MODULE 1 | LESSON 1

SAVING AND BORROWING

Reading
45 minutes
Time
Prior
None
Knowledge
Interest Rate, Principal, Time to Maturity,
Keywords
Default
In this lesson, we will examine how you can either earn interest as a
depositor or pay interest as a borrower. We'll show how you can calculate
the amounts of interest under different types of compounding. We'll also
discuss how these interest rates differ regarding how long you're willing to
maintain the investment.
1. Fixed Interest Rates
Imagine that, through luck or hard work, you have some money to save. As
many grandmothers say, “Save money for a rainy day.” You find a bank that
will give you interest on the money you deposit. Since it is not money you
need to live right now and you’re willing to part with it for a while, you decide
to put it in the bank. You deposit an amount, called the principal, that
earns you interest.The interest is specified by an annualized number called
the interest rate.
Indeed, let’s say you could put it in the bank for three months where you
agree you do not withdraw any funds. In this case, you are entering
a Certificate of Deposit or CD. If you agree to keep it there, without ever
withdrawing it until the end, you will get 2% annualized interest. How does
that work?
Simple Interest = Principal * Interest Rate * Time
 Principal is the amount you deposit.
 Interest Rate is the annualized number that represents the interest
being earned per year.
 Time is the number of years.

Let us apply the formula by using the numbers we discussed. Note that three
months will show up as ¼ year.
Simple Interest = Principal * Interest Rate * Time
= $1,000 * 2% * ¼
= $5.
You’ve earned $5 of interest.
At the financial institution holding you are holding your funds, the banker
suggests that you keep the money for six months to earn a 3% interest rate.
In that case, you earn more because the rate is higher throughout the whole
period.
Simple Interest = Principal * Interest Rate * Time
= $1000 * 3% * ½
= $15.
If you were willing to save the money for a longer period of time, you earn
more money for two reasons:
1. The time is longer, so there’s more time for interest to accrue.
2. The interest rate is higher, so you earn more interest over the entire
time.
In this case, you doubled the time, but tripled the money.
Typically, short-term rates will be lower than long-term rates. However, it is
also possible that the rate can vary.

2. Variable Interest Rates

What if, on the other hand, your banker suggests that you invest in a
variable interest rate?
Now, let’s review our formula.
Simple Interest = Principal * Interest Rate * Time
= $1,000 * ? * ½
Since the rate is unknown, we cannot calculate with certainty what the
earned interest will be. We cannot calculate for sure how much we will have
in three months, or six months, but we can estimate using some rates. If you
think interest rates will increase, you may opt for a variable rate to take
advantage of higher interest rates leading to more interest. On the other
hand, if you think interest rates will decrease, you may opt for a fixed rate to
lock in a higher rate. Note that even for a simple loan, there are many
decisions that must be made:
1. The amount of principal to deposit
2. The amount of time to "lock up" the money
3. The choice of a fixed or variable rate
These decisions may not be as simple as they seem.
First, do we know how much we can lock up right now? Who knows about our
future income and expenses?
Second, are we sure that the amount of time the money is locked up for is
reasonable? Will we need the funds sooner?
Third, we can anticipate rates going higher (or lower), but what if we are
wrong?
Certainly, these decisions are related. Would I be willing to take a lower fixed
rate for a shorter amount of time? Or could I split my deposit across different
times so that I can take advantage of not only some shorter times but also
some higher rates?
Much of finance involves making decisions under uncertainty. Indeed, this
will be a theme we will see well beyond this course and in the very heart of
financial engineering itself.
3. Nominal Rates vs. Real Rates
There’s even more to it—the value of money changes over time.
Based on only wanting to secure the funds for three months, you decided to
save $1,000 for three months. You receive your $5. With your first successful
interest payment, you decide to celebrate with a Big Mac at McDonald's.
Note that for vegetarians, the Impossible Burger version of the Big Mac is
forthcoming! As an optional reading, “The Big Mac Index” shows how that $5
works to buy a Big Mac.
You realize, however, that you live in a part of the world where that amount
of interest is not enough to buy a Big Mac. What happened?
Inflation! Inflation is a rise in prices of good and services, resulting in a drop
in the purchasing power of money. Inflation is a thief, making the money you
have less valuable, due to higher prices for the same goods and services.
The Big Mac Index represents purchasing power in regional economies.
Suppose over those 3 months, inflation rose 2%. Indeed, as we are still in a
COVID-19 economy, you can see high inflation rates in different economies.
How do we know if the interest we earn is sufficient to offset the reduced
purchasing power of our funds? Let us compute another form of rate called
the nominal rate.
The nominal rate is the actual interest rate you earn. In our 6-month
example, this is 3%.
The inflation rate is the rate at which prices increase. Let’s assume that is
2%.
Both rates are annualized, so they would prorate to the same quarterly
amount.
Then, we can define the inflation-adjusted or real-interest rate.
real interest rate = nominal rate – inflation rate
= 3% - 2% = 1%.
The real interest rate is 1%. Although it feels like you earned 3%, in fact the
$1,000 became less valuable six months later due to inflation. That interest
payment was simply an amount that just barely outperformed inflation.
Indeed, if the interest you received, say, was only 2%, then you would have
had a real interest rate of 0. You would not have increased your purchasing
power at all. But it can get worse: Suppose the inflation were 5% over the 3-
month period. Then, the real interest rate is
real interest rate = nominal rate – inflation rate
= 2% - 5%
= -3%
Here, the real interest rate is negative. This means you had more purchasing
power at the beginning of the 3-month period than you did at the end of it. It
would have been easier to have the french fries (or chips) now instead of
later. Typically, nominal rates exceed inflation. Otherwise, it pays to spend
today.

4. Types of Compounding
Let's go back to the three decisions: amount, time, and rate. Only the rate is
out of our control. As a depositor, you can choose how much and how long to
save. But the interest rate paid to depositors is determined by market forces.
The interest rate itself is interesting. How? Let’s consider how often it gets
applied.
Let’s increase our savings horizon to one year and imagine that we have a
choice of compounding.
Suppose the interest were compounded annually.
Interest = Principal * ((1 + Rate) ^ (Period Length) - 1)
= $10,000 * ((1 + 0.04) ^ 1 - 1)
= $400
If interest compounded once during the year, then we earn $400 of interest.
But what if we applied the interest rate two times per year, known as semi-
annual compounding?
Note that we have to convert our rate and our time to semi-annual periods.
The 4% annual rate becomes a 4/2% = 2% semi-annual rate.
The 1-year period becomes 2 half-year periods.
Interest = Principal * ((1 + Periodic Rate/ 2 ) ^ (2 * Period Length) - 1)
Interest = $10,000 * ((1 + 0.04/2) ^ (2 *1) - 1)
= $10,000 * ((1 + 0.02) ^ 2 - 1)
= $404
That’s a small monetary difference—$4 (not enough for a Big Mac) but a big
conceptual one. By shortening the frequency of compounding, we received
interest in six months. That interest earned interest.
Let’s break it down. In the first 6-month period,
Interest = Principal * ( (1 + Rate/N ) ^ (N * Period Length) - 1)
= $10,000 * ((1 + 0.02) ^1 - 1)
= $200 after 6 months
Then, that $10,200 becomes the new principal for a second 6-month period.
Interest = $10,200 * ((1 + 0.02)^1 - 1)
= $10,200 * (1.02 - 1)
= $204
The $200 of interest earned after six months earns an extra $4 over the
following six months.
Note that we have the same starting principal, same interest rate, and same
1-year savings horizon. The only difference is the compounding frequency.
The greater the compounding frequency, the greater the amount of interest
earned.
Let’s continue by looking at quarterly interest. The period is three months.
The periodic rate is the annual rate / 4 for a 3-month rate. The number of
periods is four (4 periods * 3 months/period = 12 months).
Interest = $10,000 * ((1 + 0.04/4) ^ (4) - 1)
= $10,000 * ((1 + 0.01) ^ 4 - 1)
= $10,000 * 0.040604
= $406.04
Now after three months, there’s interest. That interest earns interest for nine
more months. Now, the interest received in six months earns interest for six
more months. And even the interest paid in nine months earns interest for
three months. Compounding makes a big difference. Compared to the annual
compounding, we earn an extra $6.04 using quarterly compounding.
Let’s do one more. Let’s assume continuous compounding. For this, we rely
on the mathematical constant :
Interest = $10,000 * (e ^ (rate * t) - 1)
= $10,000 * 0.040810
= $408.10
Indeed, this is substantially more than the 4% if interest only accrues once a
year.
Compounding is amazing. Indeed, Albert Einstein, the great physicist,
reportedly said, “Compound interest is the eighth wonder of the world. He
who understands it, earns it…he who doesn’t…pays it.” See "10 Reasons
Why Compounding Interest is the 8th Wonder of the World" for some
optional reading on that topic.
In addition, see the web app for this lesson. In this example, you can select
an interest rate, principal amount, and a time (in months). Then, you will see
the different amounts of interest that are earned, depending on the
frequency of compounding: annual compounding, semi-annual compounding,
and continuous compounding.
With that, if you’re earning interest, compound interest is your friend. But
what if you are borrowing money

5. Rates of Saving vs. Rate of Borrowing

Suppose instead of saving $1,000 in the bank, you need to borrow $1,000.
Suppose you use a credit card to do that. You note that the interest you are
charged is 18%. Wow! That is considerably more than the rate the bank was
paying you. Recall that earlier you deposited $1,000. In one year’s time,
assuming simple interest, you would earn
nterest = $1,000 * 0.03^1 =$30.00 of interest
If you were to borrow $1,000, you would pay
Interest = $1,000 * 0.18^1 =$180.00 of interest
Why are the rates of saving so different from the rates for borrowing? Well,
for one thing, banks make money because they pay relatively little to borrow
money (your deposit) and charge relatively high amounts to lend out money
(your credit card rate). Like any other business, banks need to charge more
for their products than their raw materials. Do you see how many depositors
are providing banks with the funds they need? In turn, banks perform and
provide a myriad of financial services and charge substantially higher.
Typically, banks will receive savings accounts from depositors, which are
short-term, and lend money out, like with mortgage loans, which are long-
term. Indeed, the term to maturity is one of the primary influences that
determines the interest rate. Let’s take a look at the first of these in the next
section.

6. Term to Maturity
When you had deposited $1,000 into a certificate of deposit, you agreed to
"lock up" your funds for say a 3-month period. That 3-month period is known
as the term to maturity. Likewise, if you were willing to purchase a 6-
month CD, then six months would be the term to maturity. Term to maturity
refers to how long the holding period lasts. It is a unit of time that starts
today and goes to some future time when you receive your principal back.
For certain types of accounts, like a certificate of deposit, the term to
maturity is well specified. Please note there are other accounts, like a simple
savings account, that do not require a term to maturity because you can
withdraw your funds at any time. However, these savings accounts typically
have very low rates. At the time of writing, the typical savings account rate is
a fraction of one percent! For example, $100 in an account could earn $0.01
interest per year.
7. Different Maturities Have Different Interest
Rates
Generally speaking, the longer the term to maturity, the greater the interest
rate. This means that when you agree to save for a longer time, you will be
earning more interest for that entire period. Indeed, different maturities have
different interest rates. Let’s consider two intuitive reasons why this may be.
The first is that it is more desirable to spend money sooner rather than later.
If you were to save for one month, there is likely not going to be much
difference between now and one month from now. In one month, the
inflation rate will likely be similar, if not the same. In one month from now,
there will be less uncertainty about the overall economy than, say, one year
from now. Consequently, the 1-year lock up has more uncertainty associated
with it. Delaying access to your funds deserves a higher rate.

8. Default
Another reason why interest rates vary is due to the ability and likelihood of
the borrower to pay. For example, suppose you have a 1-month loan from
the bank. The bank is concerned that you won’t repay. In one month's time,
you could lose your income, or overspend, but the reality is that in one
month, the bank will see if you are able to make your repayment. Compare
that to the scenario where you borrow funds from the bank for one year.
That means you may not owe any payments until one year from now. This
time is substantially longer, where both your ability to repay, as well as the
economy, can worsen. There is more uncertainty about your ability to repay.
What happens if you don't pay? This is considered a default.

9. Conclusion
In this first lesson, we looked at how interest works from the perspective of
both a borrower and a lender. Interest rates vary with the term to maturity,
in regards to inflation, and with the creditworthiness of the borrower. In the
next lesson, we'll see how this notion of default affects the ongoing
relationship between borrower and lender.

MODULE 1 | LESSON 2

COUNTERPARTIES AND CREDIT RISK

Reading
60 minutes
Time
Prior
Interest
Knowledge
Credit Risk, Collateral, Regulation, Deposit
Keywords
Insurance, Bonds
In the previous lesson, we looked at the interaction of a borrower and a
lender. First, we looked at an individual depositing funds in a bank. Then, we
looked at an individual borrowing funds from a bank. We examined how to
calculate interest under different types of compounding. We concluded by
saying some borrowers may default.
In this lesson, we examine the process of default and the broader picture of
credit risk. We will examine how institutions, regulation, and insurance all
help to keep this credit risk in check.
1. Overdue Payments
Welcome to the next lesson in your travel along financial markets. In the
previous lesson, we realized that not all borrowers are able to pay their debt.
In this first section, we will discover what it means to pay late on a debt.
An overdue payment means that the borrower fails to make a timely
payment of either interest or principal or even both.
Let’s first tackle the overdue payment part. Certainly, the borrower may
simply pay late. An overdue payment is considered to be any payment that
is past a clearly defined and agreeable payment date. Sometimes, late
payments occur due to holidays or weekends delaying the processing of
payments. There's always the excuse that the payment is lost in the mail.
But a payment is overdue because someone simply did not make the
payment.
So, what happens when a borrower doesn't pay? Depending on the type of
loan, there could be fees that are assessed. Let's look at both sides—from
the depositor’s perspective and from the lender’s perspective. First, let’s
consider the depositor’s perspective. After the term to maturity, the
depositor is expecting to receive both the earned interest and the principal
back. For some reason, suppose the bank failed to pay this. Most likely, this
would be a bank error and could be fixed quickly. It’s unlikely the bank will
have to pay more because the fine print that is part of the agreement may
not hold them liable for such operational mishaps. Nevertheless, banks
invest huge amounts of capital to build computational infrastructure to
handle the automatic crediting of interest, so these errors are not very
common.
Now let’s suppose that borrowers are the ones failing to pay on time. Of
course, this can be for any number of reasons. In this case, the banks
have grace periods, which are extra amounts of time to facilitate the
payment being processed. If the payment is still not made by a grace period,
then there might be extra fees the bank charges, such as late fees, as well
as even raising the interest rate for non-payment. Overdue payments are
serious and can be the precursor to an actual default. Let us turn to default,
the topic of our next section.
2. Defaulting
In this section, we'll discuss the concept of defaulting. What does it mean to
default? Well, borrowing funds has the implied promise that the funds will be
returned in full. In addition to the interest payments, the principal repayment
is expected. Default occurs when the borrower fails to make some
combination of interest payments, principal payments, or both. A default is
an overdue payment that remains unpaid. There may even be multiple
payments in default.
As we've seen, default occurs when the borrower fails to make payments
(interest or principal) to the lender. Essentially, the borrower is not owning
up to the responsibility that was set out in the terms of the loan. Clearly, this
means that the lender is not going to receive their money in full. They
certainly may receive a partial amount. Can the lender sue the borrower for
the balance? Well, virtually every country has laws that protect borrowers
who are unable to make full payments by their declaring a type
of bankruptcy. Interestingly, the word bankruptcy comes from the Italian
term, banca rotta, which means "broken bench." At one point in history,
these money dealers worked from benches. If a money dealer ran out of
money, they would be taken out of business—by having their bench broken.
With a banca rotta, the dealer would no longer be able to conduct business.
So, the “broken bench” notion is meant to convey that the person is out of
business. Fortunately, bankruptcy laws today protect borrowers, which could
include small business owners. They may be allowed to continue operating
their business and have a reduced amount they are legally required to pay
their lenders. While defaulters are generally able to avoid “debtor’s prison”
(which was also common in history) or serious criminal penalties, they do
suffer a financial setback in terms of their credit becoming less favorable.
For example, suppose you are a lender. You are looking to lend money to
one of two different people. The first person has an excellent history of
making payments. The second person, however, has consistently declared
bankruptcy a number of times. Which of the two borrowers do you think
would be given a better interest rate? Well, from a bank's perspective, the
borrower who defaults poses such uncertainty as to whether the bank
receives its funds back. The bank may require a much higher interest rate to
offset that greater uncertainty. This is essentially the first real challenge we
face as financial practitioners—the challenge of credit risk.

3. Credit Risk
In this section, we introduce credit risk. Credit risk is the risk to the lender
that the lender does not receive the full amount of principal and interest
payments initially spelled out in the loan. Credit risk is a risk that there will
be an expected loss due to the inability or even unwillingness of the
borrower to repay their obligations. Credit risk tends to affect the lender and
not so much the borrower.
Let’s revisit the previous examples. Suppose you put $1,000 in a savings
account. You wonder if that money will be there when you wish to withdraw
it. You also wonder if the bank will honor the interest payments you are
meant to receive. Indeed, there have been times in history where banks
have had bank runs and were not able to supply the depositors with their
own money. Please refer to the required reading for this lesson, which
discusses a bank failure nearly half a century ago and how it continues to
affect supervision in banks today.
Well, banks do not just keep the money locked in accounts; they need to use
it for other purposes. Throughout history, the banks may have invested in
opportunities that turned out to be deeply unprofitable and lost much of the
depositor’s funds. Some depositors who lined up early to withdraw may have
received their fair share, but others who came later were left with losses,
whether through the loss of value or through some operational mishap.
So how can we minimize this credit risk from the depositor’s point of view?
Well, many countries today are part of the International Association of
Depositors Insurers, or IADI. In the United States, this is handled by the FDIC:
Federal Depository Insurance Corporation. They maintain a directory of other
countries in the program. In South Korea, this is handled by the KDIC, the
Korea Deposit Insurance Corporation.
These corporations basically guarantee that there are mechanisms, with
federal government backing, to ensure that depositors will never lose their
deposits (up to a certain amount) even if the bank itself goes bankrupt. This
is a very important idea and really our first major theme in the course of
credit risk. In order for counterparties to engage in transactions, there has to
be a clear understanding of the risks of each other's credit. Depositing funds
in a bank account is truly one of the safest transactions in the world of
finance. The credit risk is the risk that the bank would be unable to pay
interest and principal back. These Depository Insurance corporations reduce
the risk by providing backup for those banks. These corporations, with the
help of government agencies, will require banks to show prudent use of
those funds to avoid situations that might cause them to lose the deposited
amount. These corporations ensure that there is widespread trust and
confidence in the financial system. Can you imagine if people put money in
banks, then the banks declare bankruptcy and depositors lose their hard-
earned savings? People would be afraid to use banks. Banks are the
cornerstones of the financial industry.
Let's switch directions and look at the credit risk from the bank’s point of
view when lending to an individual or small business. Unlike banks, an
individual borrower does not have the backing of the Insurance Corporation.
Instead, a borrower's creditworthiness comes through their reputation to
repay their debts in a timely manner. Nevertheless, an individual may have
unexpected income loss, due to a job loss or even COVID-19, as well as
higher expenses, perhaps from medical expenses. Any circumstance that
hinders the ability of the borrower to repay the debt is an example of credit
risk.
Credit risk converts much of finance from deterministic problems to random
problems. Let's consider the lender's perspective. The amount of total funds
received should be known. Several times, we have seen the equation that
shows the amount of interest received. Yet, thanks to credit risk, not all
payments are guaranteed to be made. They have some uncertainty. There is
a small probability associated with the timing and/or the size of each
payment. Credit risk is endemic to virtually all transactions where there are
counterparties engaged in a transaction. One thing that can help mitigate
credit risk is collateral, the topic of our next section.

4. Collateral
Collateral is a financial or physical asset that serves as a backup for the
credit risk of the borrower. Suppose a borrower has a $1,000 loan from a
bank. From the bank's point of view, we learned that there's an uncertainty
associated with recollecting this $1,000. How can the bank be expected to
bear this risk? One way they could do so is to require collateral for the loan.
For example, suppose the loan went to purchase a car. The car serves as
collateral. If the borrower continues to make payments in a timely fashion,
then the borrower can continue to use the car. However, if the borrower fails
to make timely payments, the ownership of the car effectively diverts back
to the lender. This transfer is the purpose of collateral. The car collateralizes
the loan. Defaulting on the loan means the bank gets the car instead of the
money that was lent to buy it. This is an example of collateral that is
physical.
Banks don’t really want to own cars as they are in the financial industry and
not the automotive industry. Banks do want to measure credit risk carefully
so their customers can provide timely payments with minimal defaults. This
allows them to focus on their core business, such as servicing depository
accounts and lending funds to qualified individuals and businesses. Banks
are not the only financial institutions that can do this. What other institutions
exist in the financial landscape? We will discuss this topic in the next section.

5. Financial Institutions
There are distinct types of financial institutions. One way to consider distinct
kinds of financial institutions is to look at the types of activities in which they
engage. In doing so, we can categorize financial institutions according to the
way in which they provide their primary services:
1. Depository Institutions. Depository institutions include banks and
their close relatives, such as savings and loans companies, credit
unions, trust companies, and mortgage loan companies.
2. Contractual institutions. Contractual institutions are those whose
businesses provide long-term contractual services. The main types of
these are insurance companies and pension funds.
3. Investment institutions. Investment institutions are those financial
institutions that either originate or manage ongoing investments.
 These include underwriters, investment banks, mutual funds, closed-
end funds, hedge funds, and unit investment trusts.
The reason to know these distinct types of financial institutions is to
understand that each offers different services. Keep in mind that some firms
can easily be involved in all three services. For example, you may find a
multinational bank that can:
 provide you with a loan or mortgage,
 maintain your property insurance program, and
 manage your investment account.
So, within multinational large financial institutions, it is likely that a multitude
of services are provided. It is also easy to find companies that specialize in
one of the services. For example, within the world of investment institutions,
you may find a mutual fund that provides a way to own a collection of bonds
that are professionally managed. The mutual fund will not be of any help,
however, if you need a loan, a mortgage, or insurance. Furthermore, there
are also new FinTech or disruptive types of businesses that are providing
these financial services independently. For example, it is possible to find a
FinTech company that allows you to transfer money from one place to
another (Winngie). Banks charge hefty wiring fees for this service, but
FinTech companies, through apps on your smart phone, can do this for a
fraction of the cost if not for free. Later in this module, we will distinguish
between distinct types of financial institutions to better understand their
features and benefits.
Certain large financial institutions are so important to the financial system
that their demise could wreak havoc. For example, if a multinational bank
were to fail, it could cause widespread fear and panic, leaving depositors
without their funds, causing insurance claims to go unpaid, and failing
pension recipients who need their retirement income, etc. Can we trust these
financial institutions to adopt best practices and ethical behavior? While an
amount of self-regulation is helpful, it is even better to have regulation at
regional, national, and even international and global levels. This regulation
can provide stability and reassurance to promote a rehabilitative reliability
and assurance that the financial institution acts in prudent and appropriate
ways for the trust of the stakeholders in the system. Prior to the global
recession, these institutions ran into trouble and looked for assistance to
help bail them out of trouble. This term is known as "too big to fail." As a
result, indeed, some of them were too big to fail, meaning that their fall
could have caused further collapse in the financial system. What helps to
minimize or contain this risk? What would help to avoid the problems in the
first place? Regulation.
6. Regulation
To understand regulation in the financial industry, first, let us simply think of
regulation in a sporting industry. For example, consider football (or in
America what is known as soccer). There are specific rules in the sport of
football. These rules apply to games that are played by most nations in the
world. These nations meet periodically on the football field to determine the
winner of the World Cup. These rules are well-known by players, enforced by
referees, and often challenged by the coaches who find that they may have
been broken to the disadvantage of their team. Imagine a football game
without such rules—the fouls, the cheating, the kicks we don’t see. That
would be a different game altogether. The rules and regulations are meant to
ensure a safe, fair, and equitable game. It also increases the reliability that
the team that wins did so without resorting to cheating or using unethical
and unscrupulous tactics. That builds confidence in the spectators and
sponsors, knowing that the business model of advertising and marketing
work in a trustworthy environment.
In the same way, financial institutions have regulation. Financial regulation is
meant to ensure the safety and protection of the interests of stakeholders.
These stakeholders include consumers, taxpayers, employers, and
employees, pension holders, investors, homeowners, small businesses, large
businesses, and even the financial institutions themselves. This list
comprises everyone in the financial system.
This financial regulation not only includes the rules and practices by which
firms and individuals operate but also the enforcement of said rules. Just as
in the game of football, the rules don't change, but there could be games
where the referees selectively enforce rules, miss certain bad plays, or
simply make bad calls. Likewise, in finance, some companies break
regulatory rules, receive fines or penalties, and fail to comply with mandated
policies. Regulation seeks to ensure that the financial system works in a
smooth and trustworthy manner.
It is not always easy to determine whose authority a problem may fall under.
It may be difficult to identify the culprit in markets with millions, and perhaps
billions, of transactions. The complexity of trades, investments, disclosures,
and informational asymmetries can create scenarios that have never
occurred before. Our goal here is to simply introduce the concept of
regulation. In the next topic, we will tackle how regulation can help to
minimize credit risk.

7. Insured Accounts
When you think of finance, you can think of it as two-way interactions. Let's
examine the “assurance” those accounts have from each side. Let us begin
with the lender. The lender has lent funds to a borrower. How can the lender
have assurance that the borrower will repay? As discussed, one of the
contributions of regulation that came out of the global crisis is that there are
more transparent qualifications needed to get the loan in the first place. The
idea of a no-documentation loan is harder to achieve. Even though this might
have been more “profitable” for the bank in the short run, the aggregation of
multiple loans is a definite increase in the credit risk of the bank. Therefore,
regulation can help assure the stakeholders of that financial institution—its
investors, its employees, and even other participants in the financial industry
—that the financial institution is acting in a prudent manner in its lending.
Likewise, from the depositor's point of view, how can the depositor be
assured that the bank is protecting its deposits? For this, we return to the
depository insurance corporation. For example, there are over 144 countries
that have a type of deposit insurance system. According to the deposit
insurance system website, these countries provide not
merely assurance but insurance that if anything happens to a deposit (up to
a specified monetary amount), then the depository insurance corporation
guarantees the amount. Therefore, borrowers can sleep well at night
knowing that their deposits are safe. For example, in South Korea, each
depositor has protection of up to 20 million Korean won. For each insurance
policy holder, there is protection of up to 50 million Korean won. The idea of
this insurance coverage helps to provide stability and trust in the financial
system. Therefore, the idea of putting your money into a savings account or
a certificate of deposit or other insured account is a very safe investment.
But what if you are interested in more than just saving money and earning
interest? Is there a way that you could also invest in the fixed-income
market? This topic will be addressed in the next lesson—the topic of bonds.

8. Bond Definition
What is a bond? A bond says that a borrower has issued an I.O.U. to the bond
buyer. In other words, the borrower has received a stated amount of money
up front. This is known as the face value of the bond. It is also called the
bond principal or the bond notional. Very often, the same idea in finance
can be referred to with many different terms. In addition to the principal, the
bond issuer is providing timely interest payments, known
as coupon payments, to the bond buyer. So, to recap, if you wanted to
receive some money, you could do one of two things.
1. You could invest your money in a certificate of deposit. In this
investment, you are giving money to a bank, which holds it for a
specified period of time and then pays you interest and the principal
back at the term of maturity.
2. You could purchase a bond. For this, you go to a specific issuer from
whom you buy the bond. You might pay them par, or the face value,
for a 2-year bond. Over the next two years, you would receive coupon
payments periodically, and the principal back at the end of two years.
These amounts are fixed, assuming no defaults.
So, what are the differences between our savings example and the bond
example? Both opportunities are examples of fixed income investments. It
is called fixed income for the two reasons that comprise the term: that the
rates being provided are fixed and that there is a stream
of income consisting of the interest payments. The repayment of principal
is not so much income as it is just the return of your original investment. In
other words, so long as the issuer does not default, the bond will repay the
amounts just as the bank would repay the amounts.
The difference between the two is that the bond is an asset and not merely
an account. The bond can be traded. It is something for which you can see a
market price. In the saving example, the CD is not a traded asset. Its value
does not fluctuate over its lifetime. You cannot cash out of it without severe
penalties. The bond, on the other hand, can be sold to someone else, so in a
sense, you can get its value liquidated to cash before the term to maturity.
That is, the bond does not need to be held to maturity.
To review, there are three ways to get paid from holding a bond:
1. Wait until a coupon date to receive the coupon payment.
2. Wait until maturity at which you receive the principal repayment.
3. Sell the bond before the term to maturity at the prevailing market
price.
Since it is an asset, it can be sold in the marketplace. And so, because the
bond can trade, its price can fluctuate with the market. What is it that drives
the price of bonds? This is the topic of our next lesson.

9. Conclusion
In this lesson, we examined the process of default and the broader picture of
credit risk. We looked at how collateral, regulation, and insurance all help to
keep this credit risk in check. We ended by introducing bonds. In the next
lesson, we'll expand our coverage on bonds.
References
 Winngie. “The 7 Best Transfer Money and Currency Exchange Apps.
Future of Fintech.”Winngie, 9 Feb. 2021, winngie.com/2020/10/26/the-
7-best-transfer-money-and-currency-exchange-apps-future-of-fintech.
MODULE 1 | LESSON 3

BUYING AND SELLING SHORT

Reading
75 minutes
Time
Prior Interest, Interest Rates, Term To Maturity, Bond
Knowledge Definition
Discounting, Credit Risk, Buy-Side, Sell-Side, Shorting,
Keywords
Financing
In the previous lesson, we examined ways in which the lender can have their
risk mitigated. We also saw that aside from loans, a borrower can issue a
bond, which would then make interest payments to the bond holder. In this
lesson, we examine bonds in more detail. We'll discuss buying a bond and
selling a bond short. Note that this is different from selling a bond. We'll
conclude by studying the bid-ask spread
1. Bond Pricing
What is the price of a bond? A bond's price is a funny thing. It's funny
because you think of having an amount of money you’re receiving, but these
are all at different points in time. Consider a two-year bond. You receive a
coupon, say, in six months. You receive another six months later, another six
months later, and the last one in two years, along with the principal amount.
So, if we think about the total amount, what we must consider is that the
separate times will result in those amounts having different value today. In
other words, we simply cannot add cash flows at all different time points in
the future and expect to have a straightforward way to sum them today. So
how do we treat different cash flows at various times?
In addition to the different times, we have to realize that there is a rate at
which we have to discount the value. So far, up to this point, we have
thought about taking money now invested or deposited into an account and
determining the amount of interest that we receive on it. Let us consider the
direction where we move back in time. Suppose we have $1,000 invested for
one year at 4%. What we're doing is something called future valuing. This
helps us to calculate what that $1,000 will be 1 year from now. The answer is
$1,040. What if we did that problem in reverse? What if we discounted
$1,040 that we receive one year from now to today’s dollars? This is known
as present-valuing. What is that worth today? To answer this, we must
have a rate at which we discount the bond question. This is the topic of our
next section.
2. Discounting
To price the bond, we must learn how to discount cash flows. In a sense, you
know how to do this already because you have already done future valuing
of cash flows. Throughout finance, this type of calculation is quite common.
There is an amount of funds at a moment in time. Then, what you must do is
determine how much a present value is worth in the future or how much a
future value is worth in the present. These are known as future valuing and
present valuing, respectively.
That is,
 When you take an amount in the present and imagine how much it's
worth in the future, we call this future valuing.
 When you take an amount in the future—an amount that has not
occurred yet—and bring it back to today, then this is called present
valuing. It is also known as discounting.
So, the topic here is how do you discount cash flows? If we know how to
discount one cash flow, then we can simply discount a stream of cash flows,
add them up, and arrive at the price of a bond. So, let's examine how
discounting works. In a sense, you know that this counting is simply moving
backwards in time. So, all we must do is use the equation of interest that
we've had, and instead of solving for the future value, we solve for the
present value. As such, consider the following formula:
In this case, we have shown what the total amount will be in the future,
given that we know three things:
 The present value—the amount being invested
 The interest rate that is being earned
 The investment's length of time
The left-hand side of this equation refers to a future amount. The right-
hand side includes all the terms known at the present time: present
value, interest rate, and the term to maturity.
To discount, we need to rearrange the equation to solve for present
value:
Notice the substantial difference here. When we future value, the power
term of time is positive. When we discount or present value, the time
exponent is negative. Therefore, based on whether the exponent containing
time is positive or negative, we can tell if we are either future valuing or
present valuing.
Now let's look at some numerical examples to illustrate this. Just for fun, let's
start with 0 interest rates. What does it mean to have an interest rate of 0? It
means there’s no difference in values because the money is not growing.
Future values equal present values. Looking at the equation, we see that
future (1 + rate) becomes 1. As you know, one to any power is one. So that
means that all present values equal all future values. If this were the case,
then nobody would be paying or earning interest. This is a very unlikely
situation because of one of the factors affecting finance—inflation. So, if for
no other reason than inflation, interest rates are likely to be positive. (There
are some unusual times when interest rates are negative, but that is a story
for another time).

3. Higher Interest Rates Mean Lower Prices

Assuming we have positive interest rates, what is the relationship between
higher interest rates and the amount of those discounted cash flows? As you
can see in the formula, if interest rates were zero, then we do not lose any
amount. With zero interest rates, there's no discounting: $1 today is the
same as $1 in the future. However, suppose that the interest rate is 10%.
That means that the term in parentheses becomes 1.10. So, using our
formula, our future value is $110. The term one plus r equals 1.10. The time
exponent is -1. Effectively, we are dividing the number 110 by 1.10. This
gives us $100. Notice we arrive in the same place where we started. In other
words, future value is the inverse function of present value. If you future
value a cash flow at 10%, and then present value that new amount at 10%,
you return to the original value where you started. The formula shows this
because the positive and negative exponents will cancel out.
Let’s apply this to an example of a two-year bond. Let us assume that the
coupons are paid one time a year. They are often paid semi-annually or twice
a year. But for now, let us just keep it easy. So, there are two cash flows in
this bond.
Cash flow 1 occurs one year from now and is equal to $40.
Cash flow 2 occurs two years from now and equals $1,040 (both principal
and interest).
We'd like to discount the $40 by and discount the $1,040 by
Note that the same interest rate is used when we discount the cash flows of
a bond.
This number is known as the yield to maturity. Although the 1-year rate
and the 2-year rate may be technically different, the yield to maturity is a
simplifying assumption. The assumption is that the coupon that is paid in one
year's time can effectively be reinvested for the remaining year at the exact
same interest rate. This assumption is known as the constant reinvestment
rate assumption. Relying on this assumption, the yield to maturity becomes
the standard and accepted way in which to quote bond prices. Ironically,
even though the bond price is a price that is in dollars or euros or yen, most
bonds are quoted in this yield to maturity. The reason that yield is helpful is
because the yield is the way the cash flows discount it. So, a bond could be
more or less expensive, but what we know is the following: if interest rates
go up, then the bond prices go down. The graph in figure 1 shows a
relationship between bond price and the bond yield. Why is it that higher
interest rates make the price lower? The answer in one word: discounting.
You see, if you have higher interest rates, then you are discounting each
cash flow more deeply. This deeper discounting results in a lower amount of
money.
Figure 1: Price vs. Yield
When we look at a bond issued by a UK Treasury or U.S. Treasury, we see
that the yield for a two-year bond is 3%. However, if we were to look at a
bond issued by a company, call it XYZ, then we see that the yield is 4%. Why
would two different issuers have two different yields for the same maturity?
The answer is an old friend—credit risk, the topic of our next section.

4. Credit Risk
Credit risk did not go away. It is always an issue for a lender. Consider the
following situation: When you are depositing funds in an account, you are
“lending” the bank your funds for a period. Remember, you are protected by
institutions such as the depository insurance corporation. When you are a
bond buyer, you are also a lender. The bond buyer is supplying the funds up
front to the bond issuer. The bond issuer is the one who is borrowing. They
are the ones who are making prompt interest and principal payments.
Therefore, the credit risk is born by the bond buyer, which is acting as the
lender here.
From the bond buyer’s perspective, why would they want more yield from
the corporation than they would from the federal government? The answer
comes, in part, from credit risk. You see, the credit risk of the federal
government bonds is effectively zero. That is because the federal
government has protections that will eliminate the chance of default. (There
are historical cases where countries have defaulted on their bonds, but at
this time, we’ll assume government bonds are risk-free). This is why the yield
associated with government-issued bonds is called the risk-free rate. So,
when you look at bonds issued by other governments outside your country,
these are also called risk-free rates in their sovereignty. The risk-free rate
return refers to an interest rate for a given maturity that is default free. That
means that the issuer is considered to have zero probability of defaulting on
the payments.
Certain federal governments can safely be considered risk free because they
have advantages that corporations do not have. These advantages include
setting monetary policies, printing new currencies, and increasing taxes.
(Note that not all countries have debt that is considered to be risk free).
These revenue-generating actions can ensure that they have sufficient funds
to meet their liabilities. However, the company XYZ does not have these
activities available to them. They could either increase revenue, cut costs, or
issue new longer-term debt to pay off short-term debt. Therefore, XYZ-issued
bonds have some probability of default. (We’ll talk much more about this
in a later module.)
Depending on the quality of that issuer, the bond must attract investors or
prospective buyers by offering a higher yield. The buyers are aware of this
and realize that the extra yield does not come for free because defaults can
and do happen. If you are a prospective bond buyer, you may look at the
risk-free products, which will have lower yields for the same maturity that
the risky bonds have. As the buyer, it is prudent to be aware of these credit
risks so that when you compare the yields, you're taking into account the
amount of uncertainty of the issuer as to whether you receive those funds. If
you felt that it was worth the extra risk for the extra yield of risky bonds,
then perhaps you would be interested in buying the bonds from XYZ. Keep in
mind that the higher yield of XYZ bonds means that the price that you paid
today, for the same maturity and coupon, is less than that price for the risk-
free bond. But suppose you felt that XYZ bonds were overpriced. In other
words, you do not want to buy an XYZ Bond. Instead, you think it's
overpriced and would like to sell it, but you do not own it. To understand this,
let us first clarify the difference between two types of institutions: the buy-
side and the sell-side, the topic of our next section.

5. Buy-Side vs. Sell-Side

The terms buy-side and sell-side at first seemed to convey the idea of one
side buying assets and the other side selling assets. This understanding,
however, is a misunderstanding. The buy-side refers to the market that is
investing on behalf of others. The buy-side includes institutions that collect
funds from investors, workers, pension holders, labor unions, etc., and seeks
to invest on their behalf, with their stated investment interests and risk
tolerances. The buy-side, in other words, is professionally managing client
money. At times, those investment managers may decide to buy
investments. At times, they want to realize the capital gains on those
investments and sell the investments. As such, the buy side is both buying
and selling securities, but they are doing so on behalf of investors.
The sell-side, on the other hand, is NOT acting on behalf of investors but
rather is acting on behalf of the investment bank. The sell-side’s primary
responsibility is to make markets. Market-making means that they are
willing to engage with the buy-side (or even other sell-side firms) by both
offering securities to sell and bidding for securities to buy. You see, the buy-
side is trading on behalf of customers; they are looking for opportunities that
appeal to their customer base. The sell-side, on the other hand, is simply
trading according to the needs and desires of the buy-side and other sell-side
firms who want to trade. Sell-side trades make what is known as a two-
sided market.
How does each side effectively make money? In broad terms, the buy-side
makes profit by earning a fee for managing the funds. In addition to a
management fee, they may collect fees related to the trading in the account
or consulting with clients, and they might collect a performance incentive
fee. If the fund earned above a certain amount (which may be 0%), then the
fund may take a percentage of the amount earned. Effectively, the buy-side
acts as a fiduciary for its clients by offering professional management and is
paid both a fixed fee and potentially an incentive fee for good performance.
The sell-side, however, makes money in a more complicated way. To
understand this, let us look at an example by considering a buy-side firm
called PDQ. Let us say that they wish to set up a brokerage account with a
sell-side firm called ABC. ABC is willing to do two things at any given time:
ABC is willing to sell shares of our risky bond XYZ at $101.00
ABC is willing to buy shares of our risky bond XYZ at $100.50.
(Of course, that price may be displayed in a yield term.)
The price at which ABC is offering to sell is known as the offer price. Like
everything there is also another way to refer to this—the ask price. We will
use offer price and ask price interchangeably since they mean the same
thing.
The price at which ABC is willing to buy is known as the bid price. In the
next section, we will discuss the difference between these.
6. Bid-Ask Spread
The bid price is the price at which someone is willing to buy. The ask price is
the price at which someone is willing to sell. The difference between these
two prices is known as the bid-ask spread. The sell-side makes a profit by
this bid-ask spread. Imagine that there was no bid-ask spread: You would be
able to buy and sell at the exact same price. So which financial institution
could afford to supply trading to market participants without earning any
money for it? Well, none.
If you have ever been to an airport kiosk that provides a foreign exchange
service, then you will understand this. Suppose you arrive at the airport
wanting to convert euros to Japanese yen. Your 100 euros bought you 12,800
yen. Then, you find out that your flight got cancelled. So you return to the
airport kiosk and convert the 12,800 yen back to euros—but you only get 95
euros. The kiosk makes money by selling you yen at a high price and buying
back the yen at a low price. If you were to do this repeatedly, you would run
out of money. The difference between the two prices is known as the bid-ask
spread. This is how the foreign exchange kiosk attendant earns money. In
addition to the bid-ask spread, they may have market transaction costs, such
as commissions or transaction fees.
The same ideas apply to sell-side market makers. The bid-ask spread, and
any transaction costs, are part of the revenue of the sell-side. You can see
that the sell-side has a tough job because to buy and sell, they must have
inventory amounts that may drive them to hold either too much of a security
or run out of it and borrow the security. Indeed, it is possible to sell things
that you don't even have. So, how is it possible to sell things that you do not
have? How is it possible that the sell-side can consistently sell a security,
even if they do not have any? For this, we turn to the next section—shorting.

7. Shorting
One of the lessons you would learn early in finance is that you should “buy
low and sell high.” This means that if you see a security that you like, you
use funds that you have to purchase it, hold onto it until the price goes up,
and then sell it at a higher price, realizing the capital gain as a profit, less
any fees like bid-ask spreads and transaction fees.
The idea of buying low and selling high is very straightforward, but less so is
that the order can be reversed. In other words, what if you were to “sell high,
then buy low?” This is indeed a trading strategy. But how can you sell
something you don’t own? This is known as shorting. Shorting refers to
borrowing a security that you do not own, selling it in the marketplace and
receiving cash for it. The short seller then hopes and waits for the price to
drop, and if and when it does, the short seller buys the security at this lower
price. When that happens, the short seller is covering the short.Once they
take possession of the security, they return it to the party that lent it to
them. If the sold at a high price and covered at a lower price, they still make
a profit: selling price - buying price.
So shorting is somewhat of a complex transaction. It involves:
 Borrowing something that you do not own.
 Selling it in the marketplace.
 Paying the lender (owner of record) of the security a fee (that
increases with time).
  Buying (covering) the short later.
 Returning the security to its original owner.
Short sellers trade because they think a security is overvalued. They prefer
to sell it now at what they believe is an inflated price. They receive cash for
it, which they can deposit in an account for any costs associated with the
short. If all goes well, then the price does indeed drop and the short seller
can cover the security, return it to the owner, and complete their
responsibilities. Doing so has earned them whatever the capital gain is (high
– low), less any transaction fees.
The lender of the security, in some way, is like the lender of our loan
examples. The borrower of the security—the short seller—is like the borrower
of our loan examples. Therefore, we have seen this familiar scenario before.
Instead of lending cash, we are lending securities. What is the same and
what is different?
The number one similarity is that both have credit risk in that the borrower
may not be able to return the security (just like the cash borrower was not
able to pay back the loan).
Suppose you were to short the XYZ bond. Then, instead of the price going
down, imagine the price went up...way up! Ouch. In that case, you may not
have enough funds to buy back the security because you will need more
money than what is in the account. Therefore, you may be unable to give the
lender back their security. How can such a problem be avoided? Well, credit
risk should be closely watched, and it's possible that you would have a
financing problem on your hands. In the next topic, we will talk about this
very thing.

8. Financing Short Positions

Someone is only willing to lend you a security if there is something in it for
them. What can that be? If you short a security from an owner of XYZ, then
whoever holds XYZ Bond will want to receive some income for that. A
financial institution is not like a public library where one can simply borrow
books for a period of time without cost. Whoever lends out the security will
want to receive an amount of income for it. This is known as the financing
cost. So, imagine that you are the owner of XYZ Bond. As a bondholder, you
make money by receiving interest payments. However, there is another way
you can make money. You can agree that your broker on the sell-side can
lend out your bonds to another customer. When you do so, you will receive
whatever the financing cost is from that short seller. Financing provides
extra income to the owner of a security.
When someone lends out the security, they want to be assured that they
receive this financing rate from the short seller. In addition, they also get the
interest from the bond as if they still owned it. In other words, the short
seller sells the bond to another customer. The person that buys those bonds
now owes them. The original owner merely has an “I.O.U.” from the short
seller. However, the true cost of shorting requires you to make good on all
income that the ownership bestowed. So when the issuer makes a coupon
payment, the short seller is expected to make that payment, as part of the
financing cost, to the original owner. Otherwise, the owner would have
forfeited that interest income. Remember, the original bond holder is looking
to make extra income by lending out their bonds, not substituting interest
income for income from financing. So, the cost of financing is two-fold. If you
are shorting a bond, then you have two costs to deal with:
1. The financing cost, which is effectively an interest rate for borrowing
the security.
2. The income cost of whatever that security produced. Since you borrow
the bond, you are responsible for making that interest payment to the
original owner!
To emphasize: The person who lent you the bond still is eligible to receive
the interest. But they do not have current ownership of the bond. Instead,
they have an “I.O.U.”—the short’s sellers promise to make good on the
interest payments. So, when you are shorting an investment, you must cover
the lost income generated, as well as a financing cost for the privilege of
borrowing the bond.
For short sellers, it is very prudent to find bonds for which they believe the
price will drop far enough to offset both the financing costs and income cost,
as well as other transaction fees, and to ensure that a profit can still be
earned. Doing so gives truth to the statement “sell high and buy low.”
Shorting is a remarkably interesting part of the market because it serves the
purpose of preventing assets from getting overvalued. If there's consensus
that a financial asset is overvalued, then short sellers come into the market
and put downward pressure on that asset, helping it to achieve its natural
equilibrium state. If there is no mechanism to short, then a market can
become frozen. That means that sellers have prices that are too high, and
there are no buyers willing to pay the prices. Does this sound unrealistic?
Think of commercial real estate. There are many properties throughout the
world that remain vacant because property owners expect to receive an
amount for them that exceeds what businesses are willing to pay for them.
As a result, there is not a good consensus of what the price is. To put it in
terms that we just learned, the offer price for commercial real estate often
exceeds the bid price by such a large amount that properties stagnate. This
means that property owners are looking for an offer price that is much
greater than the prospective tenants are willing to pay. The offer price
exceeds the bid price.There is no middle ground—they do not meet halfway.
They simply do not come to terms. Consequently, the real estate remains
vacant, often for years.
Shorting is a risky business because of the potential of an unlimited loss.
When you think about the fact that prices can jump up, there are potentially
catastrophic losses to the short seller. We have been discussing bonds, but
imagine you apply this to other asset classes for which there are no natural
ceilings to the prices—like stocks or Bitcoin. During the global recession,
there was a lack of confidence in the financial institutions themselves. It got
to a point where so many investors were shorting the financial institutions
that the government intervened and prohibited short selling of financials.
This helped to restore some faith and trust in the financials and was part of a
more comprehensive solution to avoiding a global depression. This was one
of the actions that regulatory agencies suggested. In the next lesson, we will
talk about these things first by focusing on central banks.

9. Conclusion
In this lesson, we examined the process of discounting and introduced the
relationship between bond prices and interest rates. We saw that higher
interest rates mean lower prices. We then examined the buy-side and sell-
side types of financial institutions, and the idea of bid prices and offer prices
to reflect a two-sided market. We concluded by showing the procedure and
strategy of shorting. In the next lesson, we'll round out our discussion of the
financial landscape by outlining the types of banks in the financial industry.
References
 Winngie. “The 7 Best Transfer Money and Currency Exchange Apps.
Future of Fintech.”Winngie, 9 Feb. 2021, winngie.com/2020/10/26/the-
7-best-transfer-money-and-currency-exchange-apps-future-of-fintech.
MODULE 1 | LESSON 4

SURVEYING THE FINANCIAL INDUSTRY

Reading
45 minutes
Time
Prior
Bonds, Interest Rates, Credit Risk
Knowledge
Central Bank, Monetary Policy, Investment Banks, Market
Keywords
Risk, Reinvestment Risk, Default Risk
In the previous module, we looked at bonds as another security in which
lenders provide funding to borrowers. We also saw that buy-side and sell-
side institutions comprise the financial industry. In this lesson, we examine
different types of banks. We'll also look at different types of risks associated
with bonds.
1. Central Banks
While we have discussed distinct kinds of banks, there is one type of bank
we have yet to discuss—the central bank. Central banks are financial
institutions whose purpose is to maintain stability and transparency for
countries' economies. Central banks help to keep inflation in check, provide
maximum employment opportunities, and enforce healthy monetary policy
for a stable economy. Please refer to the required reading by Fotia and
Bindseil, Chapter 1 and Chapter 3.
One of the responsibilities that central banks have is to help set operational
targets. As you do the required reading, note that the ultimate targets are
the inflation rate and the foreign exchange rate. Central banks can set
interest rates at which banks borrow and lend from each other. By doing so,
they can help ensure that there are sufficient funds that can be provided
between banks for them to conduct their business.

2. Investment Banks: Functions, Maturities, and

Products
Different from central banks are investment banks. Investment banks have
distinct functions:
1. They underwrite securities.
2. They help with IPO issuance.
3. They engage in sales and trading with investors.
4. They provide research for clients.
5. They bundle and sell securitized products.
6. They perform mergers and acquisitions.
Investment banks will also help underwrite new businesses. One thing
that they must do is provide credit to businesses. Once again, in our module,
we see credit risk. Investment banks continually monitor the credit risks of
their clients, of their investments, and of each other. If you are a business,
then you have a measure that will constitute your credit score. Investment
banks will look at this credit score to determine the amounts and even rates
at which you are charged for the use of funds.
Another purpose of banks is to provide credit to individuals. Individuals
need a quantitative measurement of their credit. For example, in the United
States, there is something known as a FICO score. FICO is an acronym for
Fair Isaac's Company. This company developed a quantitative model that
considers multiple factors in determining the credit worthiness of an
individual and distills them down to a single number. That number is on a
spectrum ranging from 300 to 850. Based on someone's FICO score, a person
has credit worthiness that is made readily available to lenders—credit card
lenders, mortgage lenders, property owners, and other financial institutions.
Imagine the challenging work required if each prospective stakeholder in
those examples would have to conduct their own credit risk assessment of
an individual. These credit scores help recognize and reward individuals who
build and maintain good credit by allowing them the use of credit at rates
that reflect their creditworthiness.
Banks can also provide an array of fixed-income products ranging from very
short-term loans and certificates of deposit to intermediate and advanced
products:
 Short-term: typically less than 1 year.
 Intermediate-term: typically 1 to 10 years.
 Long-term: typically more than 10 years.
There are distinct types of products, including:
 Commercial paper
 Certificates of deposits
 Treasury bills
 Treasury notes
 Treasury bonds
3. Types of Risks
Each of these products has its own set of risks. Consider, for example, that
you have a choice between depositing money in a savings account, such as a
certificate of deposit, or purchasing a bond. As such, you want to know what
the risks are. Let's consider four different risks.

3.1 Market Risk

Market risk is the risk due to price fluctuation, which makes the value of
assets go down. If you have a savings account, then you are immune to the
market risk because you have a specified interest rate. However, if you own
a bond, the prices do change. If you bought a bond and then try to sell it, you
might find that you sell at a lower price. As a result, you would lose money
due to market fluctuation. One safe way to avoid market risk in a bond is
simply to hold the bond to maturity. If you hold a bond to maturity, then the
bond price can change. So long as there is no default, you are immune to
price fluctuations because you never sell the bond.
3.2 Reinvestment Risk
If you decide to go with the bond, then periodically, you will receive a coupon
interest. You may decide not to spend that coupon interest but to reinvest it.
What will interest rates be like when you do sell? If interest rates go up, then
that means you will be able to reinvest at a higher rate of interest, which is
good. However, if interest rates go down, then you would reinvest at a lower
rate of interest. The risk is there. Reinvestment risk is the risk that rates
are lower when you have access to new investment funds. Reinvestment risk
exists for CDs because, upon maturity, as you seek to renew a certificate of
deposit, the rate may be lower than what you originally had.
3.3 Default Risk
Default risk is the risk that your bond issue fails to pay you back the stated
interest and/or the principal. As we have seen, the certificate of deposit is
insured by our trustworthy depository insurance corporation, so default risk
is a non-issue. If you were the holder of a risk-free bond, then likewise, you
need not worry about the default risk of those securities. However, if you are
the buyer and/or holder of a risky bond, then you are certainly subject to the
default risk of the bond issuer. If the bond issuer defaults, then the bond will
be worth less. Even if the bond issuer has a credit rating that declines, the
bond will be worth less.
Again, let's look at the difference between holding the bond to maturity
versus trading the bond. If you simply hold the bond to maturity, then you
run the risk that there may be a default. This means that you lose the
interest and principal. But suppose you only hold the bond for a brief time—
you are still subject to the credit risk. The decline in credit will cause a
market drop, so although it is not default risk specifically, it is credit risk in
general. Default risk is just an extreme form of credit risk. Any lower credit
rating results in a price drop of the bond. As a result, when you go to sell the
bond, you will undoubtedly get less due to that higher credit risk. Default risk
is just one type—the main type—of credit risk. Credit risk really refers to the
degradation of credit worthiness. At a small scale, this results in a simple
lowering of the credit score. At an extreme scale, this is actual default.

3.4 Inflation Risk

Inflation risk is the risk that the money you receive is simply worth less
because inflation was higher than expected. For example, suppose either the
certificate of deposit or the bond earned you 3% interest over the year. But
what if inflation were 8% that year? Indeed, your real rate of return would be
-5 percent. That is, had you gone to the marketplace, you could have
purchased goods and services that now, by delaying a year, cost you more
money; even though you have 3% more, those goods and services cost 8%
more. In fact, people find themselves in this situation in high inflation
environments. This is where central banks can help. When central banks find
inflation to be high, they look to perform monetary policy, like rising interest
rates, that will help to keep inflation under control.
4. Types of Marketplaces
We have already discussed different types of maturities, products, and risks,
so now, we'll close this lesson by showing that there are distinct types of
marketplaces as well. Broadly speaking, there are two kinds. The first type of
marketplace is an exchange. The second is what is called over the
counter, abbreviated as OTC.
Exchanges have the following characteristics:
  They offer a variety of benefits that OTC markets do not have. The
main advantages of exchanges are efficiency, transparency,
equitability, and credit risk mitigation.
 They primarily provide a centralized marketplace, making trading
efficient. They have very well-defined rules for handling the processing
and clearing of trades.
 They provide transparency because all market participants have
access to the order screens that contain the bid sizes and amounts, the
offer sizes and amounts, and a record of the previous trades that took
place.
 The transparency and availability of data makes trading fairer for
market participants. Of course, big institutional investors may have
bigger infrastructure with fast computers and smart algorithms to
detect and process orders more efficiently than smaller individuals or
institutions do.
 They solve the problem of credit risk. When you perform a transaction
on an exchange, all the credit risk is eliminated. How? The credit risk is
taken by the exchange itself. In other words, suppose someone named
Mamadou borrowed a security from you in order to sell it short. Soon
after Mamadou sells it, the price jumps up! Now, you have more credit
risk because it just became more difficult for Mamadou to cover that
short. The exchange can require Mamadou to post additional financing.
Financing was one of the two challenges in this module (with the other
being credit risk). The exchange continually monitors the value of that
security and requires Mamadou to post additional funds, even as often
as intraday. In doing so, you as the lender of the security would be
assured that, even with price increases, you will be able to receive the
security back because Mamadou cannot run out of money to cover it.
The exchange enforces this by mandating intraday requirements such
that Mamadou must post cash in an account to make sure he has
sufficient funds available to cover that short. If Mamadou were not able
to do so, the exchange could force the sale to immediately cover the
security and return it to the lender. So, the exchange’s monitoring and
enforcement of margin helps to ensure that financing remains
creditworthy.
Ideally, all securities would be exchange traded for the advantages of
equitability, transparency, and the minimization of credit risk. When we turn
to OTC markets, we see that trading occurs directly between counterparties.
Yes, there may be brokers in between, but the brokers do not take credit
risk. The brokers are there to facilitate and manage the transaction, not to
assume the credit risk of either side. Likewise, the transparency is more
difficult because OTC markets decentralize the process. For example, stocks
that trade on a stock exchange only trade in that one place. However, bonds
may trade OTC for which there are different OTC markets. That means that
selected OTC markets can have more market share than others. As a result,
there could be slightly different prices from time to time between markets.
Therefore, it is much harder to assure that you have received a fair price.

5. Conclusion
We started off this lesson by introducing central banks. For now, we want to
emphasize that banks help to address the challenge we've seen in this
module: credit risk. Credit risk appears in several places; in this module, we
discussed the challenge of financing. We concluded by showing that the type
of financial trading—namely exchanges—can also help mitigate credit risk.
However, there are still many products that trade over the counter, so credit
risk continues to be an ongoing concern for many financial transactions.
In the next lesson, we will switch asset classes, by moving from fixed income
to equities and to cryptocurrencies. Those assets have much more volatility
than fixed income does. Just as credit risk is a major challenge to fixed
income, volatility will be a significant consideration for equities and
cryptocurrencies.
References
 Fotia, Alessio, and Ulrich Bindseil. “Introduction to Central
Banking.” Conventional Monetary Policy, Springer, Cham, 2021, pp. 1–
9.
 Fotia, Alessio, and Ulrich Bindseil. “Economic Accounts and Financial
Systems.” Conventional Monetary Policy, Springer, Cham, 2021, pp.
21–51.