed Removed
l n

n
a
A

Scenario 3:
n

Term to
u

A
n

n Scenario 2: Market expects Maturity

A
Term to Market expects Term to a
Scenario 1: Maturity reduction in
 Figure 5. Impact of liquidity premium on the yield curve under three scenarios
Source: Madura J. (2008). Financial Institutions and Markets.

Figure 5 provides a graphical explanation of impact of liquidity premium on interest rates

and yield curve.

25
2.4.3. Market segmentation theory

According to the market segmentation theory, interest rates for different maturities are
determined independently of one another. The interest rate for short maturities is
determined by the supply of and demand for short-term funds. Long-term interest rates are
those that equate the sums that investors wish to lend long term with the amounts that
borrowers are seeking on a long-term basis.
According to market segmentation theory, investors and borrowers do not consider their
short-term investments or borrowings as substitutes for long-term ones. This lack of
substitutability keeps interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as substitutes, they may switch
between maturities. However, if investors and borrowers switch between maturities in
response to interest rate changes, interest rates for different maturities would no longer be
independent of each other. An interest rate change for one maturity would affect demand
andsupply, and hence interest rates, for other maturities.

2.4.4. The preferred habitat theory

Preferred habitat theory is a variation on the market segmentation theory. The preferred
habitat theory allows for some substitutability between maturities. However the preferred
habitat theory views that interest premiums are needed to entice investors from their
preferred maturities to other maturities.
According to the market segmentation and preferred habitat explanations, government can
have a direct impact on the yield curve. Governments borrow by selling bills and bonds of
various maturities. If government borrows by selling long-term bonds, it will push up
long-term interest rates (by pushing down long-term bond prices) and cause the yield
curve to be more upward sloping (or less downward sloping). If the borrowing were at the
short maturity end, short-term interest rates would be pushed up.
Question What factors influence the shape of the yield curve?

2.5. Forward interest rates and yield curve

The expectations that are relevant to investment decisions are expectations relative to
market expectations. An active portfolio manager bases investment decisions on attempts
to forecast interest rates more accurately than the average participant in the money market.
For this reason the manager of an actively managed bond portfolio needs to be able to
ascertain the market consensus forecast. Such market expectations can be deduced from
forward interest rates.
Forward interest rates are rates for periods commencing at points of time in the future.
They are implied by current rates for differing maturities. For example, the current 3-
month interest rate and the current 6-month interest rate between them imply a rate for a 3-
month period which runs from a point in time three months from the present until a point
in time six months hence.
The forward 3-month rate for a period commencing three months from the present is the
rate which, when compounded on the current 3-month rate, would yield the same return as
the current 6-month rate. For example if the 3-month rate is 9% p.a. and the 6-month rate
is 10% p.a., the forward rate is shown as x in equation:
(1,0225)(1 + x) =1,05

26
The forward rate is calculated as:
x=(1,05/1.0225) - 1 = 0,0269
which is 2.69% over three months and hence 10.76% p.a.
The forward rate can be interpreted as the market expectation of the future interest rate
under the assumptions that: the expectations theory of the yield curve is correct and there
is no risk premium. If the expectations theory is seen as a good model, but there is a risk
premium, an adjustment is required to remove the effects of the risk premium before the
result can be interpreted as the market forecast of the future interest rate.

Question What is the meaning of the forward rate in the context of the term
structure of interest rates?

The yield curve based on zero coupon bonds is known as the spot yield curve. It is
regarded as more informative than a yield curve that relates redemption yields to
maturities of coupon bearing bonds. The redemption date is not the only maturity date.

Example The one-year interest rate is 6,5% p.a. and the six-month interest rate is
6% p.a. What is the forward six-month
interest rate for the period between six months and one year
from now? Can this forward interest rate be taken to be the
interest rate expected by money market participants?
Let x be the forward interest rate p.a. (so that the rate for six
months is x/2).
(1,03)(1 +x/2) =1,065
1 +x/2 =(1,065)/(1,03)
x/2 =[(1,065)/(1,03)] -1
x=2{ [(1,065)/(1,03)] -1}
Therefore x=0,068, i.e. 6,8% p.a.
The forward interest rate of 6,8% p.a. can be taken to be the
 market expectation if the expectations theory of the yield
curve is correct and there is no risk premium. If the
expectations theory is correct but there is a risk premium, the
risk premium must be removed before carrying out the
calculation. Suppose that the six-month rate contains no risk
premium, but the one-year rate contains a risk premium of
0,1% p.a. The one-year interest rate, net of the risk premium,
is 6,4% p.a. The new calculation would be as follows:
(1,03)(1 + x/2) = (1,064)
x=2{[(1,064)/(1,03)] -1}
Therefore x=0,066, i.e. 6,6% p.a.
Coupon-bearing bonds may have differing redemption yields, despite having common
redemption dates, because of differences in the coupon payments. Yield curves based on
coupon-bearing bonds may not provide a single redemption yield corresponding to a
redemption (final maturity) date.

27

Example Suppose, zero coupon bonds with maturities one, two, and three years
from the present have prices of 95, 88, and 80
Euro. What are the spot one-, two-, and three-year interest
rates? Draw the yield curve.
In the case of the one-year bond, an investment of 95 Euro
entails a receipt of 100 Euro in one year. 100/95 =1,0526
which implies a spot one-year interest rate of 5,26%. In the
case of the two-year bond, an investment of 88 Euro yields a
receipt of 100 Euro after two years.
100/88 =1,13636
√1,13636 =1,0660 or a spot 2-year interest rate of 6,60% p.a.
b) In the case of the three-year bond, an investment of 80
Euro provides a receipt of 100 Euro after three years.
100/80 = 1,25
1,250.33=1,0772 or a spot three-year interest rate of 7,72% p.a.
The forward yield curve relates forward interest rates to the points of time to which they
relate. For example, rates of return on five-year bonds and rates on four-year bonds imply
rates on one year instruments to be entered into four years from the present. The implied
forward rate can be calculated by means of the formula:
(1 + 4r1) = (1 + 0r5)5 / (1 +0r4)4
where r5 is the five-year interest rate, r4 is the four-year interest rate, and 4r1 is the one-year
rate expected in four years’ time.
This formula arises from the relation:
(1 +0r5)5=(1 + 0r4)4 (1 + 4r1)
which states that a five-year investment at the five-year interest rate should yield the same
final sum as a four-year investment at the four-year rate with the proceeds reinvested for
one year at the one-year rate expected to be available four years hence. The value of 4r1
would be related to the point in time, of four years, on the yield curve. Carrying out such a
calculation for a succession of future periods produces a series of forward interest rates.
Question Why might forward rates consistently overestimate future interest rates?

Question How liquidity premium affects the estimate of a forward interest rate?

When plotted against their respective dates, the series of forward rates produces a forward
yield curve. The forward yield curve requires the use of zero coupon bonds for the
calculations.
This forms also the basis for calculation of short-term interest rate futures. Short-term
interest rate futures, which frequently take the form of three-month interest rate futures, are
instruments suitable for the reduction of the risks of interest rate changes. Three-month
interest rate futures are notional commitments to borrow or deposit for a three-month
period that commences on the futures maturity date. They provide means whereby

28
borrowers or investors can (at least approximately) predetermine interest rates for future
periods.
Assume that the three-month interest rate is 4.5% p.a. and
Example 5% p.a. is 2,5% over six months, and 4,5%
p.a. is 1,125% over three months.
(1,025)/(1,01125) = 1,013597
1.013597 - 1 = 0.013597, i.e. 1.3597% for
three months or 5.44% p.a. (to two
decimal places).
The forward interest rate is 5,44% p.a.

2.6. Summary
the six-month interest rate is 5% p.a.
What is the forward interest rate for the
three-month period commencing three
months from now?

Level of interest rates in an economy is explained by two key economic theories: the
loanable funds theory and the liquidity preference theory. The loanable funds theory states
that the level of interest rates is determined by the supply of and demand for loanable
funds. According to the liquidity preference theory, the level of interest rates is determined
by the supply of and demand for money balances.
Interest rates in the economy are determined by the base rate (rate on a Government
security) plus a risk premium (or a spread). There are several factors that determine the
risk premium for a non- Government security, as compared with the Government security
of the same maturity. These are (1) the perceived creditworthiness of the issuer, (2)
provisions of securities such as conversion provision, call provision, put provision, (3)
interest taxes, and (4) expected liquidity of a security’s issue.
The term structure of interest rates shows the relationship between the yield on a bond and
its maturity. The yield curve describes the relationship between the yield on bonds of the
same credit quality but different maturities in a graphical way. Apart from spot rates,
forward rates provide additional information for issuers and investors. The major theories
explain the observed shapes of the yield curve are the expectations theory, liquidity
premium, market segmentation theory and preferred habit theory.

Key terms
∙ Interest rates
∙ Loanable funds
∙ Spot rate
∙ Forward rate
∙ Term structure of interest rates
∙ Yield curve
∙ Expectations
∙ Biased expectations
∙ Liquidity
∙ Segmented markets

29
∙ Preferred habitat

Further readings
1. Culbertson J.M. (1957). The Term Structure of Interest Rates, Quarterly Journal
of Economics, November, p. 489-504.
2. Estrella A., Mishkin F. S. (1996). The yield curve as a predictor of U.S.
recessions. Federal Reserve Bank of New York Current Issues in Economics
and Finance.
3. Favero C. A., Kaminska I., Söderström U. (2005). The predictie power of the
yield spread: Further evidence and a structural interpretatio,. CEPR Discussion
Paper, No. 4910.
4. Kane E.J. (1970). The term structure of interest rates: An attempt to reconcile
teaching with practice, Journal of Finance, Vol.25, May, p. 361-374. 5. Ron U.
(2002). A practical guide to swap curve construction. Chapter 6 in F. J. Fabozzi
(ed.) Interest Rate, Term Structure, and Valuation Modeling. New York, John
Wiley & Sons.
Relevant websites
∙ http://www.bloomberg.com
 ∙ http://www.federalreserve.gov
∙ http://www.ft.com
∙ http://www.ecb.int/stats/money/yc/html/index.en.html
∙ http://www.treas.gov/offices/domestic-finance/debt-management/interest
rate/yield.shtml
∙ http://www.newyorkfed.org/research/capital_markets/ycfaq.html ∙
http://demonstrations.wolfram.com/PriceYieldCurve/

Review questions and problems

∙ How would you expect an increase in the propensity to save to affect the
general level of interest rates in an economy?
6. Explain how an increase in the rate of inflation might affect (a) real interest rates
and (b) nominal interest rates.
7. Why are some lenders capital risk averse and others income risk averse? What
slope will the yield curve have when the market is dominated by capital risk
aversion?
8. Why might interest rates payable on long-term, ‘risk-free’ government bonds
include a term premium?
9. Look at the most recent interest rate change by European Central bank, US FED,
Bank of England, Central Bank of Lithuanian, Central Bank of Latvia and
Central Bank of Estonia. Compare them. What conclusions can be drawn?
10.What conclusion might you draw about possible future interest rates if a
positive term premium were to increase?
11.Why might interest rate movements of various developed countries be more
highly correlated in recent years than in earlier years?

30
12.Consider the prevailing conditions for inflation (including oil prices), the
economy, and the budget deficit, the central bank of your country and EU
central bank monetary policy that could affect interest rates. Based on the
prevailing conditions, do you think interest rates will likely increase during the
following half a year? Provide arguments for your answer. Which factor do you
think will have the largest impact on interest rates?
13.Assume that a) investors and borrowers expect that the economy will weaken
and that inflation will decline; b) investors require a low liquidity premium; c)
markets are partially segmented and the Government prefers to borrow in the
short-term markets. Explain how each of the three factors would affect the term
structure of interest rates, holding all other factors constant. Then explain the
overall effect on the term structure.
14.Assume that the yield curves in the US, Germany and Japan are flat. If the yield
curve in the US suddenly becomes positively sloped, do you think the yield
curves in Germany and Japan would be affected? If yes, how?
15.A company X has funded its operations by bank loans extensively. The interest
rate on the loans is tied to the market interest rates and is adjusted every six
months. Thus the cost of funds is sensitive to interest rate movements. Because
of expectations that EU economy would strengthen during the next year, the
company plans further growth through investments. The company expects that it
will need substantial long-term financing to finance its growth and plans to
borrow additional funds in the debt market.
a) What can be the company’s expectations about the change in interest rates in
the future? Why?
b) How would these expectations affect the company’s cost of borrowing on its
existing loans and on future debt?
c) How these expectations would affect the company’s decision when to borrow
funds and whether to issue floating-rate or fixed rate debt?
16. Assume that the interest rate for one year securities is expected to be 4 percent
today, 5 percent one year from now and 7 percent two years from now. Using
only the pure expectations theory find what are the current (spot) interest rates
on two and three year securities.
17. Assume that the spot (annualized) interest rate on a three year security is 8
percent, while the spot (annualized) interest rate on a two year security is 5
percent. Use only this information to estimate the one year forward rate two
years from now.
18.Assume that the spot (annualized) interest rate on a two year security is 7
percent, while the spot (annualized) interest rate on a one year security is 6
percent.
a) Using only this information estimate the one year forward rate.
b) Assume that the liquidity premium on a two year security is 0,4 percent. Use
this information to re-estimate the one year forward rate
19.Assess the shape of the yield curve using the website http://www.ecb.int/stats/
money/yc/html/index.en.html. Based on various theories attempting to explain
the shape of the yield curve, provide your explanations of the difference
between the 1 year and the 30 year government securities. Which theory
according to your opinion is the most reasonable? Why?

31
20.Consider how quickly other interest rates in the economy changed thereafter.
Why does the MPC change interest rates each time it acts by only 1/4 or, at
most, 1/2 a per cent?
21.Could the MPC of the Bank of England raise interest rates when everyone was
expecting them to fall? Look at the financial press and find the current interest
spread between five-year and ten-year government bonds. Is there a positive
term premium?
22.What conclusion might you draw about possible future interest rates if a
positive term premium were to increase? How is money actually transferred
from an account in one country to an account in another?
23.Has the growth of the Euromarkets been, on balance, a positive development for
 the world economy?
24.How many reasons can you think up for preferring fixed to floating rate loans
and vice versa?
25.Find out as much as you can about:
a) the activities of the international credit rating agencies;
b) the role of the international banks in the international debt crisis of the
developing countries.
26.What is:
a) EURIBOR?
b) a euroeuro?
c) a swaption?
d) a plain vanilla swap?
27.Look in the financial press and find examples of variations on plain vanilla
swaps that re not mentioned in the text.
28.If you swapped a floating rate payment for a fixed rate payment, would you gain
or lose if interest rates unexpectedly rose? Why?

32
3. MONEY MARKETS

Mini contents ∙ The purpose of money markets

∙ Money markets segments and participants
∙ Money market instruments
∙ Money market rates and yields
 3.1. Money market purpose and structure
3.1.1. The role of money markets
The purpose of money markets is facilitate the transfer of short-term funds from agents
with excess funds (corporations, financial institutions, individuals, government) to those
market participants who lack funds for short-term needs.
They play central role in the country’s financial system, by influencing it through the
country’s monetary authority.
For financial institutions and to some extent to other non-financial companies money
markets allow for executing such functions as:
∙ Fund raising;
∙ Cash management;
∙ Risk management;
∙ Speculation or position financing;
∙ Signalling;
∙ Providing access to information on prices.
Money markets are wholesale markets with very large amounts of transactions, e.g. with
transactions from 500 million Euro to 1 billion Euro or even larger ones. This is the most
active financial market in terms of volumes of trading.
From the start of emergence the traditional money markets performed the role of
monetary policy. In order to influence the supply side, governments have employed
methods of direct regulation and control of the savings and investment behaviour of
individuals and companies. However due to fast technological advances,
internationalization and liberalization of financial markets, possibilities to carry out policy
objectives through such measures have diminished. Current policy through market oriented
measures is aimed primarily at demand side. Thus money markets serve the interface
between execution of monetary policy and the national economies
Another role of domestic money markets is to serve public policy objectives, i.e.
financing public sector deficits and managing the accumulated government deficits.
Government public debt policy is an important determinant of the money markets
operations, since government debt typically forms a key part of the country’s money
markets (as well as debt markets). The scope and measures of monetary policy are also
linked to the government’s budget and fiscal policies. Thus the country’s money market

33
shifts are dependant upon the goals of national public policy and tools used to reach these
goals.
Changes in the role and structure of money markets were also influenced by
financial deregulation, which evolved as a result of recognition that excessive controls are
not compatible with efficient resource allocation, with solid and balanced growth of
economies. Money markets went through passive adaptation as well as through active
influence from the side of governments and monetary authorities.
 Finally, money markets were influenced by such international dimensions as
increasing capital mobility, changing exchange rate arrangements, diminishing monetary
policy autonomy. The shifts in European domestic money markets were made by the
European integration process, emergence and development of European monetary union.

3.1.2. Money market segments

In a broad sense, money market consists of the market for short-term funds, usually with
maturity up to one year. It can be divided into several major segments:
Interbank market, where banks and non-deposit financial institutions settle
contracts with each other and with central bank, involving temporary liquidity surpluses
and deficits.
Primary market, which is absorbing the issues and enabling borrowers to raise
new funds.
Secondary market for different short-term securities, which redistributes the
ownership, ensures liquidity, and as a result, increases the supply of lending and reduces
its price.
Derivatives market – market for financial contracts whose values are derived
from the underlying money market instruments.
Interbank market is defined mainly in terms of participants, while other markets are
defined in terms of instruments issued and traded. Therefore there is a considerable
overlap between these segments. Interbank market is referred mainly as the market for
very short deposits and loans, e.g. overnight or up to two weeks. Nearly all types of money
market instruments can be traded in interbank market.
Key money market segments by instruments are provided in Figure 6

Figure 6. Key money market instruments

The money-market instruments are often grouped in the following way: ∙

Treasury bills and other short-term government securities (up to one year);

34
∙ Interbank loans, deposits and other bank liabilities;
∙ Repurchase agreements and similar collateralized short-term loans;
∙ Commercial papers, issued by non-deposit entities (non-finance companies, finance
companies, local government, etc. ;
 ∙ Certificates of deposit;
∙ Eurocurrency instruments;
∙ Interest rate and currency derivative instruments.
All these instruments have slightly different characteristics, fulfilling the demand of
investors and borrowers for diversification in terms of risk, rate of return, maturity and
liquidity, and also diversification in terms of sources of financing and means of payment.
Many investors regard individual money market instruments as close substitutes, thus
changes in all money market interest rates are highly correlated.
Major characteristics of money market instruments are:
∙ short-term nature;
∙ low risk;
∙ high liquidity (in general);
∙ close to money.
Money markets consist of tradable instruments as well as non-tradable instruments.
Traditional money markets instruments, which included mostly dealing of market
participants with central bank, have decreased their importance during the recent period,
followed by an increasing trend to finance short-term needs by issuing new types of
securities such as REPOs, commercial papers or certificates of deposit. The arguments
behind the trend are the following:
1. An observed steady shift to off-balance sheet instruments, as a reaction to
introduction of capital risk management rules for internationally operating banks in
the recommendations of Basel II Accord and EU Directives on banking.
2. Advantages provided to high-rated market participants, allowing to diversify
borrowing sources, to cut the costs, to reduce the borrowers’ dependence on
banking sector lending and its limitations.
In terms of risk two specific money-market segments are:
∙ unsecured debt instruments markets (e.g. deposits with various maturities, ranging
from overnight to one year);
∙ secured debt instruments markets (e.g. REPOs) with maturities also ranging from
overnight to one year.
Differences in amount of risk are characteristic to the secured and the unsecured
segments of the money markets. Credit risk is minimized by limiting access to high-quality
counter-parties. When providing unsecured interbank deposits, a bank transfers funds to
another bank for a specified period of time during which it assumes full counterparty credit
risk. In the secured REPO markets, this counterparty credit risk is mitigated as the bank
that provides liquidity receives collateral (e.g., bonds) in return.
Money markets structures differ across the countries, depending upon regulatory and
legislative frameworks, factors that have supported or limited the development of such

35
national markets. The influence of business culture and traditions, industrial structures
have played an important role also.
Economic significance of money markets is predetermined by its size, level of
development of infrastructure, efficiency. Growth of government securities issues, their
costs considerations, favourable taxation policies have become additional factors boosting
some of the country’s money markets.

3.1.3. Money market participants

Money market participants include mainly credit institutions and other financial
intermediaries, governments, as well as individuals (households).
Ultimate lenders in the money markets are households and companies with a financial
surplus which they want to lend, while ultimate borrowers are companies and government
with a financial deficit which need to borrow. Ultimate lenders and borrowers usually do
not participate directly in the markets. As a rule they deal through an intermediary, who
performs functions of broker, dealer or investment banker.
Important role is played by government, which issue money market securities and use the
proceeds to finance state budget deficits. The government debt is often refinanced by
issuing new securities to pay off old debt, which matures. Thus it manages to finance long
term needs through money market securities with short-term maturities.
Central bank employs money markets to execute monetary policy. Through monetary
intervention means and by fixing the terms at which banks are provided with money,
central banks ensure economy’s supply with liquidity.
Credit institutions (i.e., banks) account for the largest share of the money market. They
issue money market securities to finance loans to households and corporations, thus
supporting household purchases and investments of corporations. Besides, these
institutions rely on the money market for the management of their short-term liquidity
positions and for the fulfilment of their minimum reserve requirements.
Other important market participants are other financial intermediaries, such as money
market funds, investment funds other than money-market funds, insurance companies and
pension funds.
Large non-financial corporations issue money market securities and use the proceeds to
support their current operations or to expand their activities through investments.
In general issuance of money market securities allow market participants to increase their
expenditures and finance economic growth.
Money market securities are purchased mainly by corporations, financial intermediaries
and government that have funds available for a short-term period. . Individuals (or
households) play a limited role in the market by investing indirectly through money
market funds. Apart from transactions with the central bank, money-market participants
trade with each other to take positions dependant upon their short-term interest rate
expectations, to finance their securities trading portfolios (bonds, shares, etc.), to hedge
their longer-term positions with short-term contracts, and to reduce individual liquidity
imbalances
36
3.2. Money market instruments
3.2.1. Treasury bills and other government securities
Treasury bills are short-term money market instruments issued by government and backed
by it. Therefore market participant view these government securities as having little or
even no risk. The interest rates on Treasury securities serve as benchmark default-free
interest rates. A typical life to maturity of the securities is from four weeks to 12 months.
As they do not have a specified coupon, they are in effect zero-coupon instruments and are
issued at a discount to their par or nominal value, at which price they are redeemed. Any
new issue with the same maturity date as an existing issue is regarded as a new tranche of
the existing security.
Question What are key characteristics of Treasury bills?

Treasury bills are typically issued at only certain maturities dependant upon the
government budget deficit financing requirements. Budget deficits create a challenge for
the government. Large volumes of Treasury securities have to be sold each year to cover
annual deficit, as well as the maturing Treasury securities, that were issued in the past. The
mix of Treasury offerings determines the maturity structure of the government’s debt.
Primary market. The securities are issued via a regularly scheduled auction process.
Upon the Treasury’s announcement of the size of upcoming auction, tenders or sealed bids
are being solicited.
Concept A tender is a sealed bid.

Bidders are submitting two types of bids: competitive and non-competitive. A competitive
bidder specifies both the amount of the security that the bidder wants to buy, as well as the
price that the bidder wants to pay. The price is set in terms of yield. The price of the
securities in the auction is set based on the prices offered in competitive bids, taking the
average of all accepted competitive prices. Not all competitive bids that are tendered are
accepted. Typically the longer the maturity, the greater would be the percentage of
accepted bids. The percentage of accepted bids is determined by the size of the issue as
compared to the amount of bids tendered. Competitive bidders are the largest financial
institutions that generally purchase largest amounts of Treasury securities. In general 80-
90% Treasury securities are sold to them.
A non- competitive bidder specifies only the amount of the security that the bidder wants
to buy, without providing the price, and automatically pay the defined price. Non
competitive bidders are retail customers, who purchase low volumes of the issues, and are
not enough sophisticated to submit a bid price. Limits on each non-competitive bid can be
set. Direct purchases of Treasury securities by individuals are limited in many countries. In
such cases they use the services of dealers.
The Figure 7 illustrates the results of sealed bid (tender) auction. The Treasury will accept
the competitive bids with the highest price and lowest interest rates, and will reject other
bids.
Depending upon the existing regulation in a specific country treasury security auctions can
be organized and held at the central bank or stock exchanges.
There are two auction forms:
∙ Uniform price auction, when all bidders pay the same price;

37
∙ Discriminatory price auction, in which each bidder pays the bid price.

Price
Supply curve

Accepted
bids

Rejected
bids

Price of
lowest
accepte d bid Figure 7. Prices in a
sealed-bid auction

Demand
curve

Amount of bonds

The procedure of the discriminatory price auction one is more sophisticated. At first, all
the non-competitive bids are totaled, and their sum is subtracted from the total issue
amount. This way all non-competitive bids are fulfilled. The price, which non-competitive
bidders are going to pay, is determined taking into account the results of the competitive
part of the auction.
Concept Uniform price auction is an auction, when all bidders pay the same
price.
 Concept Discriminatory price auction is an auction, in which each bidder pays
the bid price.
Further on, all competitive tenders are ranked in order of the bid yield. In order to
minimize the governments borrowing costs, the lowest competitive bid is accepted first.
As a result, the highest bid prices are accepted until the issue is sold out fully. The lowest
rejected bid yield (or the highest accepted bid yield) is called stop yield. The
corresponding price is called the stop-out price.
During such a Treasury auction, each competitive bidder pays the price for the securities,
which is determined by the yield that was bid. The average yield is the average of all
accepted competitive bids, weighted by the amounts allocated at each yield. All non
competitive bidders pay the average yield.

38
The discriminatory auction is characterized by
∙ a tail – the difference between the stop yield and the average yield;
∙ a cover – the ratio between the total amount competitive and non-competitive bids
tendered and the total issue (i.e. the total amount of accepted bids). .
A large cover indicates active market participation in an auction. Average cover can be
evaluated in terms of a difference between maximum and minimum accepted bid yields (in
basis points) A small tail shows that most competitive bidders provide similar evaluation
of Treasury security issue, and thus pay nearly the same price for it. The larger the cover
and the smaller the tail, the more efficient is the Treasury auction.
Concept Basis point is a very fine measure of interest rates, equal to one
hundredth of one percentage point.

In a discriminatory price auction the bidder’s price is determined by his own tender. A low
bid, i.e. low yield and high offered price, increases the bidder’s chance of his bid to be
accepted. However, this can lead to the possibility of the winner’s curse. In such a case
the low bidder’s tender is accepted, but he pays a price that is higher than of others lower
priced (or higher yield) bids. Therefore competitive bidders may be reluctant to submit low
bids, because this will oblige them to pay high prices for newly issued securities. This is a
problem of discriminatory price auction.
Concept Winner’s curse is the case, when the low bidder wins acceptance of the
tender, but pays a price, which is higher
than that of other lower bidders.
A uniform price auction (or a Dutch auction) does not have a problem of this kind. All the
procedures of the auction except for the last one are the same as in the discriminatory price
auction. Each accepted bid pays the price of the lowest accepted bid.
As a result, uniform price auction becomes more expensive to the Treasury and it receives
lower revenue. Besides, the average bidder may bid a higher price, shifting demand curve
to right with the possibility offsetting the negative effect to the Treasury (see Figure 8).
Price Supply curve
 Accepted bids Rejected bids

Single-price
Price in single price auction
Discriminatory demand
Lowest accepted discriminatory
bid Amount of
demand bonds

Figure 8. Impact of single-price auction upon demand curve

39
Uniform price auction is considered fairer because all competitive bidders pay the same
price. This may encourage greater participation in the auction, and finally increase the
auction’s cover indicator. Competitive bidders are not afraid to submit too low bids,
because they will not be paying the price they bid. Conversely, the lower they will bid, the
higher likelihood is that their bid will be accepted. As a result, bidders tend to reduce their
bids, thereby lowering the average yield on the entire issue. Such changes in bidder
behaviour may offset the direct effect of higher issuer’s interest costs in the uniform price
auction.
While evaluating the effectiveness of the Treasury auction method, there is a concern, that
competitive as well as non-competitive bidders can be neglected, while few large financial
institutions may be favoured. This can cause decline in auction participation, undermining
the Treasury’s abilities to place large amounts of securities. On the other hand, since
bidders do not pay their tendered prices, the uniform price auction may be more subject to
manipulation or collusion by informed bidders.
Question What is the role of competitive and non-competitive bidders in the
Treasury securities auction?

Secondary market. Typically the Treasury securities have an active and liquid secondary
market. The most actively traded issues, which are usually the ones sold through an
auction most recently, are called on-the-run issues. They have narrower bid-ask spreads
than older, off-the-run issues. The role of brokers and dealers is performed by financial
institutions. As a rule, competitive bidders can submit more than one bid to each auction,
with different prices and quantities on each tender. However, in well developed markets
limitations are being placed to the amount of securities in each auction allocated to a
particular single bidder. The aim of such a rule is to prevent market from influence of a
single bidder, and thus squeezing other financial institutions with their own customers.
Question What is the role of competitive and non-competitive bidders in the
Treasury securities auction?

The text then can follow (starting with the style of the first paragraph). Then, we can have
some readings or an example. It can be but in the same format as the Concept/Check
Question.
Price of a Treasury bill is the price that an investor will pay for a particular maturity
Treasury security, depending upon the investor’s required return on it. The price is
determined as the present value of the future cash flows to be received. Since the Treasury
bill does not generate interest payments, the value of it is the present value of par value.
Therefore, since the Treasury bill does not pay interest, investors will pay a price for a
one-year security that will ensure that the amount they receive one year later will generate
the desired return.
Example Assume investor requires a 5 percent annualized return on a one-year
Treasury bill with a 100000Euro par value. He will
be willing to pay the price
P = 100000 Euro / 1,05 = 95238 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.

40
In case the maturity of Treasury bill is shorter than one year, then the annualized return
will be reduced by the fraction of the year, during which the investment is made. The
simplified calculations are provided in the example below.
Example Assume investor requires a 5 percent annualized return on a 6 month
Treasury bill with a 100000 Euro par value. The price
of the security will be
P = 100000 Euro / ( 1 + 0,05 / 2) =
= 100000 Euro / ( 1 + 0,025) = 97560,9 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.
The price of the Treasury bill calculated on discount rate basis is:
P = PAR x (1- (d x n / 360))
where d is the yield or rate of discount, PAR is par or maturity value and n is the number of
days of the investment (holding period).
Example Assume investor requires an 8 percent annualized return on a 91-day
Treasury bill with a 100000 Euro par value. The price
of the security will be
P = 100000 Euro x ( 1 – (0,08 x 91/ 360) =
= 100000 Euro x ( 1 – 0,02 ) = 98000 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.
Yield of a Treasury bill is determined taking into account the difference between the
selling price and the purchase price. Since Treasury bills do not offer coupon payments,
the yield the investor will receive if he purchases the security and holds it until maturity
will be equal to the return based on difference between par value and the purchase price.
The annualized yield on Treasury bill is calculated in the following way:
y = (PAR - P) / P x (365/n)
where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
Example Assume investor requires pays 98000 Euro for a 91-day Treasury bill
with a 100000 Euro par value. The annualized
yield of the security will be
y = (100000 – 98000) / 98000 ) x ( 365 / 91 ) =
= 0,02 x 4,01 = 0,0802 or 8,02 %.
If the Treasury bill is sold prior to maturity, the return is calculated on the basis of
difference between the price for which the bill was sold in the secondary market and the
purchase price.
The annualized yield on Treasury bill is calculated in the following way:
y = (SP - P) / P x (365/n)

41
where d is the yield, SP – selling price, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
In some countries (e.g. US) Treasury bills are quoted on a discount rate (or referred to as
Treasury bill rate) basis. The Treasury bill discount rate represents the percent discount of
the purchase price from par value of a new issue of a Treasury bill. It is determined in the
following way:
d = (PAR - P) / PAR x (360/n)
where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
In such a case the year is assumed having 360 days, and the number of days of the
investment can be actual or an assumed convention. If a newly issued Treasury bill is held
until maturity, then its yield is always greater than rate of discount. The difference is due to
price or value used in denominator, since purchase price is always lower than par value.
Besides, the yield is always calculated on 365 day during a year basis.

3.2.2. The interbank market loans

Interbank market is a market through which banks lend to each other.
Commercial banks are required to keep reserves on deposits within central bank. Banks
with reserves in excess of required reserves can lend these funds to other banks.
Traditionally this formed the basis of the interbank market operations. However, currently
these operations involve lending any funds in reserve accounts at a central bank.
Concept Interbank market is a market which involves bank borrowing and
lending of any funds in reserve accounts at the
central bank.
In US the interbank market is the federal funds market, which involves the borrowing and
lending any funds in reserve accounts at the Federal Reserve Bank (FED).
The major characteristics of the interbank markets are:
∙ The transfer of immediately available funds;
∙ Short time horizons;
∙ Unsecured transfers.
Individual banks have a possibility to invest (lend) surplus funds and have a source of
borrowing when their reserves are low, thus they manage their reserve position and fund
their assets portfolio by trading at the interbank market. This is a wholesale market with
deals usually in large denominations. It is used by all types of banks, involved in loans for
very short periods, from overnight to fourteen days mostly. Then bank borrows in the
interbank market, it is said to be a funds buyer. When bank lends immediately available
reserve accounts, it is said to be a seller. Most banks simultaneously buy and sell funds all
the time. By acting as dealers they make markets for funds by announcing willingness to
buy or to sell at the current competitive interbank rate.
The interbank interest rates and interest rates in the traditional market are interconnected.
If banks are short of liquidity they will lend less to both markets and will cause interest
rates to rise. When Central bank provides funds to the discount market, less attractive
terms are offered by banks. Thus they may choose other markets to invest and will cause
the drop in interest rates.

42
Interbank rates are generally slightly higher and more volatile than interest rates in the
traditional market. In periods of great shortage of liquidity, the needs of banks which do
not have sufficient funds to meet the central bank requirements drive up the overnight rates
significantly.
To keep up the speed of the transfer and the costs of transfer down, the interbank market
transfers are unsecured, i.e. not backed by any collateral and have no protection against
default by the borrowing bank.
Credit risk in the interbank market is controlled through the interbank rate, which is truly
competitive, quoted market rate. It is determined entirely by the supply and demand of
banks for funds. Since the market is a closed interbank system, the aggregate value of all
buy orders (demand for funds) should be equal to the aggregate value of all sell orders
(supply of funds). If the demand for fund purchases increases, it drives up the interbank
interest rate.
Question How is interbank interest rate determined?

Participants in the interbank market typically undertake two types of transactions:

∙ reserve management transactions;
∙ portfolio management transactions.
Bank reserve management transactions allow complying with contemporaneous bank
reserve requirements.
Through portfolio management transactions banks use interbank market to finance their
assets’ portfolio. These are encouraged by the interbank market liquidity and flexibility.
With time horizons as short as overnight, the transactions can be made rapidly at low
transaction costs.
Unlike other instruments ‘traded’ in the money markets, interbank deposits are not
negotiable i.e. do not have a secondary market. A lending bank which wishes to retrieve its
funds simply withdraws the deposit from the bank to which it was lent. Thus, In this case,
the distinction between primary and secondary markets is irrelevant.
Question How has the interbank interest rate volatility changed over the recent
years? What is the major cause of this change?

3.2.3. Commercial papers

Commercial paper (CP) is a short-term debt instrument issued only by large, well known,
creditworthy companies and is typically unsecured. The aim of its issuance is to provide
liquidity or finance company’s investments, e.g. in inventory and accounts receivable.
The major issuers of commercial papers are financial institutions, such as finance
companies, bank holding companies, insurance companies. Financial companies tend to
use CPs as a regular source of finance. Non-financial companies tend to issue CPs on an
irregular basis to meet special financing needs.
Thus commercial paper is a form of short-term borrowing. Its initial maturity is usually
between seven and forty-five days. In US, the advantage of issuing CPs with maturities
less than nine months is that they do not have to register with the Securities Exchange

43
Commission (SEC) as a public offering. This reduces the costs of registration with SEC
and avoids delays related to the registration process.
CPs can be sold directly by the issuer, or may be sold to dealers who charge a placement
fee (e.g. 1/8 percent). Since issues of CPs are heterogeneous in terms of issuers, amounts,
maturity dates, there is no active secondary market for commercial papers. However,
dealers may repurchase CPs for a fee.
Question What is the role of financial institutions in the commercial paper
market?

The price of CP is calculated in the following way:

P = PAR x (1- (d x n / 360))
where d is the yield or rate of discount, PAR is par or maturity value and n is the number of
days of the investment (holding period).
CP is sold at a discount to its maturity value, thus it is the other money market instrument
whose return is expressed on a discount basis.
Example A 30 day CP with 10 million Euro par value yields 4,75%. The price
of this CP currently offering is equal to
P = 10,0 million Euro x (1- (0,0475 x 30 / 360)) =
= 10,0 million Euro x (1- 0,003) = 9,97 million Euro
The yield on CP is calculated in the following way:
d = (PAR - P) / PAR x (360/n)
where d is the yield or rate of discount, PAR – par value, P - initial price of the CP and n is
the number of days of the investment (holding period).
Example Investor has purchased a 30 day CP with a par value of 1 million Euro
for a price of 990 000 Euro. What is the yield of
this CP investment?
d = (1 mil Euro - 990 000 Euro) / 1 mil Euro x (360/30) =
= 0,01 x 12 = 0,12 or 12 %.
Commercial paper is normally unsecured against any specific assets and firms wishing to
use the commercial paper market will usually seek a credit rating from one or other of the
credit rating agencies. A high rating will mean that such paper can be issued at a smaller
discount, often amounting to the equivalent of 1 per cent. Although commercial paper is
unsecured, typically it is backed by a line of credit at a commercial bank.
As a source of finance, commercial paper serves a similar purpose to commercial bills
(and is priced in the same way). Thus, in countries with a highly developed discount, or
bills, market, the market for commercial paper is relatively small (e.g. UK). However,
when the commercial bill market is less developed, the commercial paper market is very
large (e.g. France and US). The main difference between commercial papers and
commercial bills lies in the manner of their creation. A firm borrows via a commercial bill
when it agrees to ‘accept’ a bill which is ‘drawn’ by a creditor. The bill originates with the
lender. A firm borrows via commercial paper when it issues the paper itself.
Question What are the substitutes for commercial paper?

44
3.2.4. Certificates of deposit
Certificate of deposit (CD) states that a deposit has been made with a bank for a fixed
period of time, at the end of which it will be repaid with interest.
Thus it is, in effect, a receipt for a time deposit and explains why CDs appear in definitions
of the money supply such as M4. It is not the certificate as such that is included, but the
underlying deposit, which is a time deposit like other time deposits.
An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it
itself makes a deposit or buys a certificate in the secondary market. From an institution’s
point of view, therefore, issued CDs are liabilities; held CDs are assets.
The advantage to the depositor is that the certificate can be tradable. Thus though the
deposit is made for a fixed period, he depositor can use funds earlier by selling the
certificate to a third party at a price which will reflect the period to maturity and the
current level of interest rates.
The advantage to the bank is that it has the use of a deposit for a fixed period but,
because of the flexibility given to the lender, at a slightly lower price than it would have
had to pay for a normal time deposit.
The minimum denomination can be 100 000USD, although the issue can be as large as 1
million USD. The maturities of CDs usually range from two weeks to one year.
Non-financial corporations usually purchase negotiable CDs. Though negotiable CD
denominations are typically too large for individual investors, they are sometimes
purchased by money market funds that have pooled individual investors’ funds. Thus
money market funds allow individuals to be indirect investors in negotiable CDs. This way
the negotiable CD market can be more active. There is also a secondary market for these
securities, however its liquidity is very low.
Concept Negotiable certificates of deposit are certificates that are issued by
large commercial banks and other depository
institutions as a short-term source of funds.
The negotiable CDs must be priced offering a premium above government securities (e.g.
Treasury bills) to compensate for less liquidity and safety. The premiums are generally
higher during the recessionary periods. The premiums reflect also the money market
participants’ understanding about the safety of the financial system.
Question What factors lead to rise / decline in certificates of deposit market?

Negotiable CDs are priced on a yield basis. Institution issue negotiable CDs at a par value.
Thus the yield of the security is calculated:
y = ( PAR – P )/ P x (360 / n)
Example A three-month CD for 100 000 Euro at 6 per cent matures in 73 days.
It is currently trading at 99 000 Euro. Rate of return
of this CD current offering is
y = (100 000 – 99 000 )/ 99 000 x (360 / 73) =
= 0,01 x 4,93 = 0,0493 or 4,93%

45
The market price of the CD is found by discounting the par or maturity value by the rate of
interest currently available on similar assets, adjusted for the residual maturity.
The price of CDs is determined using the following equation:
P = PAR / (1 – (i x n / 360))
Question Find the price of a three-month 150,000 Euro CD, paying 4 per cent,
if it has 36 days to maturity and short-term interest
rates are 4 per cent.
What will be the price of this same CD if short-term interest
rates fall to 2 percent?
The annualized yield they pay is the annualized interest rate on negotiable CDs. If
investors purchase and holds negotiable CDs until maturity, their annualized yield is the
interest rate. However, if investors purchase or negotiable CDs in the secondary market
instead of holding them from issuance to maturity, then annualized yield can differ from
the annualized interest rate.
y = (Selling Price – Purchase Price + Interest) / Purchase Price
Example An investor purchased a negotiable CD a year ago in a secondary
 market. He redeems it today upon maturity and
receives 1 million Euro. He also receives 40000 Euro of
interest. What is investor’s annualized yield on this
investment?
The interest rate paid on CDs is often linked to interbank rate. If LIBOR is 4,75 per cent,
for example, the CD described above might be paying 5 percent because it is quoted as
paying LIBOR plus 25 basis points.
Certificates of deposit are an alternative of short-term, wholesale lending and borrowing.
Three- and six-month maturities are common. Some CDs are issued for one year and even
for two years but the market for these is comparatively thin. This has led to the practice of
banks issuing ‘roll-over’ CDs, i.e. six-month CDs with a guarantee of further renewal on
specified terms. CDs are issued by a wide variety of banks. It is quite common for a bank
both to have issued and to hold CDs, though normally of differing maturities. It will issue
CDs with a maturity expected to coincide with a liquidity surplus and hold CDs expected
to mature at a time of shortage.

3.2.5. Repurchase agreements

A repurchase agreement (REPO) is an agreement to buy any securities from a seller
with the agreement that they will be repurchased at some specified date and price in the
future.
Concept Repurchase agreement (REPO) is a fully collateralize loan in wich the
collateral consists of marketable securities.

In essence the REPO transaction represents a loan backed by securities. If the borrower
defaults on the loan, the lender has a claim on the securities. Most REPO transactions use
government securities, though some can involve such short-term securities as commercial
papers and negotiable Certificates of Deposit.

46
Since the length of any repurchase agreement is short-term, a matter of months at most, it
is usually assumed as a form of short-term finance and therefore, logically, an alternative
to other money market transactions.
Concept Open REPO is a REPO agreement with no set maturity date, but
renewed each day upon agreement of both counterparties.

Concept Term REPO is a REPO with a maturity of more than one day.

A reverse REPO transaction is a purchase of securities by one party from another with the
agreement to sell them. Thus a REPO and a reverse REPO can refer to the same
transaction but from different perspectives and is used to borrow securities and to lend
cash.
The participants of REPO transactions are banks, money market funds, non-financial
institutions. The transactions can amount 10 million in USD terms with the maturity from
one to 15 days and for one, three, six months. There is no secondary market for REPOs
Since the effect of the REPO transactions influence money market prices and yields, it is
normal to regard such REPOs as money market deals. In a REPO, the seller is the
equivalent of the borrower and the buyer is the lender. The repurchase price is higher than
the initial sale price, and the difference in price constitutes the return to the lender.
The amount of REPO loan is determined in the following way:
REPO principal = Securities market value x ( 1 – Haircut )
Securities market value = PAR x ( 1 – (d x n / 360 ))
where the securities market value is determined as the current market value of these
securities, d is the rate of discount of the securities, n is term of the securities, PAR is the
par value of the securities.
In the REPO transaction securities market value is equal to the value of collateral, against
which the borrowing takes place. Since the value of the securities may be fluctuating
during the term of , the amount of the loan (the principal) is less than the current market
value of the securities.
The deduction from current market value of the securities collateral required to do the
REPO transaction is made, which is call a haircut or a margin. The haircut is a margin
stated in terms of basis points. A standard haircut can be, e.g. 25 basis points (or
0,0025%). Thus a REPO loan is overcollateralized loan meaning that the amount of the
collateral exceeds the loan principal and the haircut.
Repurchase of the securities is made by repaying REPO loan and
interest: REPO principal + Interest = REPO principal ( 1 + (y x t / 360 ))
where y is the yield or rate of the REPO transaction, t is the term of the REPO
transaction. REPO principal = Securities market value x (1 – Haircut)
Securities market value is defined as present value of the par value of the securities
involved in the transaction.
Concept Haircut – the function of a broker/ dealer’s securities portfolio, that
cannot be traded, but instead must be held as
capital to act as a cushion against loss.

47
The haircut or margin offers some protection to the lender in case the borrower goes
bankrupt or defaults for some other reason. The size of the risk, and thus this haircut /
margin, depends in large part upon the status of the borrower, but it also depends upon the
precise nature of the contract. Some REPO deals are genuine sales. In these circumstances,
the lender owns the securities and can sell them in the case of default. In some REPO
contracts, however, what is created is more strictly a collateralized loan with securities
acting as collateral while remaining in the legal ownership of the borrower. In the case of
default, the lender has only a general claim on the lender and so the haircut / margin is
likely to be greater.
Example Consider a 90 day REPO transaction, with a REPO rate of 4,75%. 180
days government securities with a rate of
discount of 5% and a par value of 10 million Euro are used as
collateral. Assume that the haircut is equal to 25 basis points.
 What is the amount of REPO loan? What is the amount of
REPO loan repayment in the transaction?
REPO deals are quoted on a yield basis. The rate is quoted as a simple interest yield on a
360 days basis set upon initiation of the transaction and fixed for the term of REPO.
The REPO rate or yield is calculated:
y = ( PAR – P ) / P x (360 / t )
where P is the purchase price, PAR is the agreed repurchase price and t is the period of the
transaction.
Example Investor has purchased securities at a price of 9 980 000 Euro, with an
agreement to sell them back at 10 million Euro.
At the end of 15 days period. What is the yield of the
transaction?
REPO transactions have two legs: 1) when cash is borrowed against collateral; 2) when
REPO transaction takes place, i.e. securities are repurchased by repaying REPO loan plus
interest.
The repurchase of the securities (REPO payment) is completely independent from the
market value of the securities on the maturity date of the REPO. This reinforces the
economic reality that REPO transaction is a collateralized loan.
In a reverse REPO transaction the reverse payment is calculated:
Reverse principal + Interest = Reverse principal x ( 1 + (y x t / 360))
where y is the yield or REPO rate, t is maturity of the reverse REPO.
Example Assume a financial institution utilizes a reverse REPO to borrow
securities and to lend cash. The securities collateral is
1 million of par value government securities paying 6% p.a.
semi annually with 5 years to maturity. A REPO rate is 4,5%,
181 day of maturity, with a 50 basis points of haircut. What is
the amount of reverse REPO repayment of the transaction?
REPO and reverse REPO markets as well as number of their participants have grown up
tremendously, especially due to increased sensitivity to interest rate risk and the
opportunity cost of holding idle cash.

48
Question What determines the size of the REPO principal? What determines the
size of the REPO repayment?

REPO transactions are negotiated through a telecommunications network. Dealers and

REPO brokers perform the role of financial intermediaries to create REPO transactions fro
the companies with funds deficit or excess funds, and receive a commission for such
services. However, direct REPO transaction is executed, when there is a possibility to find
counterparty for it.
Market participants include central banks, financial institutions, non-financial
corporations.
Central banks conduct short-term REPO transactions on bonds of any residual maturity as
a means of influencing money market interest rates. ‘
Non-financial companies, private financial institutions are more likely to utilize reverse
REPOs to earn interest on their cash balances during the periods of high interest rates.
Speculative REPO and reverse REPO transactions are attractive to financial institutions
with the increased volatility of interest rates. Money market funds often take the other side
of REPO transactions and hold reverses in their assets portfolios as flexible short-term
investment vehicles. Individuals, owning shares in these funds, earn interest on the
reverses. The fund managers may speculate on interest rate fluctuations using REPOs and
reverse REPOs without being subject to the limitations on speculative derivative
transactions. Important participants of the REPO market are security dealers. They make
markets by carrying inventories of marketable securities, and can use these securities as
collateral on REPO loans. Thus they can reduce the cost of financing, utile REPOs to take
positions on interest rates, finance their securities portfolios.
Interest yields for REPOs of different terms reflect a term structure of interest rates which
is a market consensus on forecasted interest rates. The REPO rate is significantly lower
than other money market rates, however higher than the rate of government securities. It is
maintained by possibility to substitute different money market instruments. There is no
REPO secondary market.

3.2.6. International money market securities

Apart from variety of money market instruments which enable short-term lending and
borrowing to take place in the domestic currency, in recent years some of the fastest
growing markets have been the so-called eurocurrency markets. These are markets in
which the borrowing and lending denominated in a currency of some other country takes
place. In general, eurocurrency market instruments are the same as other money market
instruments. When such instruments are denominated in some other currency, they are
identified as ‘euro-’, though it can be any currency (e.g. US dollars, or Japanese yen). The
trading can also take place anywhere (in European countries or in New York or Tokyo or
Hong Kong).
Concept Eurocurrency instrument is any instrument denominated in a currency
which differs from that of the country in which it
is traded.
The factor contributing to the long-term development of eurocurrency business was the
ability of eurobanks to offer their services at more competitive rates than domestic
institutions. ‘Eurobanks’ are banks which specialize in eurocurrency business. They
channel funds between surplus and deficit units and, and thus create assets and liabilities

49
which are more attractive to end-users than if they dealt directly with each other, also they
help to use funds which might otherwise lay idle.
In the Eurodollar market banks channel the deposited funds to other companies which
need to receive Eurodollar loans. The deposit and loan transactions are of large
denominations, e.g. exceeding 1 million USD. Therefore only governments and largest
corporations can participate in the market. The market growth was influenced greatly by
Eurocurrency liabilities of financial institutions are the following:
∙ Euro Certificates of deposits
 ∙ Interbank placements
∙ Time deposits
∙ Call money
Euro certificates of deposits (Euro CDs) are negotiable deposits with a fixed time to
maturity.
Time deposits are non negotiable deposits with a fixed time to maturity. Due to illiquidity
their yields tend to be higher than the yields on equivalent maturity of negotiable Euro
certificates of deposits.
Interbank placements are short-term, often overnight, interbank loans of Eurocurrency
time deposits.
Call money are non negotiable deposits with a fixed maturity that can be withdrawn at any
time.
Eurocurrency assets of financial institutions are the following:
∙ Euro Commercial Papers (Euro CPs)
∙ Syndicated Euroloans
∙ Euronotes
Euro Commercial Papers (Euro CPs) are securitized short-term bearer notes issued by a
large well-known corporation. They are issued only by private corporations in short
maturities with the aim to provide short-term investments with a broad currency choice for
international investors. Most issues are pure discount zero coupon debt securities with
maturities from 7 to 365 days. Issuance may be conducted through an appointed panel of
dealers.It can be resold in a highly liquid secondary market. The issuers should be highly
rated as Euro CPs are unsecured.
Syndicated Euroloans are related to bank lending of Eurocurrency deposits to non
financial companies with the need for funds. Since they are non-negotiable, banks used to
hold the syndicated loans in their portfolios until they mature. Due to their illiquidity, the
loans are often made jointly by a group of lending banks, which is called a syndicate. The
role of syndication is to share loan risks among the banks that members of the syndicate.
Euronotes are unsecuritized debt instruments, substitutes for non-negotiable Euroloans.
They are short –term, most often up to one year. Floating rate notes (FRNs) offer a
variable interest rate that is reset periodically, usually seminannually or quarterly,
according to some predetermined market interest rate (e.g. LIBOR). For a high rated issuer
the interest rate can be set lower than LIBOR.

50
3.3. Money market interest rates and yields
Short-term money market instruments have different interest rate and yield quoting
conventions. The yield on short-term money market instruments is often calculated using
simple interest as opposed to compound interest, and as a result is not directly comparable
with the yields to maturity.
Short-term government securities (Treasury bills), commercial papers are often quoted and
traded on a ‘discount’ basis, while interbank loan rates, REPO rates are quoted on an “add
on” basis.
Besides, it is a convention in the US Treasury bills market to assume that a year has 360
days, while if it is denominated in sterling it has 365 days, even in a leap year. Short-term
money market instruments frequently do not have a specified coupon and as a result
investors in them obtain a return by buying them at a discount to their par or maturity
value.
Below is provide the comparison of different money market rates and yields.

1) Rate on a discount basis

d = ( PAR – P ) / PAR x (360 / t )
where d is the yield on the basis of rate of discount, PAR – par value, P – the purchase
price of the security and t is the number of days until maturity.
Discount is calculated in this case as a percent from par value. It also assumes a 360 days
year.
Example A 90 day US dollar Treasury bill is issued at 99% of its par value. It
will be redeemed at its par value (100 %) 90 days
after issue. It is traded on a discount basis. The discount of
this issue is:
d = (100 − 99) / 100 × 360 / 90 = 4%
Note that in the US dollar money market a year is assumed to
have 360 days.
The discount is often converted into a yield so as to make it comparable with other money
market instruments. This yield is often called a ‘money market yield’. Using the above
example, the money market yield is just 4 × 100/99 = 4.0404 %.

2) Add-on rate
y = ( PAR – P ) / P x (360 / t )
where y is the yield on the basis of add-on rate, PAR – par value, P - the purchase price of
the security and t is the number of days until maturity.
Example Assume 990 000 Euro is lent for a 90 day period at the add on rate. The
par value is 1000 000 Euro.
The annualized yield of the security at an add-on basis will be
y = (1000000 – 990000) / 990000 ) x ( 360 / 90 ) =
= 0,0404 or 4,04 %.

51
3) Bond-equivalent yield
y = ( PAR – P ) / P x (365 / t )
where y is the yield, PAR – par value, P - the purchase price of the security and t is the
number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at 99% of its
par value. It will be redeemed at its par value (100
%) 90 days after issue. The bond equivalent yield this issue
is:
y = (100 − 99) / 99 × 365 / 90 = 4, 097%
The bond equivalent yield is used to compare Treasury bill yields with the yields to
maturity of coupon bearing Treasury notes and bonds. The bond equivalent yield is is an
approximation of the yield to maturity of a bond.
The bond equivalent yield is higher than the discount rate. The difference is larger for
longer maturities and for higher levels of discount rate d. Therefore an error of yield using
discount rate d increases for longer maturities and for higher rates.

4) Annual yield to maturity

y = ( PAR / P ) (365 / t )– 1
where y is the yield, PAR – par or maturity value, P - the purchase price of the security and
t is the number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at 99% of its
par value. It will be redeemed at its par value (100
%) 90 days after issue.
Annual yield to maturity of this money market instrument is:
y = ( 100 / 99) (365 / 90)- 1 = 4, 097%

5) Semiannual yield to maturity

y = 2 x ( PAR / P ) (365 /2 t )– 2
where y is the yield on the basis of add-on rate, PAR – par or maturity value, P - the
purchase price of the security and t is the number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at 99% of its
par value. It will be redeemed at its par value (100
%) 90 days after issue.
The semiannual yield to maturity of this money market
instrument is:
y = 2 x ( 100 / 99) (365 /2x 90)- 2 = 4, 097%
Comparison of all the money markets rates and yields are provided in Figure 9.
It shows that the largest is always the annual yield, which is then followed by semiannual
yield, bond equivalent yield, the yield on the basis of add-on rate and the yield on discount
basis. The difference between bond equivalent yield and the semiannual yield are smaller
for longer maturities and approach as the maturity approaches half a year. The longer the
maturity, the smaller is the difference between bond equivalent yield and the annual yield.

52
Finally, the longer the maturity, the larger are the differences between the money market
discount rate and other rates.

Rate

Semiannual

Annual

Add-on rate

Discount rate 90 180Days

Bond equivalent yield

Figure 9. Money market rates and yields

Several specific money market interest rates are used in Europe.
The key European Central Bank (ECB) interest rate is the minimum bid rate, which
represents the price floor, which ensures central bank liquidity in the open-market
operations. The two other key interest rates, on the marginal lending facility and the
deposit facility, define the corridor within which the overnight interest rate can fluctuate.
The Governing Council of the ECB sets the level of the minimum bid rate in the
Eurosystem’s weekly main refinancing operations (MROs). Through the MROs, the ECB
aims to supply the liquidity necessary for the banking system to operate smoothly. This
way very short-term money market interest rates are aligned with the monetary policy of
the ECB. Through the money-market yield curve, monetary policy is transmitted to
financial instruments and credit conditions more generally, which in turn will influence
saving and investment decisions and thus will affect price developments in the euro area.
When money market is affected by crisis in the financial markets, the ECB needs to
provide additional liquidity in order to support market confidence.
Apart from the ECB interest rates, there are other main market interest rates for the money
market:
∙ EONIA (euro overnight index average). The EONIA is the effective overnight
reference rate for the euro. It is computed daily as a volume-weighted average of
unsecured euro overnight lending transactions in the interbank market, as reported
by a representative panel of large banks.
∙ EURIBOR (euro interbank offered rate). The EURIBOR is the benchmark rate of
the large unsecured euro money market for maturities longer than overnight (one
week to one year) that has emerged since 1999. It is based on information provided
by the same panel of banks.
 53
∙ EUREPO (the REPO market reference rate for the euro) for different maturities. The
EUREPO is the benchmark rate of the euro REPO market and has been released
since March 2002. It is the rate at which one prime bank offers funds in euros to
another prime bank when the funds are secured by a REPO transaction using
general collateral.
∙ The rate of interest paid on interbank loans in London (UK) is known as London
InterBank Offer Rate or LIBOR. It is an important reference to banks of the cost
of raising immediate marginal funds. Numerous bank interest rates are therefore
tied to LIBOR, particularly to the rate for three-month deposits.
The spreads among the key ECB interest rates and short-term market interest rates are low.
E.g., EONIA is mostly slightly above, but very close to, the minimum bid rate. The small
spread (about 6 to 7 basis points) reflects that the EONIA is an unsecured interbank rate. It
includes a small premium for credit risk and transaction costs. Larger spreads normally
occur at the end of the reserve maintenance period when there is a need for the banks to
fulfil the reserve requirement.
The yields of money market securities are closely monitored by money market
participants. Since money market securities are seen as close substitutes, investors may
exchange them to achieve more attractive yields. This causes yields among the securities
to come closer. If there is a difference between yields, investors will avoid lower yielding
instruments and will favour the ones with high-yield. During the periods of larger
uncertainty about the economy, investors tend to shift from more risky money market
securities to Treasury bills and other government securities.

3.4. Summary
Money market securities short-term instruments, which have maturities shorter than one
year. Trading with these securities in interbank, primary and secondary markets are very
active. The volume of transactions in national markets as well as international markets is
large. A variety of money market securities allow to meet special needs of borrowers and
lenders.

Key terms
∙ Money market
∙ Commercial paper
∙ Certificate of deposit
∙ REPO
∙ Treasury bills
∙ Interbank market

Further readings
1. Bernanke B., Blinder A. (1992). The FF rate and the channels of monetary
transmission, Journal of Banking and Finance, No. 16, p. 585-623.
 2. European Central Bank (2007). Euro Money Market Survey, ECB, Frankfurt am
Main.

54
3. European Central Bank (2008). The Analysis of the Euro Money Market from a
Monetary Policy Perspective, ECB Monthly Bulletin, February.
4. Hartmann P., Manna M., Manzanares A. (2001). The Microstructure of the
Euro Money Market, ECB Working Paper 80.
5. International Capital Market Association (2007). European REPO Market
Survey, Number 12, conducted December 2006, Zürich, ICMA.
6. Wolswijk G., de Haan J. (2005). Government Debt Management in the Euro
Area: Recent Theoretical Developments and Changes in Practices, ECB
Occasional Paper 25.

Relevant websites
∙ http://news.ft.com/home/uk
∙ http://www.bankofengland.co.uk
∙ http://www.ecb.int/pub
∙ http://www.bis.org/publ

Review questions and problems

1. How do money markets differ from capital markets?
2. Who are the main participants of money markets?
3. What is the difference between money market instruments quoted ‘on a discount
basis’ and ‘on a yield basis’?
4. How are government securities (e.g. Treasury - bills) priced?
5. How are commercial papers priced?
6. How are certificates of deposit priced?
7. How are REPO agreements priced?
8. Assume that one-month government security and one-month CDs are both
quoted as having a yield of 5 per cent. Which gives the higher yield to an
investor?
9. Suppose that long-term interest rates are expected to fall in future. How is this to
influence the supply of commercial paper and why?
10. Assume that the government makes a major sale of bonds to the private sector.
Explain the likely effect on
a) liquidity of the banking system;
b) demand for money market instruments.
11. Imagine that the central bank is concerned about the rate of growth of credit in
the economy. Explain how it might use its position in the REPO market to
 address this problem.
12. How can the central bank of a country use REPOs on government bonds to
raise interest rates from 4,5 percent to 5 percent?

55
13. A money market security with the par value of 100000 Euro is selling for
881600 Euro. What is required return of investor, if the security has two years
until maturity?
14. Government is selling its 91 days securities with the face value of 1 000 000
Euro for 880 000 Euro.
a) What is the yield on the investment, if the bank invests and holds the
securities until maturity?
b) How can the annualized yield be affected if the purchase price is lower?
c) How can the annualized yield be affected if the selling price is lower?
Explain the logic of the relationship.
d) How would the annualized yield be affected if the number of holding days
is shorter, but the purchase price and the selling price is constant? Explain the
relationship.
15. A company has received a substantial loan from commercial banks. The
interest rate on the loans is tied to market interest rates and is adjusted every six
months. The company has obtained a credit line to satisfy temporary funds
needs. Besides, in order to solve unexpected liquidity problems, it can sell short
term government securities, which it has bought half a year ago. The economic
forecasts are rather optimistic, thus in order to satisfy the rising demand, the
company may be in need to increase its production capacity by about 40 percent
over the next two years. However, the company is concerned about potential
slow down in the economy due to possible actions of European central bank
aimed at sustaining the inflation rate low. The company needs funding to cover
payments to suppliers. It is also considering other possibilities of financing in
the money market. The interest rate that the company is paying for its line of
credit is less than the prevailing commercial paper interest rate of highly rated
companies.
a) Should the company issue commercial paper on this prevailing interest rate?
b) Should the company sell its holding of government securities to cover the
payments to suppliers?
c) Should the company use its credit line?
d) Which alternative has the lowest cost for the company? Provide the
reasoning.
56
4. DEBT MARKETS

Mini contents ∙ The characteristics of debt markets

∙ The characteristics of debt instruments
∙ Valuation of bonds
∙ Bond duration and convexity
∙ Callable bonds and other bond instruments

4.1. Debt market instrument characteristics

Debt markets are used by both firms and governments to raise funds for long-term
purposes, though most investment by firms is financed by retained profits. Bonds are long
term borrowing instruments for the issuer.
Major issuers of bonds are governments (Treasury bonds in US, gilts in the UK, Bunds in
Germany) and firms, which issue corporate bonds
Corporate as well as government bonds vary very considerably in terms of their risk. Some
corporate bonds are secured against assets of the company that issued them, whereas other
bonds are unsecured. Bonds secured on the assets of the issuing company are known as
debentures. Bonds that are not secured are referred to as loan stock. Banks are major
issuers of loan stock. The fact that unsecured bonds do not provide their holders with a
claim on the assets of the issuing firm in the event of default is normally compensated for
by means of a higher rate of coupon payment.
Important characteristics of bonds involve:
The conventional or straight bond has the following characteristics:
Residual maturity (or redemption date). As time passes, the residual maturity of
any bond shortens. Bonds are classified into ‘short-term’ (with lives up to five
years); ‘medium-term’(from five to fifteen years) ; ‘long-term’(over fifteen years).
Bonds pay a fixed rate of interest, called coupon. It is normally made in two
installments, at six-monthly intervals, each equal to half the rate specified in the
 bond’s coupon.
The coupon divided by the par value of the bond (100 Euro) gives the coupon
rate on the bond.
The par or redemption value of bonds is commonly 100 Euro (or other currency).
This is also the price at which bonds are first issued.
However, since the preparations for issue take time, market conditions may change
in such a way as to make the bonds unattractive at their existing coupon at the time
they are offered for sale. They will then have to be sold at a discount to 100 Euro,
in order to make the coupon rate approximate the market rate of interest. If, vise
versa, the market interest rates fall, the coupon may make the bond attractive at a
price above 100 Euro. In these cases the issuers are making a last-minute
adjustment to the price which they hope will make the bonds acceptable to the
market.
Bond prices fluctuate inversely with market interest rates. If market rates rise,
people prefer to hold the new, higher-yielding issues than existing bonds. Existing

57
bonds will be sold and their price will fall. Eventually, existing bonds with various
coupons will be willingly held, but only when their price has fallen to the point
where the coupon expressed as a percentage of the current price approximates the
new market rate.
The yield on bonds are expressed commonly in two forms:
∙ redemption yield;
∙ interest yield or running yield.
Concept Interest yield (or running yield) - the return on a bond taking account
only of the coupon payments.

Concept Yield to maturity or redemption yield: The return on a bond taking

account of the coupon cash flows and the capital
gain or loss at redemption.
The types of bonds include:
Callable and putable bonds. Callable bonds can be redeemed at the issuer’s discretion
prior to the specified maturity (redemption) date. Putable bonds can be sold back to the
issuer on specified dates, prior to the redemption date.
Convertible bonds. These are usually corporate bonds, issued with the option for holders
to convert into some other asset on specified terms at a future date. Conversion is usually
into equities in the firm, though it may sometimes be into floating rate notes.
Eurobonds. Eurobonds are bonds issued in a country other than that of the currency of
denomination. Thus bonds issued in US dollars in London are eurobonds, as are yen bonds
issued in New York. The bonds themselves may be straights, that is fixed-interest, fixed
redemption bonds like the sterling ones described above, or they may come in any of the
variations listed here. Eurobonds are issued by governments but more usually by
corporations.
Euro bonds. These are bonds denominated in euros and issued in the euro currency area.
If bonds denominated in euros would be issued outside the euro currency area, they would
be euro eurobonds.
Floating rate notes (FRNs). These are corporate bonds where the coupon can be adjusted
at pre-determined intervals. The adjustment will be made by reference to some benchmark
rate, specified when the bond is first issued. An FRN might specify, for example, that its
coupon should be fifty basis points above six-month treasury bill rate, or six-month
LIBOR, adjusted every six months. FRNs are, in part, a response to high and variable
inflation rates.
Foreign bonds. These are corporate bonds, issued in the country of denomination, by a
firm based outside that country. Thus, a US firm might issue a sterling bond in London.
Index-linked bonds. These are corporate bonds where the coupon can be adjusted to high
and variable rates of inflation. While other bonds have a maturity (redemption) value fixed
in nominal terms and therefore suffer a decline in real value as a result of inflation, both
the value and the coupon of an index-linked bond are uprated each year in line with lagged
changes in a specified price index.
Junk bonds. Junk bonds are corporate bonds whose issuers are regarded by bond credit
rating agencies as being of high risk. They will carry a rate of interest at least 200 basis
points above that for the corresponding bonds issued by high-quality borrowers.

58
Strips. Stripping refers to the breaking up of a bond into its component coupon payments
and its maturity (redemption) value. Thus a ten-year bond, paying semi-annual coupons,
would make twenty-one strips. Each strip is then sold as a zero-coupon bond. That is, it
pays no interest but is sold at a discount to the payment that will eventually be received. In
this sense, it is like a long-dated bill. The strips are created from conventional bonds.

4.2. Bond market

4.2.1. Bond market characteristics
Debt markets include:
primary markets for bonds, i.e. the markets in which newly issued instruments are
bought,
secondary markets , in which existing or second hand instruments are traded.
Majority of world bond markets have different institutional arrangements for the issue and
trading of government bonds and corporate bonds. The reason is that governments should
be able to sell the debt, which they use for budgetary and other purposes. Thus an active
market with high rated participants should be ensured. Therefore government bond
markets are subject to high level of supervision and regulation by the central bank.
For governments bonds are the main instrument (mainly central governments, but also
regional and local government authorities, and social securities funds) to finance their
budget deficits. This is true especially for within the euro area countries. Besides,
government bonds often serve as a benchmark for pricing other assets and they are also
frequently used as collateral in various financial transactions.
In governments debt securities issues form the most important market segment, followed
by debt securities issued by financial institutions (consisting of monetary financial
institutions (MFIs) and non-MFI financial institutions), and those issued by non-financial
corporations. Monetary financial institutions include all financial institutions whose
business is (1) to receive deposits and/or close substitutes for deposits from entities other
than MFIs and (2) to grant for their own account credit and/or invest in securities..
The non-government bond market is dominated by bank debt securities. This segment
includes different types of bonds, including unsecured bank debt securities and covered
bonds.
Concept Covered bonds are claims of the bond holders against the issuing MFI
that are secured by a pool of cover assets on the
MFI’s balance sheet, such as mortgage loans or loans to the
public sector. .
The introduction of the euro in 1999 had a major impact on the operations of government
debt managers as the disappearance of exchange rate risks within the euro area created the
conditions for a pan-European capital market. As a result, debt managers became players
in a larger European market. Investors turned their focus more on credit risk and liquidity,
while bond portfolios have become increasingly internationally diversified, especially in
the smaller euro-area countries. Consequently, competition among debt managers has
increased, stimulating a more efficient primary market and a deeper, more liquid secondary
market. Governments have put great effort into making their outstanding debt and new
issues more attractive to international bond investors. In addition to local systems, the
European electronic platform for government securities, EuroMTS, was introduced in
1999, enabling quotation and trading of some European benchmark bonds

59
4.2.2. Bond market yields
Bond yields are influenced by interest-rate expectations, the term premium, credit risk and
liquidity.
Risk-averse investors demand a risk premium (term premium) for investments in long term
bonds to compensate them for the risk of losses due to interest rate hikes; those losses
increase with bond duration. The term premium leads to a positive term spread, i.e., the
spread of yields for bonds with longer maturity over yields for bonds with shorter maturity,
even when markets expect increasing and decreasing interest rates to be equally likely.
Liquidity is one of the key characteristics of the bond market.
Liquidity is the ease with which an investor can sell or buy a bond immediately at a price
close to the mid-quote (i.e., the average of the bid–ask spread).
A liquid market allows market participants to trade at low trading costs. Kyle (1985)
identifies three dimensions of liquidity:
∙ tightness: the cost of turning around a position during a short period. Tightness in
essence refers to a low bid–ask spread;
∙ depth: a market is deep if only large buy or sell orders can have an impact on prices;
∙ resiliency: a market is resilient if market prices reflect ‘fundamental’ values and, in
particular, quickly return to ‘fundamental’ values after shocks.
The spread between the yield of a bond with liquidity and a similar bond with less liquidity
is referred to as the liquidity premium
Credit risk is the risk of loss because of the failure of a counterparty to perform according
to a contractual arrangement, for instance due to a default by a borrower. The spread
between the yield of a particular bond and the yield of a bond with similar characteristics
but without credit risk is the credit-risk premium. Rating agencies – like Moody’s,
Standard & Poor’s, and Fitch – indicate issuers’ credit risk by assigning them a rating.
.Credit risk and liquidity premia of euro-denominated bonds are typically calculated as
the spread of the bond yields over those of German government bonds. There are two
reasons for this. First, German government bonds have consistently received the highest
ranking from the three main rating agencies, indicating that German government bonds are
associated with zero or very low credit risk. Second, German government bonds are very
actively traded, ensuring that they are very liquid.
Yield differentials vary considerably across countries, while for each country the yield
differential varies considerably over time. Pagano and Von Thadden (2008) discuss studies
that try to explain these yield differentials, arguing that they may arise from (1) intrinsic
differences in country-specific default risk or different sensitivities of bonds’ future
payoffs to common shocks, or (2) market frictions, like trading costs, clearing and
settlement fees, and taxes.
They state that credit risk explains a considerable portion of cross-country yield
differences but explains very little of their variation over time.

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4.3. Bond valuation
4.3.1. Discounted models
The fair value or fair price of a bond is based on the present value of expected future cash
flows. The general formula for estimating the fair price of a bond is:
P = C/(1+r) +C/(1+r)2 + C/(1+r)3 +. . .+ C/(1 + r)n + B/(1+r)n
where P is the fair price of the bond (its dirty price, which includes accrued interest), C is
the regular coupon payment each period, B is the money value to be paid to the
bondholder at maturity (redemption), r is the rate of discount per period, and n is the
number of periods to maturity (redemption).
Example A bond pays a coupon of 4 Euro every six months, and 100 Euro will be
repaid at maturity. There are two years to
maturity and the next coupon is due in six months. The
redemption yield on similar bonds is 6% p.a. Estimate the fair
price of the bond.
An interest rate of 6% p.a. indicates a rate of 3% per six
month period.
P = 4/(1,03) + 4/(1,03)2 + 4/(1,03)3 +4/(1,03)4 + 100/(1,03)4
P = 3,88 + 3,77 + 3,.66 + 3,55 + 88.85 = 103,71 Euro
Typically a single rate, the redemption yield or redemption yield, is applied to discounting
all future cash flows. The redemption yield of a bond could be viewed as an average of
discount rates applicable to the various future cash flows. The redemption yield indicates
the average annual return to be received by an investor holding a bond to maturity.
The rate of discount is the required rate of return from a bond. The required rate of return
can be regarded as the sum of the yield on bonds that are free of default risk (government
bonds) and a risk premium to reflect the default risk of the bond being valued. High default
risk entails a high required rate of return and hence a high discount rate.
Therefore, for any particular stream of future cash flows, high risk bonds would have
higher rates of discount and hence lower fair prices than low risk bonds. Thus, bond prices
have an inverse relationship to interest rates, and second, that they have an inverse
relationship to the risk of default. High interest rates and high risk are associated with low
prices.
An important distinction when considering bond prices is between the clean and dirty
prices. When a bond is purchased, the buyer must include in the purchase price a sum
corresponding to the seller’s share of the next coupon. If the coupon is paid six-monthly,
and the bond is sold three months after the last coupon payment date, the seller would
require the price to include half the next coupon so that holding the bond for the previous
three months provides an interest yield. The rights to the coupon accumulated by the seller
are referred to as accrued interest. The clean price of a bond excludes accrued interest
whereas the dirty price includes it.
Concept Clean price - the price of a bond ignoring any interest which may have
accrued since the last coupon payment.

Concept Dirty price - the price of a bond, including any accrued interest.

61
Quoted prices are usually clean prices whereas the price to be paid is the dirty price.
Example Assume it is 22 November 2010.Treasury 10% 2012 matures on 21
November 2012. Calculate the fair price of this bond
when the redemption yield is 10% p.a. and 5% p.a.
Assume it is 22 November 2010.Treasury 5% 2012 matures
on 21 November 2012. Calculate the fair price of this bond
when the redemption yield is 10% p.a. and 5% p.a.
Assume it is 22 November 2010. A zero-coupon bond
matures on 21 November 2012. Calculate the fair price of this
bond when the redemption yield is 10% p.a. and 5% p.a.
Treasury 10% pays 10 Euro per year, i.e. 5 Euro every six
months.
5/(1,05) + 5/(1.05)2 + 5/(1.05)3+ 105/(1,05)4 = 4,76 + 4,54 +
4.32 + 86,38 = 100 Euro
(Note that 105/(1,.05)4 is the same as 5/(1,05)4 + 100/(1,05)4
)
5/(1,025) + 5/(1,025)2 + 5/(1,025)3 + 105/(1,025)4 = 4,88 +
4,76 + 4,64 + +95,12 = 109,40 Euro
 Treasury 5% pays 5 Euro per year, i.e. 2.50 Euro every six
months.
2,5/(1,05) + 2,5/(1,05)2 + 2,5/(1,05)3 + 102,5/(1,05)4 = 2,38 +
2,27 + 2,16 + 84,33 = 91,14 Euro
2,5/(1,025) + 2,5/(1,025)2 + 2,5/(1,025)3 + 102,5/(1,.025)4 =
2,44 + 2,38 + 2,32 + 92,86 =100 Euro
A zero coupon bond pays no coupons. The only cash flow
receipt is the 100 Euro at redemption.
100/(1,1)2 = 82,64 or 100/(1,05)4 = 82,27 Euro
100/(1,05)2 = 90,70 Euro or 100/(1,025)4 = 90,60 Euro
Bond prices are inversely related to interest rates, but the relationship is not symmetrical.
The proportionate fall in the bond price resulting from a rise in interest rates is less than
the proportionate rise in the bond price caused by a fall when the percentage point change
in interest rates is the same in the two cases.
This can be illustrated by reference to the case of a bond with no maturity date. The price
of such a bond is:
P = C/r
where P represents the fair price of the bond, C the coupon, and r is the interest rate
(required rate of return). Consider the case of a 5 Euro annual coupon and an initial
interest rate of 10% p.a. The fair price of the bond would be estimated as:
5 / 0,1 = 50 Euro
If the interest rate falls by 2 percentage points to 8% p.a., the price of the bond is expected
to rise to:
5 / 0,08 = 62.50 Euro

62
If the interest rate rises by 2 percentage points to 12% p.a., the fair price of the bond falls
to:
5 / 0,12 = 41,67 Euro
Whereas the interest rate fall results in a 25% price rise, the equivalent interest rate
increase causes a 16,67% price decline. This asymmetry of price response is referred to as
convexity.
Future cash flows from a bond, together with the required rate of return, can be used to
estimate the fair price of the bond. The process could be reversed in order to find the
redemption yield of the bond knowing its current price and the future cash flows. The
redemption yield (y) can be obtained by solving equation for y.
P =C/(1+y)1+C/(1+y)2+C/(1+y)3+C/(1+y)4+B/(1+y)4
where P is the current market price of the bond, C is the annual coupon, B is the
redemption value of the bond, and y is the redemption yield (yield to maturity).
The effective annual yield takes account of the compounding. The effective annual yield
is given by: (1+y)2-1 .
Realized compound yield is the average compound rate of return actually obtained from
an investment. Realized compound yield is affected by yield on reinvested coupons.
The calculations of redemption yield assume that coupons are reinvested at the redemption
yield. The realized compound yield equals the redemption yield if coupons are reinvested
at the redemption yield and the bond is held to redemption. If the reinvestment rate for the
coupons exceeds the redemption yield, the realized compound yield will exceed the
redemption yield.
If the reinvestment rate for the coupons is less than the redemption yield, the realised
compound yield will be less than the redemption yield. Bond duration and risk
There are two types of risk encountered by investors in bonds. There is price (or capital)
risk, and reinvestment (or income) risk. Price risk is the risk that bond prices can
change. For example a general rise in interest rates, or a fall in the credit rating of a
particular bond, would reduce the price of a bond. A capital loss would result.
Reinvestment risk refers to the uncertainty of the interest rate at which coupons and
redemption sums can be invested. This causes uncertainty as to the final sum that will be
available at the end of an investment horizon.

4.3.2. Bond price volatility

Bond price volatility is measured by duration. The duration measures include Macaulay’s
duration, modified duration, and money duration. Macaulay’s duration is the average
period of time to the receipt of cash flows. Each time period (to the receipt of a cash flow)
is weighted by the proportionate contribution of that cash flow to the fair price of the bond.
Macaulay’s duration is transformed into modified duration by means of dividing it by
(1+r/n), where r is the redemption yield (which approximates an interest rate) and n is the
number of coupon payments per year.
Macaulay’s duration has another meaning, it is the proportionate change in the bond
price (fair price of the bond) arising from a unit proportional change in (1 + redemption
yield).
Macaulay’s duration = (ΔP/P) / (Δ(1+r)/(1+r))

63
Where Δ is the change in, and P is the bond price.)
The corresponding interpretation of modified duration is:
Modified duration = (ΔP/P) / Δ r
Δ (1+r) = Δ r.
Equations assume annual coupon payments. When coupons are paid more frequently, r is
replaced by r/n (the annual redemption yield divided by the number of coupon payments
per year).
The calculation of duration can be demonstrated by an example. Suppose that a bond has
just paid a coupon, matures in two years, and pays a coupon of 6 Euro six-monthly. The
interest rate is 10% p.a. for all maturities. The fair price of the bond is:
P = 6/(1,05)+6/(1,05)2+6/(1,05)3+106/(1,05)4 = 5,71 + 5,44 + 5,18 + 87,21 = 103,54
An interest rate of 10% p.a. is 5% per six-month period.
Macaulay’s duration is calculated as the weighted average of the periods to the receipt of
cash flows. The weighting is based on the contribution of the period’s cash flow to the fair
price of the bond. The periods are 0,5, 1, 1,5, and 2 years.
Macaulay’s duration=(5,71/103,54)0,5+(5,44/103,54)1,0+(5,18/103,54)1,5 +(87,21/103,54)2,0
=0,028 + 0,053 + 0,075 + 1,685 = 1,841 years.
Conversion of Macaulay’s duration to modified duration is made through division by
(1+r/n).
Modified duration =1,841/(1 +0,1/2) =1,841/(1,.05) =1,753
Example A corporate bond pays an annual coupon of £10 and has four years to
maturity. It has just paid a coupon. As a result of a
downgrading of its credit rating, its required rate of return
rises from 8% p.a. to 12% p.a. What are the effects of this
change on (a) the price, and (b) the Macaulay’s duration, of
the bond? (c) Discuss your results.

Example Treasury 10% 2012, which pays coupons six-monthly, will reach
maturity on 10 June 2012. It is now 11 June 2010.
Interest rates for 0,5, 1, 1,5, and 2 years are all 7% p.a.
Estimate the fair price, Macaulay’s duration, and modified
duration of the bond.

Example An investor has two bonds. Bond A pays a 5 Euro annual coupon and
matures in five years. Bond B pays a 4 Euro
coupon semi-annually and matures in three years. The
investor needs to sell one bond immediately and hold the
other for two years. The current rate of interest, for all
maturities up to five years, is 6% p.a.
Which bond would the investor sell if that investor expected
interest rates to: (a) increase, (b) decrease?

64
4.3.3. Behavior of Macaulay’s duration
Macaulay’s duration of a bond behavior can be summarized by a set of rules.
Rule 1: The duration of a zero coupon bond equals its time to maturity. Since a zero
coupon bond generates only one cash flow, the payment of principal at maturity, the
average time to the receipt of cash flows equals the time to that payment.
Rule 2: Holding time to maturity and redemption yield constant, duration is inversely
related to the coupon.
Rule 3: Holding the coupon rate constant, duration generally increases with time to
maturity.
Rule 4: Holding coupon and maturity constant, duration is inversely related to redemption
yield.
Rule 5: The duration of an irredeemable bond is given by (1 + r)/r, where r is the
redemption yield. If a bond pays the same coupon each period forever without the
principal ever being repaid, the duration equals (1 + r)/r.
Example A fund manager holds a 100-million Euro bond portfolio comprising three
bonds: A, B, and C. Bond A has duration of
four years and accounts for 25 Euro million of the portfolio.
Bond B has a duration of seven years and accounts for 25
Euro million. Bond C, of which 50 Euro million is held, has
duration of ten years. What is duration of the portfolio?

4.3.4. Immunization
Bonds are used in institutional investment portfolios not only as means of accumulating
wealth but also as means of funding annuity payments. Since it is possible to obtain
reasonably reliable estimates of the duration of prospective annuity payment streams as
well as the duration of bond portfolios, it is possible to match the duration of the bond
portfolio with the duration of the annuity payments. Such duration matching, or
immunisation, is very useful for annuity and pension providers since it provides a high
degree of protection against interest rate risk.
Duration is also important for the structuring of bond index tracker funds. If such a fund
were to be constructed using stratified sampling based on a cell structure, one of the
characteristics of a cell would be duration. Other characteristics might be redemption yield
and credit rating.
There would be a cell for each combination of characteristics (e.g. high duration, low
redemption yield, high credit rating), and the portfolio would contain an appropriately
weighted combination of cells. If an annuity fund, index tracker fund, or other bond fund
exhibits a duration that differs from the optimum it is possible to use bond futures to adjust
the portfolio duration to the desired value.

4.3.5. Bond convexity

Duration provides just an approximation to the relationship between yield changes and
bond price movements. The analysis of the price/yield relationship for a bond together
with a straight line representing duration (i.e. price value of a basis point, PVBP), shows
that for small changes in yield it is sufficient.

65
Concept Convexity is a measure of the change in duration with respect to
changes in interest rates.

However, the actual price change is expressed by the curved price/yield relationship. Thus
for large yield changes, the duration line provides a poor estimate of the actual price
change. Duration underestimates price rises and overestimates falls. In both cases the new
bond price is underestimated. The inaccuracies arise because money duration fails to take
account of the convexity (curvature) of the actual price/yield relationship of a bond.
While constructing bond portfolios a bond portfolio manager should be concerned with not
only duration, but also convexity. Convexity has value in that it leads to higher bond prices
following interest rate movements, when compared with an investment with zero
convexity. High convexity bonds provide this benefit to a greater extent than low
convexity bonds. The benefits of convexity are greater when interest rate changes are
relatively large. This implies that the portfolio manager needs to consider the prospective
size of interest rate movement as well as the direction.

Price
e

First & second

derivatives
Price

First derivative

y3 y1 y2 Figure 10. Duration and

Initial convexity
interest Interest rate
rate

If instead of duration a Taylor expansion is used, expressing the percentage change in bond
price in terms of the first, second and higher derivatives, the approximation is more
accurate. The second derivative incorporates what has been called convexity:
Convexity = ( d2P / dy2) x ( 1/P ) x (1 / 2 ) to y2,
Figure 10 shows, that for increases of interest rates to y2 the duration plus convexity
approximation gives a high estimate of bond price. For decreases in interest rates to y3 , the
duration and convexity approximation give a low estimate of bond price.

Example A bond has just paid a six-monthly coupon of 4 Euro. There are four
more coupons to be paid by maturity. How accurate
is modified duration for the purpose of estimating the effect

66
of a (a) 0.2% p.a., and (b) 1% p.a., decrease in the redemption
 yield on the bond price, when redemption yields are initially
2% p.a. Comment on the results of the calculations.
A bond with high convexity will tend to have a relatively low redemption yield. The
advantage from high convexity would be offset by a lower yield. If interest rate
movements are small, the gains from convexity would not compensate for the low yield.
So if a portfolio manager expects a small interest rate change, bonds with low convexity
should be chosen. If the expectation is that there will be a substantial interest rate
movement, high convexity bonds should be chosen.
Convexity is greatest for low coupon, long maturity, and low-redemption-yield bonds (i.e.
high duration bonds).Convexity can be calculated and combined with measures of duration
when evaluating the potential effects of interest rate changes on bond prices. Since
measures of duration are accurate only for very small changes in interest rates, a convexity
correction is required in the case of large interest rate movements. To estimate the effects
of relatively large interest rate changes on bond prices, it is necessary to combine an
estimate of convexity with an estimate of duration.
4.4. Bond analysis
4.4.1. Inverse floaters and floating rate notes
Financial engineering can create derivatives from a non-derivative investment, e.g. the
division of a conventional bond into an inverse floater and a floating rate note.
Inverse floater is a bond whose interest rate is inversely related to a market rate. For
example an inverse floater might pay a coupon rate of 10% p.a. minus LIBOR (LIBOR is a
commonly used benchmark interest rate that reflects market rates).
The price of an inverse floater is extremely sensitive to interest rate movements. Not only
does the coupon rate fall when interest rates rise, but the rate at which the coupons and
principal value are discounted also rises. There are two effects of interest rate rises that act
to reduce the bond price. Conversely interest rate falls have two positive effects on the
bond price; the higher coupons are accompanied by a lower discount rate. So inverse
floaters are very sensitive to interest rate changes, in other words they have very long
durations. Inverse floaters are structured by dividing a conventional bond into an inverse
floater and a floating rate note.
Floating rate note is a bond whose coupon rate moves in line with market rates. For
example the coupon rate on a floating rate note might be 2% p.a. plus EURIBOR. Since
the coupon rate moves in the same direction as the rate of discount, effects of interest rate
changes tend to offset each other with the effect that there is little net effect on the bond
price. Floating rate notes exhibit low price volatility and hence short durations.
The high duration of inverse floaters renders them useful for hedging long-term liabilities.
Falling interest rates increase the value of the liabilities, but that would be offset by the
increase in the value of the inverse floaters. Inverse floaters might be attractive to
institutions with long-term liabilities such as pension funds, annuity providers, and life
assurance companies. Conversely floating rate notes could be attractive to institutions with
short-term liabilities, such as banks and building societies.

4.4.2. Callable bonds

Some corporate bonds are callable. This means that the issuer has the right to repurchase
the bonds at a predetermined price (the issuer has a call option on the bonds). To
 67
compensate for the risk of future calls, the bondholders require a higher coupon (on a
callable as opposed to noncallable bond), a call premium, and typically a period of call
protection during which the original coupon is locked in (see Figure 11).
A rise in the bond price that makes the repurchase desirable would be brought about by a
fall in market interest rates or an improvement in the credit rating of the bonds. Under
these circumstances the issuer could repurchase the bonds and issue new bonds at a lower
coupon rate. The issuer would choose to repurchase since that would allow for a reduction
in financing costs. Bonds with a relatively high coupon could be repurchased with money
raised from the sale of bonds with a lower coupon. The issuer thereby reduces coupon
payments.
The predetermined price at which the issuer has the right to repurchase puts an upper limit
on the value of the bonds. No one would pay a higher price knowing that that they could
be forced to sell at the predetermined price. The price/yield relationship for a callable bond
has an upper limit to the price.
Noncallable Freely callable
but
redeemable

Par
Call price

dateMaturityTime Issue
Figure 11. Callable bond

An implication of the upper limit to the price is that the convexity turns into concavity.
Another implication is that the coupon rate on a callable bond will be higher than the
coupon rate on a bond without the call feature. If investors face a ceiling on their
prospective capital gains, they would require an enhanced coupon yield in compensation.
Effectively investors are providing the issuer with a call option. The investors would
require payment for the call option. The payment to the investors takes the form of
increased coupons.
Figure 12clarifies the relationship between the values of the call option, the noncallable
bond and the callable bond. On the horizontal axis the figure shows the value of a
noncallable bond. As interest rates get lower, the value of the noncallable bond increases.
The left vertical axis shows the value of a call option for a callable bond with the same
coupon, par value, and maturity as the noncallable bond. The origin for the left axis is the
point where the thick black lines cross. As interest rates go down, the market value of a
noncallable bond increases, and the value of the call option also increases.
68
Call option Origin for left
Bond price price
EV = Excess value Par
Noncallable bond

EV EV
Option
value

Intrinsic value
0EV Call
axis

EV

Callable
bond

Par Call noncallabl Origin for

bbbbbprice e right axis
0
Value of

Lower interest rates

Figure 12. Values of callable bonds, noncallable bonds, and the call option

The right vertical axis shows the price of noncallable and callable bonds with the same
coupons, maturity, and call price. The origin of the right axis is the right corner of the
figure. The value of the callable bond is equal to the value of the non callable bond minus
the call option value. As the interest rates fall, the value of the callable bond approaches
the call price.

4.4.3. Convertible bonds

Some corporate bonds may be convertible into common stock of the company at the option
of the bond holder. The bonds are usually callable at par plus a call premium. A
convertible bond is in the money if the stock value of the bond exceeds the call price. The
call feature is included to allow the company to force conversion into common stock.
Conversion can be forced only if the bond is in the money. Call of an out-of-the money
convertible induces the bondholders to turn in their bonds at the call price. Sometimes
voluntary conversion occurs if the convertible is in-the-money and the dividend yield on
the stock exceeds the current yield on the convertible.

69
Figure 13shows the relationship between the stock value, the straight bond value and the
price of the convertible. The stock value is initially below the par value and the stock value
is assumed to grow over time. The straight bond value gradually approaches the par value
as the bond gets closer to maturity. The call price declines over time to the par value. As
the stock value rises above the call price, the premium of the convertible over the bond
value declines and the market price of the convertible approaches the stock value.
The market price of the convertible must be higher than the higher of the straight bond
value or the stock value. Otherwise arbitrage occurs.
When convertible bonds are issued, the stock price tends to decline. This evidence is
consistent with the view, that issuing convertibles is a negative signal to the market. The
evidence supports the view that convertibles are issued when the management has negative
information.

Convertible
bbbprice
Call price

Par
Stock value Straight bond value

Issue date Maturity time

Figure 13. Convertible bonds

4.5. Summary
Bonds are debts of the governments, companies, and organizations that issue them. One of
the ways in which bonds differ from shares is in the relative certainty of future cash flows.
In the absence of default by the issuer, the future cash flows from a bond are typically
known with certainty. This is in contrast to shares since shares typically have dividend
payments, which are variable and uncertain. The relative certainty of bond cash flows
influences the pricing and analysis of bonds. The fair price of a bond is estimated using a
discount model. The relative certainty of bond cash flows means that other characteristics,
such as duration and convexity, can also be reliably estimated. Other important bond
characteristics are future bond yields and of bond price volatility (risk).
The debt markets are used by both firms and governments to raise funds for long-term
purposes, though most investment by firms is financed by retained profits. Firms and

70
governments can issue corporate bonds of various types of shares. Bonds usually pay a
fixed rate of interest at pre-determined intervals. Bonds are traded on a stock exchange and
their price fluctuates in response to supply and demand. In the short run the supply of both
is fixed and price fluctuations are therefore the result of changes in demand.

Key terms
∙ Callable bond
∙ Convertible bond
∙ Redemption yield
∙ Duration
∙ Convexity

Further readings
1. Dunne P., Moore M., Portes R. (2006). European Government Bond Markets:
Transparency, Liquidity, Efficiency, CEPR, London.
2. Edwards A. K., Harris L. E., Piwowar M. S. (2007). Corporate Bond Market
Transaction Costs and Transparency, Journal of Finance, No. 62(3), p. 1421–
1454.
3. Goldstein M. A., Hotchkiss E., Sirri E. (2007). Transparency and Liquidity: A
Controlled Experiment on Corporate Bonds, Review of Financial Studies, No.
20(2), p. 235–273.
4. Pagano M., Von Thadden E. (2008). The European Bond Markets under EMU,
in X. Freixas, P. Hartmann, and C. Mayer (eds.), Handbook of European
Financial Markets and Institutions, Oxford University Press, Oxford, p. 488–
518.
5. Wolswijk G., de Haan J. (2005). Government Debt Management in the Euro
Area: Recent Theoretical Developments and Changes in Practices, ECB
Occasional Paper No. 25.

Review questions and problems

1. Why does the calculation of a ‘present value’ of a bond involve discounting?

∙ Which of the following would be likely to show the greatest short-run price
volatility: a short-term bond, a long-term bond? Explain.
∙ When market interest rates are 10 percent, what relationship would you expect
between the price and redemption yields of two 8 percent bonds, one maturing
in three years, the other maturing in ten years?
∙ Give two reasons why institutions like banks prefer to hold short-term rather than
long-term bonds.
∙ Explain the terms: dirty price, clean price, interest yield, redemption yield. ∙
Are high yield bonds good investments? Why or why not?

71
∙ Assume a redemption yield of 8%. Compute the duration for the following bonds
each 100 Euro par value. For the 12% coupon bond compute duration.
a) 10 years, zero coupon;
b) 10 years, 8 percent;
c) 10 years, 12 percent coupon.
∙ In problem 7 assume that yields change from 8 to 9 %. Work out the exact change
in price and compare it with the change in price predicted by duration. Explain
the difference. Assume 100 Euro par value.
∙ Compute the duration of a portfolio composed of equal proportions of a ten year,
zero coupon bond and a ten year 8 % coupon bond, assuming 89% yields to
maturity.
∙ A firm has decided immediately to refund existing callable bond issue. Under
what circumstances is there an immediate benefit to refunding? What does that
benefit depend upon?
∙ How can callable bonds be substitutes for short-term bonds?
∙ A firm has a perpetual callable bond outstanding with a par value of 100 Euro and
an annual coupon of 14 Euro. The firm can refund this with a new noncallable
perpetual bond having an 8 percent coupon. The call price on the old bond issue
is 114 Euro. Flotation costs for a new issue are 2 percent of par value. What is
the myopic benefit of refunding?
72
5. EQUITY MARKET

Mini contents ∙ Equity instruments

∙ The purpose and functions of stock exchanges.
∙ The distinction between primary and secondary markets.
∙ Types of stock exchange.
∙ Stock market trading systems.
∙ Bid-offer spreads.
∙ Types of purchase and sale order.
∙ Processes by which shares are issued.

Equity market is one of the key sectors of financial markets where long-term financial
instruments are traded. The purpose of equity instruments issued by corporations is to raise
funds for the firms. The provider of the funds is granted a residual claim on the company’s
income, and becomes one of the owners of the firm.
For market participants equity securities mean holding wealth as well as a source of new
finance, and are of great significance for savings and investment process in a market
economy.
The purpose of equity is the following:
∙ A new issue of equity shares is an important source of external corporate financing;
∙ Equity shares perform a financing role from internally generated funds (retained
earnings);
∙ Equity shares perform an institutional role as a means of ownership.
Within the savings-investment process magnitude of retained earnings exceeds that of the
news stock issues and constitutes the main source of funds for the firms. Equity
instruments can be traded publicly and privately.
External financing through equity instruments is determined by the following financial
factors:
∙ The degree of availability of internal financing within total financing needs of the
firm;
∙ The cost of available alternative financing sources;
∙ Current market price of the firm’s equity shares, which determines the return of
equity investments.
Internal equity financing of companies is provided through retained earnings. When
internally generated financing is scarce due to low levels of profitability and retained
earnings, and also due to low depreciation, but the need for long-term investments is high,
companies turn to look for external financing sources. Firms may raise funds by issuing
equity that grants the investor a residual claim on the company’s income.
Low interest rates provide incentives for use of debt instruments, thus lowering demand
for new equity issues. High equity issuance costs force companies to look for other sources

73
of financing as well. However, during the period of stock market growth high market
prices of equity shares encourage companies to issue new equity, providing with the
possibility to attract larger magnitude of funds from the market players.
Check Question What is the purpose of equity?

Equity markets are markets which organize trading nationally and internationally in such
instruments, as common equity, preferred shares, as well as derivatives on equity
instruments.
Concept Bourse – a French term often used to refer to stock market.

5.1. Equity instruments

5.1.1. Common shares

Common (ordinary) shares represent partial ownership of the company and provide their
holders claims to future streams of income, paid out of company profits and commonly
referred to as dividends. Common shareholders are residual claimants, i.e. they are entitled
to a share only in those profits which remain after bondholders and preference
shareholders have been paid. If the company is liquidated, shareholders have a claim on
any remaining assets only after prior claimants have been paid. Therefore common
shareholders face larger risks than other stakeholders of the company (e.g. bondholders
and owners of preferred shares. On the other hand, if the value of the company increases,
the shareholders are entitled to larger potential benefits, which may well exceed the
guaranteed interest of bondholders.
Concept Common or ordinary share (stock) – an equity share that does not
have a fixed dividend yield.

The variability of returns to shareholders is affected by the proportion of debt to equity

financing (called the debt to equity ratio) of the company. The higher the proportion of
debt financing, the larger the fixed interest payments and the lower is the number of shares
over which the net profit is to be distributed. When earned profits exceed the level
necessary to pay the interest, all the excess profit accrues to the smaller number of
shareholders. On the other hand, if profits decrease below interest payments, the whole
reduction in payments is borne by the company shareholders. The higher is the debt to
equity ratio, the greater is the variability in dividend payments to shareholders. Thus
common shares in ‘highly leveraged’ companies are usually regarded as riskier than those
in ‘low leveraged’ companies.
Concept Leverage: The amount of debt, relative to equity, in a firm’s capital
structure. Usually expressed as the ratio of debt to
equity, D/E, or debt to total capital D/(D E).
The law requires that the company provides the owners with specified information in the
annual report and accounts and that the firm must hold an annual general meeting at which
management conduct is subject to approval by common (ordinary) shareholders, each of
whom has a number of votes matching the size of his shareholding.
The decision to issue equity against debt is based on several factors:

74
∙ Tax incentives. In many countries interest payments are tax deductible, however
dividends are taxed. Thus the tax shield of debt forms incentives to finance
company by debt.
∙ Cost of distress. Increase of company leverage, increases the risk of financial
insolvency and may cause distress as well as lead to bankruptcy. Thus companies
tend to minimise their credit risk and increase the portion of equity in the capital
structure.
∙ Agency conflicts. When a company is financed by debt, an inherent conflict arises
between debt holders and equity holders. Shareholders have incentives to
undertake a riskier operating and investment decisions, hoping for higher profits in
case of optimistic outcomes. Their incentives are mainly based by limited liability
of their investments. In case of worst outcome debt holders may suffer more, in
spite of their priority claims towards company assets.
∙ Signalling effect. The companies, which issue equity to finance operations, provide
 signals to the market, that current share selling price is high and company is
overvalued.
Check Question Why does financial distress increase agency conflicts between
equity holders and debt holders?

5.1.2. Preferred shares

Preferred shares is a financial instrument, which represents an equity interest in a firm

and which usually does not allow for voting rights of its owners. Typically the investor
into it is only entitled to receive a fixed contractual amount of dividends and this make this
instrument similar to debt. However, it is similar to an equity instrument because the
payment is only made after payments to the investors in the firm’s debt instruments are
satisfied. Therefore it is call a hybrid instrument.
Technically preferred shareholders share ownership of the firm with common shareholders
and are compensated when company generates earnings. Therefore, if the company does
not earn sufficient net profit, from which to pay the preferred share dividends it may not
pay dividends without the risk of bankruptcy. Because preferred stockholders typically are
entitled to a fixed contractual amount, preferred stock is referred to as a fixed income
instrument.
Concept Preferred share – an equity security, which carries a predetermined
constant dividend payment.

Preferred stock investments may have tax advantage to institutional investors.

Majority of preferred shares have cumulative dividend provision, which entitles to
preferred share dividend payments (current and from previous periods) dividend payments
on common shares. Usually owners of preferred shares do not participate in the net profit
of the company in excess to the stated fixed annual dividend.
Due to the fact that preferred dividends can be omitted, the company risk is less compared
to risk in case of company debt. However in this case, company may find it difficult to
raise new capital before all preferred dividends are paid. Investors may be unwilling to
make new investments before the company is able to compensate its existing equity
investors.

75
Preferred stock is an attractive source of financing for highly leveraged companies. Equity
markets offer a variety of innovations in preferred shares issues. These varieties include:
∙ cumulative preference shares
∙ non-cumulative preference shares
∙ irredeemable
∙ redeemable preference shares
∙ convertible preference shares
∙ participating preference shares
∙ stepped preference shares.
With the exception of the first two, these characteristics are not excluding each other. For
example it is possible to issue non-cumulative, redeemable, convertible preferred shares.
Non-cumulative preferred shares do not have an obligation to pay any missed past
dividends, with the effect that missed dividends may be lost forever.
A redeemable preferred share has a maturity date on which the original sum invested is
repaid, whereas most preference shares have no maturity date (the issuer may pay the
dividends forever and never repay the principal sum). Some redeemable preference shares
provide the issuer with the right to redeem at a predetermined price without the obligation
to do so; in effect such preference shares provide the issuer with a call option, which
would be paid for by means of a higher dividend for the investors.
Convertible preferred shares give the holder the right to convert preference shares into
ordinary shares at a predetermined rate; the investor pays nothing to convert apart from
surrendering the convertible preference shares. In some cases the right to convert arises
only in the event of a failure to pay dividends.
Participating preferred shares allow the issuing company to increase the dividends if
profits are particularly high; the preference share dividend can exceed the fixed level if the
dividend on ordinary shares is greater than a specified amount.
Stepped preferred shares pay a dividend that increases in a predetermined way.
Specific adjustable rate preferred shares are attractive in increasing interest
environment. If the dividend is reset each quarter according to a pre-established formula
based on Treasury bill rate, these issues can be considered as company capital.
Auction rate preferred shares (ARPS) or Single point adjustable rate shares (ARPS)
reset dividend periodically using Dutch auction method. The reset date can be as frequent
as 49 days. Because of characteristics close to money market securities, they have
significantly lower yields.
Concept Dutch auction - a method, which allows all investors participating in
the auction submitting a bid for the stock by
specified deadline. The bid prices are ranked and minimum
price for selling of shares is determined. All bids equal or
above minimum price are accepted, and all bids bellow the
minimum price are rejected.

Preferred equity redemption cumulative stocks (PERCS) are shares that pay dividends
and are automatically converted into common stock at a conversion price and date. These

76
can be callable at any date after the issuance for price above the issue price (e.g. by 40%)
and gradually declines as the conversion date approaches.
The cost of preferred equity financing may be higher, compared to debt financing.
Preferred dividend is not a tax deductible expense to the company. Besides, investors are
compensated more, as they assume its risk is higher due to the fact, that the company
legally is not required to pay preferred dividends. As a rule, preferred equity has no
maturity, thus it may force company to permanent preferred dividend payments.
Check Question Why does financial distress increase agency conflicts between
 equity holders and debt holders?

5.1.3. Private equity

When companies are organized as partnerships and private limited companies, their shares
are not traded publicly. The form of equity investments, which is made through private
placements, is called private equity.
In such case investors’ liability may not be limited to the amount of contributed capital,
and may be extended to total wealth of private owners. It is used mainly by small and
medium-sized companies, young or start-up business in need to raise significant funds for
investment. However, their access to bank or public stock market financing is limited.
Typically banks do not finance start-ups due to significant risks of their operations, and a
limited company equity base. On the other hand, a public offering of shares for such
companies may be feasible only if it has a significant shareholder base to support an active
secondary market. Without an active secondary market such shares are illiquid, founders
of the companies find it difficult to “cash out” by selling their original equity investment,
can be forced to sell shares at a discount to the fundamental company value, fixed costs of
being public company are high, and this prohibits company from being public. Therefore
such companies attempt to raise additional capital from wealthy individual or institutional
investors. This type of investments has grown significantly since late 1990s, mainly in US
and is slowly gaining ground in European countries.
The most important sources of private equity investments come from venture capital
funds, private equity funds and in the form of leveraged buyouts.
Venture capital funds receive capital from wealthy individual or institutional investors,
willing to maintain the investment for a long-term period (5-10 years). Venture capital
market brings together private businesses that need equity financing and venture capitalists
(business angels) that can provide funding. Venture capital fund identifies potential of the
business, negotiates the terms of investment, return from the investments, exit strategy.
The invested funds are not withdrawn before a set deadline. Common exit strategies are
either through the public sale of the equity stake in public stock offering, or through cash
out if the company is acquired by another firm.
Private equity funds pool resources of their partners to fund most often new business
start-ups. They can rely heavily on debt financing, also. Thus, they perform the role of
financial intermediaries. Private equity funds usually take over the businesses, manage
them and control the restructuring, charge annual fee for managing the fund. Exit
strategies are similar to the ones used by venture capital funds.
Leveraged buyouts are company equity purchases by individual or institutional investors,
which are financed by a minor portion of share capital and a major portion of debt,
provided by banks or other financial intermediaries.

77
Check Question Why does financial distress increase agency conflicts between
equity holders and debt holders?

5.1.4. Global shares and American Depository Receipts (ADR)

Investors may invest into foreign shares by purchasing shares directly, purchasing
American Depository Receipts (ADRs), Global Depository Receipts (GDRs).
Alternatively, investments can be made by investing into international funds or purchasing
exchange traded funds (ETFs).
Direct purchases of foreign shares can be limited due to limited access to the stock
exchanged, a limited available set of shares, high transaction costs through specialized
brokerage companies.
Shares in international funds (International mutual funds (IMFs)) offer possibility of
investing into a portfolio of international securities, created and managed by various
financial institutions. Thus individual investors may get access and diversify across
international stocks. IMFs can be specializing on specific country or across several
countries or regions.
Exchange traded funds (ETFs) are passive funds, that track specific index. Thus investor
can invest into a specific index, representing a country’s (e.g. foreign) stock market.
Although ETFs are denominated in US dollars as a rule, the net asset value of an
international ETF is determined by translating foreign currency value of the foreign
securities into dollars.
While the price of each international ETF is denominated in US dollars, the underlying
securities that make up the index are denominated in non-US currencies. Thus the return
on ETF will be influenced by the movement of the country’s currency against dollar. If the
country’s currency appreciates, this will increase the value of the index as measured in
dollars. On the other hand, if the foreign currency depreciates, this will reduce the value of
the index as measured in dollars. This is also true for IMFs.
Check Question What are advantages and disadvantages for investing into exchange
traded funds (ETFs) and international investment
funds?
American Depository Receipts (ADR) is an arrangement under which foreign shares are
deposited within a US bank, which in turn issues ADRs in the name of foreign company.
In this way the shares of a foreign company is admitted to the well developed stock
market, like US or UK. When issued in US, they are denominated in US dollars.
Dividends are also paid in US dollars, even if the underlying security’s cash flows are
denominated in terms of foreign issuer’s home currency.
ADR may represent a combination of several foreign shares (e.g. lots of 100 shares).
Trading takes place in negotiable certificates representing ownership of shares of the
company.
Concept American Depository Receipts (ADR) – a certificate of ownership
issued by a US bank to promote local trading on a
foreign stock. US bank holds foreign shares and issues ADRs
against them.
An ADR program, which is created without company’s involvement, is called an
unsponsored ADR.

78
If ADR program is created with an assistance of the company, it is called a sponsored
ADR.
Such shares can be registered within the securities exchange commission and comply with
reporting requirements, and thus be traded on an organized stock exchange. Without such
registration and reporting compliance, they can be traded on the over-the counter market.

Table 5. Comparison of equity instruments

Instrument Types Characteristics Investors Market

Common Common Corporate Companies, Stock

shares (ordinary) shares, ownership state, exchange
Puttable common financial
shares, institutions,
ADRs non-financial
GDRs intermediaries,
individual
investors

Preferred cumulative Hybrid security, Financial Preferred

shares preference shares, Features of institutions, stock market
non-cumulative equity and non-financial /
preference shares, debt, intermediari stock exchange
redeemable es,
Callability
preference shares, individual
investors
convertible
preference shares,
participating
preference shares,
stepped
preference
shares.

Private Venture capital Private Venture capital Private

equity fund shares placements, companies, equity
investments market
Private equity institutional
fund shares of pool of investors,
funds, individual
Partnerships or investors
private (business
limited angels)
form of
companies

Advantages of ADRs include

∙ easy and direct access to funding in the foreign market;
 79
∙ building company name recognition in the foreign country;
∙ reliable quoting of share prices;
∙ close following by investment analysts.
Disadvantages of ADRs:
∙ A costly investment alternative;
∙ For large institutional investors vs small retail investors differences in prices and
return;
∙ Market for ADRs can be illiquid;
∙ Multiple listing can result in share price differences in various markets globally.
Global Depository Receipts (GDRs) are negotiable receipts issued by financial institutions
in developed countries against shares of foreign companies. GDRs can be simultaneously
issued in US and Europe.
Financial institution collects and distributes dividends paid by the foreign firm to the GDR
(also ADR) investor. Thus financial institutions facilitate access to world equity markets
by intermediating between world investors and companies in developing and transition
countries.
Check Question What are advantages and disadvantages of issuing American
Depository Receipts and Global Depository Receipts to
issuing companies and to investors?

5.2. Primary equity market

When equity shares are initially issued, they are said to be sold in the primary market.
Equity can be issued either privately (unquoted shares) or publicly via shares that are listed
on a stock exchange (quoted shares).
Public market offering of new issues typically involves the use of an investment bank in a
process, which is referred to as the underwriting of securities.
Private placement market includes securities which are sold directly to investors and are
not registered with the securities exchange commission. There are different regulatory
requirements for such securities.
In the private equity market, venture capital is often provided by investors as ‘start-up’
money to finance new, high-risk companies in return for obtaining equity in the company.
In general private placement market is viewed as illiquid. Such a lack of liquidity means
that buyers of shares may demand a premium to compensate for this unappealing feature
of a security.

5.2.1. Primary public market

Initial public offering (IPO) means issuing public equity, i.e. when a company is engaged
in offering of shares and is included in a listing on a stock exchange for the first time. It
allows the company to raise funds from the public.
 If a company is already listed and issues additional shares, it is called seasoned equity
offering (SEO) or secondary public offering (SPO). When a firm issues equity at a stock

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