neler ö rendik? bölüm özeti · Financial Markets & Institutions CHAPTER 1 CHAPTER 4 CHAPTER 7 CHAPTER 2 CHAPTER 5 CHAPTER 3 CHAPTER 6 Editor Asst.Prof.Dr. Özlem SAYILIR Authors

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neler öğrendik?bölüm

özeti

Financial Markets & Institutions

CHAPTER 1

CHAPTER 4

CHAPTER 7

CHAPTER 2

CHAPTER 5

CHAPTER 3

CHAPTER 6

Editor

Asst.Prof.Dr. Özlem SAYILIR

Authors

Asst.Prof.Dr. Gülşah KULALI

Asst.Prof.Dr. Serap KAMIŞLI

Asst.Prof.Dr. Melik KAMIŞLI

Prof.Dr. Abdullah YALAMAN


Assoc.Prof.Dr. Murat ERTUĞRUL

Asst.Prof.Dr. İbrahim KARAASLAN

T.C. ANADOLU UNIVERSITY PUBLICATION NO: 3994

OPEN EDUCATION FACULTY PUBLICATION NO: 2777

Copyright © 2020 by Anadolu University All rights reserved.

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

Anadolu University.

Instructional DesignerLecturer Orkun Şen

Graphic and Cover DesignProf.Dr. Halit Turgay Ünalan

Proof ReadingsAsst.Prof.Dr. Gonca SubaşıLecturer Neslihan Aydemir

Assessment EditorLecturer Dilek Polat

Graphic DesignersAyşegül Dibek

Gülşah Karabulut

Typesetting and CompositionKader Abpak Arul

Yasin ÖzkırYasin Narin

Gülşah SokumHalil Kaya

Zülfiye ÇevirGül Kaya

FINANCIAL MARKETS & INSTITUTIONS

E-ISBN

978-975-06-3740-7

All rights reserved to Anadolu University.

Eskişehir, Republic of Turkey, February 2020

3322-0-0-0-2002-V01

iii

Contents

CHAPTER 1Introduction to Financial Markets and Institutions

Introduction ................................................... 3An Overview of the Financial System ......... 3

Components of the Financial System 4Financial Markets ........................................ 9

Informational Efficiency in Financial Markets .................................................. 11Risk and Return in Financial Markets . 11

Interest Rates ................................................. 12Theory of Portfolio Choice ................... 13

Financial Instruments ................................. 15Main Characteristics of Financial Instruments ........................................... 16Debt Instruments and Equity Instruments ........................................... 16

Financial Intermediaries ............................. 18

CHAPTER 3 Stock Markets

Introduction .................................................. 57Definition and Properties of Stocks ............ 57

Rights and Liabilities of Stockholders 58Right to Dividend ................................. 58Right to Preemption ............................ 58Right to Liquidation Surplus ............... 59Right to Vote and Right to Participate in Management .................................... 59Right to Demand Information ............ 60Secrecy Liability ................................... 60Capital Liability .................................... 60Stock Value Definitions ....................... 60

Types of Stocks ............................................. 62Common Stocks .................................... 62Preferred Stocks ................................... 62Non-Voting Stocks ............................... 63

Stock Valuation ............................................ 63The Discounted Dividend Model ........ 64The Constant Dividend Model ............ 64

Constant Growth (Gordon) Dividend Discount Model .................................... 65Price-Earnings Ratio Model ................ 66Market to Book Value Model ............. 66Regression Model ................................. 67

Stock Indices ................................................. 68Major Stock Markets .................................... 69

Volatility and Volatility Spillover ....... 71

CHAPTER 2 Bond Markets

Introduction .................................................. 31Characteristics and Types of Bonds ............ 31

Characteristics of Bonds ...................... 31Types of Bonds .................................... 32

Bond Valuation ............................................. 36Time Value of Money ......................... 36Bond Yields ........................................... 39

Risks of Bond Investments .......................... 40Types of Risks Associated WithBond Investments ................................ 40Duration and Convexity ..................... 42Bond Ratings ........................................ 45

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CHAPTER 5 Commercial Banking

Introduction .................................................. 109Functions of Commercial Banking ............. 109Sources of Funds and Uses of Funds in Commercial Banking .................................... 112

Liabilities and Equity Capital of Commercial Banks ............................... 112Assets of Commercial Banks .............. 113

Revenues and Expenses of Commercial Banks ............................................................. 115Risk Management in Commercial Banking ......................................................... 117

Interest Rate Risk ................................. 117Liquidity Risk ........................................ 118Credit Risk ............................................. 119Operational Risk ................................... 119

CHAPTER 7 Financial Crises and Regulations

Introduction ................................................... 147Global Crises ................................................... 147

Crises Prior to 1980 ............................... 148Crises After 1980 ................................... 151

Crises in Turkey .............................................. 156Crises Prior to 1990 ............................... 156Crises After 1990 ................................... 158

Regulations in the Financial Industry .......... 160Financial Regulations ........................... 160International Financial Regulations .... 160

CHAPTER 6 Investment Banking

Introduction ................................................... 129Overview of Investment Banking ................ 129Bringing New Securities to the Market ...... 131

Preparation for Public Offerings .......... 131Types of Offerings ................................. 132Public Offerings Practices ..................... 133Variations in the Offering Process ....... 135

Deal Making in Mergers and Acquisitions .................................................... 136

Categories of M&A................................ 137Advising Corporations ................................... 138

CHAPTER 4 Derivative Markets

Introduction .................................................. 87Derivatives and Derivative Markets ........... 87Types of Derivatives: Forward, Future, Swap and Options ......................................... 89

Forward Commitments ...................... 89Forward Contracts ............................... 89Futures Contracts ................................. 90Swaps .................................................... 91Contingent Claims ................................ 95Options .................................................. 95

Basics of Derivative Pricing and Valuation 98Pricing and Valuation of Forward Contracts ............................................... 98Pricing and Valuation of Futures Contracts ............................................... 100Pricing and Valuation of Swap Contracts ............................................... 100Pricing and Valuation of Option Contracts ............................................... 101Binomial Option Pricing Model .......... 102Black-Scholes Option Pricing Model .. 102

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Preface

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

Editor


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Chapter 1

Lear

ning

Out

com

es

Chapter OutlineIntroductionAn Overview of the Financial SystemFinancial MarketsInterest RatesFinancial InstrumentsFinancial Intermediaries

Key TermsFinancial SystemFinancial Markets

Interest RateFinancial Instrument

Financial İntermediaryRisk

Return

After completing this chapter, you will be able to:

Describe the financial system Explain the functions of financial markets1 2Explain how interest rates are determined

Distinguish between financial intermediaries

Identify the main characteristics of financial instruments3

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Introduction to Financial Markets and Institutions

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1Financial Markets & Institutions

INTRODUCTIONBeing one of the subject areas of finance,

“financial markets and institutions” covers the ways and processes of how funds are transferred at individual level, at corporate level, and at macroeconomic level in an economy. Financial environment, financial system, financial markets, market participants, and regulatory system are considered to be the key elements of these ways and processes.

From the point of view of the Business Administration Department, in finance courses we generally evaluate financial decisions from different perspectives such as inside of firms to outside of the firms. We try to put ourselves in the shoes of financial managers and try to see what is best for the business. In the “financial markets and institutions” course, we start getting to know other parties besides companies, which also try to find what is best for them or their business. We also start to understand how interest rate changes can affect the way the financial system works, and how different parties in the financial system are affected favorably or adversely from these changes.

Throughout this first chapter of this book, you will be introduced to the basic terms and key concepts about financial markets and institutions. You will see briefly how the financial system works with its key participants. You will grasp how financial markets are segmented, and what the reflections of this segmentation are. You will understand how money is created, and how interest rates are determined in the financial markets. You will be introduced to the main financial instruments, their fundamental properties, and financial intermediaries. The purpose of this chapter is to provide basic information about the financial environment and its key parties. In this way, our aim is to help you establish the link between the information about financial markets and institutions and the decisions of financial managers about business finance.

AN OVERVIEW OF THE FINANCIAL SYSTEM

Financial system is an open system in an economy, which enables the main actors of the economy, namely households, firms, and the government to have acceptable returns for their savings, and at the same time to borrow funds at an acceptable cost when needed. The input of the financial system is the inclusion of excess funds to the process of matching the quantity, maturity, and cost/return of borrowings/savings. The output of a financial system is the realization of transfer of funds from those who have excess funds to those who have shortage of funds. The most crucial role of a financial system in an economy is making agricultural, manufacturing, services, and trade activities easier, and sometimes-even possible. The balance between investing, production, saving, and consumption is highly influenced by how efficient and effective the financial system works. In order to link firms and the financial system, we shall remember the three decision areas in business finance, briefly explained in Exhibit 1, and pick up on the components of the financial system. People, organizations, and regulations, as the components of the financial system together determine the way financial managers act and decide. Similarly, acts and decisions of financial managers affect people, organizations, and regulations in the components of the financial system.

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1 Introduction to Financial Markets and Institutions

Exhibit 1.1 Decisions Areas in Business Finance.

Components of the Financial System In very broad terms, the financial system is a system of transferring funds from those who have excess

funds to those who need to obtain extra funds in an economy. At the same time, it is convenient to remember that financial decisions include both the present and the future. It consists of decisions about taking some actions/positions today, and getting the results at some future date. Those who have excess funds lend their savings today, with the expectation to earn some return in the future for compensating their inconvenience resulting from absence of their money. They are the first component of the financial system, and they are called “ultimate lenders”.

On the other hand, those who need to obtain extra funds to borrow today, with an acceptance of bearing some cost in the future for utilizing funds when they need. They are the second component of the financial system, and they are called “ultimate borrowers”. Ultimate lenders and ultimate borrowers are households, firms, and the government. For example, a firm may borrow some money from the financial system by issuing short-term bonds, which makes it an ultimate borrower. At the same time, the very same firm may buy shares of an X Corporation from capital markets in the financial system and hold it in its portfolio of financial assets, which makes it an ultimate lender. By this example we see that a firm may have two roles as a borrower and as a lender in the system at the same time. However, we should keep in mind that in general, firms are in need of raising capital, and they act as net ultimate borrowers in the financial system.

There is one more thing that we should keep in mind. Ultimate borrowers or ultimate lenders do not always have to be domestic in countries. It is very common that foreign households, firms, and governments funnel their savings to the domestic markets, while at the same time, domestic households, firms, and governments funnel their savings to a foreign country. Internationalization of financial markets is actualized in two forms: The first one of them is foreign direct investments, which is setting

In business finance, there are three groups of decisions to make for financial managers. First group involves investing decisions. In order to produce goods and services, companies have to invest in assets, of real and financial, or tangible and intangible types. Investing decisions include distributing limited resources of the company to the best short-term and long-term investment alternatives. Investing de-cisions also include strategic decisions such as mergers and acquisitions and foreign direct investments.

Second group covers financing decisions. It is important to know that companies cannot make all of their investments with the money they have generated in the past years, or they already have. They are always in search for funds at a minimum cost in order to partly or fully finance their investments in the short, medium, and long term. They have two alternatives for financing: (1) debt financing, (2) equity financing.

Third group consists of dividend decisions. Financial managers should decide on how much of their earnings will be paid out to shareholders in the form of dividends, and how much will be retained to finan-ce a company’s future investments and growth. It is a strategic decision involving a trade-off between the payment of dividends to shareholders and retention of earnings to finance investments. To shareholders, dividends (together with the capital gain from market value increases of shares) are a kind of return for their long-term investment in the company. To managers, dividends are strategic decisions to be made in order to serve maximization of shareholder wealth. However, it is not always clear whether or not there is an optimal condition for all companies. There is a debate in the financial literature about the effects of dividend policy on the market value of company shares. Some theories suggest that dividend policy is relevant to share value; while the other ones suggest that it is not relevant.

The financial system refers to a system of transferring funds from those who have excess funds to those who need to obtain extra funds in an economy.

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up a manufacturing unit, or making a merger / acquisition with existing manufacturing units alone or with other shareholders through expanding manufacturing to other countries. The second of them is portfolio investments, which is making investments to securities in other countries, rather than manufacturing units.

Foreign direct investments are for longer terms with the aim of building a long-lasting financial relationships in a foreign country, whereas portfolio investments are considered for shorter terms with the aim of gaining the highest possible return for assumed financial risks.

The third component of the financial system is financial instruments. It is not surprising that cash is sufficient to make all the fund transfers in an economy. There is a need for other “means” of exchange. Financial instruments are securities, providing holders some kind of financial rights or financial claims against issuers in terms of (1) receiving part of their cash flows (e.g. bonds), (2) being their shareholder (e.g. stocks). The value of financial instruments stems from this right, rather than its characteristics as a paper.

Financial instruments are needed besides money in the financial system due to the following reasons:

1. the quantity of funds is not always matched among lenders and borrowers in the case of using just money. Financial instruments offer various alternatives to investors in this manner.

2. The maturity is not always matched among lenders and borrowers in the case of using just money. Using financial instruments fulfills the demand for and supply of short-term and long-term investment/funding needs.

3. Splitability is a problem in the case of using just money. The minimum amount of funds in order to take place in the financial system as a lender (investor) is very important for inclusion of small amounts of funds in the system. Financial instruments provide means to represent small amounts of funds,

and enhance the splitability. Splitability is especially important for individual and small investors. Otherwise, borrowers would not use an important quantity of funds, and at the same time lenders would not use their small savings for gaining some return.

The fourth component of the financial system is financial intermediaries. Financial intermediaries are organizations that enable lenders and borrowers to find and trust each other in the financial system. There are two types of financing, regarding the existence of these organizations: (1) direct financing, which takes place when borrowers directly find lenders without a need for an intermediary organization. For example, if an investor individually buys and holds bonds and/or stocks, it is a case of direct financing.

(2) Indirect financing, which takes place when borrowers and lenders use financial intermediary organizations to find each other, to match the quantity/maturity, and to make transactions in trust.

Financial intermediaries are organizations that collect the savings and funnel them to parties in need.

important

In Turkey, the most dominant financial intermediaries are commercial banks. Some of the other financial intermediaries can be exemplified as development and investment banks, insurance companies, pension investment funds, and mutual funds.

important

There are five key components of a financial system: ultimate lenders, ultimate borrowers, financial instruments, financial intermediaries, and legal- administrative regulations.

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

Table 1.1 Regulatory Bodies of the Financial Sector in Turkey.

Source: Banks in 2017 Report.

important

In Turkey, primary regulatory organizations are as follows: The Central Bank, Capital Markets Board, Undersecretaries of Turkey, and Banking Regulation and Supervision Agency.

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The Central Bank of The Republic of Turkey

Further Reading

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

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

Market interest rates are highly influenced by the supply of and the demand for loanable funds.

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Let us think of supply and demand curves. Shifts (upwards or downwards) in the demand and supply curves result in a change in the market interest rate. Sometimes interest rates cause changes in the demand for or supply of loanable funds.

Madura (2015) explains some of the factors that commonly affect the demand for and supply of loanable funds as follows:

• The demand for loanable funds by households is increased when the purchase of housing,automobiles, and household items with credit; or when aggregate level of household income rises (as it increases the purchases by credit).

• Thedemandforloanablefundsbybusinessesisincreasedwhenthenumberofinvestmentprojectsimplemented rises. It is generally observed when the interest rates are decreased.

• Thedemandforloanablefundsbythegovernmentisincreasedwhenincomingrevenuesfromtaxesand other sources cannot cover government’s planned expenditures.

• Thedemandforloanablefundsbyforeigngovernmentsor corporations is increased when their interest rate is higher than a particular country’s interest rates.

• Thesupplyofloanablefundsisincreasedwheninterestrate is higher, (the other things being constant) as the interest rate is the reward of lenders for supplying funds.

FINANCIAL MARKETS Markets are places where buyers and sellers of goods and services come together to make transactions.

A market can be in any contextual form: physical, virtual, or hybrid. Financial markets are places where financial goods and services (mainly financial instruments) are traded.

We can define different kinds of financial markets according to different criteria. The most common classifications are as follows:

1. Based on maturity of financial instruments that are traded: Financial markets where transactions are made with financial instruments with a maturity of up to one year are called money markets. On the other hand, financial markets where transactions are made with financial instruments with a maturity of one year and longer are called capital markets.

important

When the demand for loanable funds increases (decreases), the equilibrium interest rate increases (decreases). When the supply of loanable funds increases (decreases), the equilibrium interest rate decreases (increases).

What is the role of “decision makers’ attitude towards risk” in the relationship between ultimate lenders and ultimate borrowers in the financial system?

How do changes in interest rates influence the demand for and supply of loanable funds?

Why is trust important in financial markets?

1 Describe the financial system

Self Review 1 Relate Tell/Share

Learning Outcomes

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The most common financial instruments of money markets are deposit accounts and short-term bonds (issued by government or firms).

The most common financial instruments of capital markets are long-term bonds (issued by government or firms) and stocks.

2. Based on the structure of financial instruments that are traded: Financial markets where financial instruments that represent a situation of borrowing (lending) some amount of money for a specified time period for a specified amount of cost (return) are traded are classified as debt markets. Financial markets where financial instruments that represent a situation of issuing and selling (buying) of some shares of a company are classified as equity markets.

3. Based on whether financial instruments are bought and sold before: If financial instruments are sold for the first time in the market after the issue, then it is a primary financial market. However, if financial instruments that are sold before in the primary market are sold for consecutive times, then it is a secondary market. Let us think of stocks of a company. After the issuance of stocks, the company sells them in the primary market, and raises capital. After that, at some point of time, if buyers of stocks do not want to hold these stocks in their portfolio any more, they sell them to new buyers in the secondary market.

Trading volume of secondary market transactions and market price of stocks are very important for companies because volume and price in the secondary markets are determinants of volume and price in the primary markets for the forthcoming issues.

important

Companies raise capital in the primary market, but not in the secondary market. The ownership of stocks are transferred, and the liquidity is provided in the secondary markets.

4. Based on the organization status: If a financial market has its specific land, building, managers, and written rules and regulations, then it is an organized financial market. However, if a financial market does not have its specific land, building, managers, and written rules and regulations, then it is an unorganized, or, an over-the-counter financial market. Because terms and conditions are not standard in over-the-counter financial markets, individuals in general feel less safe compared to organized markets.

Stock exchanges such as Borsa İstanbul are organized financial markets.

Tahtakale foreign exchange market is an over-the-counter financial market.

5. Based on the timing of payment and shipment: Financial markets where buyers make payment and sellers make shipment immediately are called spot markets. For example, if you sell some shares of stock from your portfolio for cash, and take your cash at the same time, it is a spot market transaction. Financial markets where payment and/or shipment are made at a future point of time (under conditions set in the first place) take place in futures markets.

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Informational Efficiency in Financial Markets

Financial markets are considered efficient when no one participant alone has the power to change the price of a financial instrument. It is theoretically not possible in full terms, but partial efficiency may be possible in some markets. For efficiency, there needs to be the number of buyers and sellers who can access important information fast and at a low cost. The key is the speed and cost of important information to reach buyers and sellers. Here in this context, the information that may affect buying/selling decisions of market participants is considered as important. Important information might be about (1) financial instruments, (2) market forces, or (3) issuers of financial instruments.

Informational efficiency is the degree of speed and cost of important information to reach market participants in the financial markets.

In an extreme case of a financial market, which is perfectly efficient, all of the buyers and sellers would have access to the information at the same time and at a very low cost. Therefore, the demand and supply forces would work perfectly, and the price of financial instruments would be very close to their real or economic values. Then, it would be impossible to beat the market forces and have excess returns because no one would be able to find underpriced or overpriced financial instruments.

An asset is underpriced when its market price is below its real or economic value. An asset is overpriced when its market price is over its real or economic value.

However, in real cases, most financial markets are at a point between being semi-efficient and inefficient, if we think of efficiency level as a scale from the most inefficient to the most efficient. In those levels of efficiency, it is possible to find an underpriced financial instrument and buy it, hold it until its price increases, and sell it in order to have capital gain which is above the market average.

Capital gain or loss stems from the difference between the buying and selling prices of financial assets. When the market prices appreciate, investors have capital gain as they liquidate their investment. When the market prices appreciate, investors have capital loss as they liquidate their investment.

Risk and Return in Financial Markets

All participants in financial markets need to consider risk and return. “The concept of risk refers in general to the magnitude and likelihood of unanticipated changes that have an impact on a firm’s cash flows, value or profitability. Uncertainty is a somewhat broader concept, closely related to risk and often used synonymously.” (Oxelheim and Wihlborg, 2008). We can consider risk as a form of uncertainty in a sense that the actual outcomes of an action are not known, but probabilities can be assigned to each of the possible outcomes.

Risk refers in general to the magnitude and likelihood of unanticipated changes that have an impact on a firm’s cash flows, value or profitability.

Uncertainty refers to a prerequisite condition for risk to exist, but uncertainty can also refer to the possibility that something completely unforeseen can happen.

“In finance, risk refers to the likelihood that we will receive a return on an investment that is different from the return we expect to make. Thus, risk includes not only the bad outcomes (returns that are lower than expected “downside risk”), but also good outcomes (returns that are higher than expected “upside risk”). We consider both when measuring risk.” (Damodaran, 2012).

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Figure 1.1 When we measure risk in finance, we consider both downside risk and upside risk.

Academic research studies have classified individuals according to their attitudes towards risk in three categories: Those who like to take risk (people with a risk-seeking attitude), those who dislike taking risk (people with a risk-averse

attitude), and those who neither like nor dislike taking risk (people with a risk-neutral attitude). Researchers have a consensus that most people have a risk-averse attitude towards risk. They dislike assuming risk unless they expect to have a greater benefit in return. In this regard, we can say that risk-averse investors are those who purchase assets with high risk only if they expect a premium return. Perceived risk and expected return tend to be related: the greater the perceived risk, the greater the return required by decision-makers (Pike and Neale, 1996).

important

Risk-return trade-off addresses that the greater the perceived risk, the greater the return required by decision-makers.

What is the relationship between the equilibrium market prices of shares in secondary financial markets and prices of shares in primary financial markets?

What is the relation between risk and expected return?

Describe downside risk and upside risk.

2 Explain the functions of financial markets


Learning Outcomes

INTEREST RATESInterest rate is an analytical tool that is used in

borrowing and lending funds in financial markets. Interest rate is closely related with the time value of money. By using interest rate, lenders compensate for risks and opportunity costs, resulting from trade off reinvesting opportunities. They transfer the right of use of their money for a certain period of time and require an amount of interest from borrowers as a reward.

important

Interest is a cost item in the form of interest expense for the borrower, whereas it is a return item in the form of interest earnings for the lender.

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Using interest rate, we can find the value of money at any particular past or future date in time. The future worth of a particular quantity of money received today is called “future value of money”. The present worth of a particular quantity of money which will be received at a future date is called “present value of money”. If the interest rate is positive, the future value of a certain amount of money will be higher than its present value. Conversely, if the interest rate is negative, the future value of a certain amount of money will be lower than its present value.

Calculating future value is called “compounding”.

Calculating present value is called “discounting”.

Let us briefly remember how we can find the future value and present value using compound interest.

Finding Future Value by Using Compound Interest (Compounding)

FV= PV * (1+i)n

FV= future valuePV= present value i= interest rate of the periodn= number of periods

Finding Present Value by Using Compound Interest (Discounting)

PV = FV / (1+i)n

PV = present value FV= future valuei= interest rate of the periodn= number of periods

Example 1: A person invests 20 000 TL for a period of 3 years and earns interest semiannually. The nominal interest rate is 12%. How much will the value of this person’s money be in 3 years?

Solution : The interest rate of the period is 12%/2= 6% and the number of periods is 5*2=10

FV= PV * (1+i)n

FV= 20,000 * (1+0.06)10

FV= TL 35,816.95

Example 2: A person invested in a bank account for a period of 5 years and earned interest every quarter. The nominal interest rate is 12 %. After 4 years, the value of that person’s money reached TL 100,000. How much must the person have invested in the bank?

Solution : The interest rate of the period is 12%/4= 3% and the number of periods is 2*4=8

PV = FV / (1+i)n

PV = 100,000 / (1+0.03)8

PV=TL 78,940.92

Theory of Portfolio ChoiceIn order to understand the behavior of interest

rates in the economy, we should know how demand and supply in the bond market and in the market for money works. For any decision-making about buying/holding a financial asset or selecting a financial asset over asset groups; investors take these 4 factors into account: (1) wealth, (2) expected return, (3) risk, and (4) liquidity (Mishkin, 2016: 132). The theory of portfolio choice provides insights about factors influential on the demand for an asset to be bought/to be held in the portfolios.

Wealth tells us how much resource an individual has that is available to buy an asset. Assuming that everything else is constant, the quantity demanded of an asset will increase with an increase in wealth. Vice versa, the quantity demanded of an asset will decrease with a decrease in wealth.

Expected return is the return that an individual expects to have from an asset over a period of time. Investors’ expected return is influenced from the past experiences related to that particular asset. In other words, expected return of an asset is formed

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based on historical actualized returns of the asset. If the expected return from an asset is high (relative to the asset’s past returns or relative to alternative assets’ past and expected returns), then the investor wants to buy/hold the asset.

Assuming that everything else is constant, an increase in the expected return of an asset (relative to alternative assets) results in an increase in the quantity demanded of an asset. Vice versa, a decrease in the expected return of an asset results in a decrease in the quantity demanded of an asset.

Risk of an asset tells us the calculated degree of uncertainty about the expected return of an asset. Considering two financial assets with the same level of expected returns, the degree of risk associated to that asset will be the influential factor for the demand for the asset. We remember that people are grouped into three according to their attitude towards risk: risk-seekers, risk-neutrals, and risk-averse people. In general, most people are risk-averse. That means that they do not tend to take risk unless it is necessary, or unless they expect to have a return that will at least compensate the bearded risk.

Assuming that everything else is constant, an increase in the liquidity of an asset results in an increase in the quantity demanded of an asset. Vice versa, a decrease in the liquidity of an asset results in a decrease in the quantity demanded of an asset.

Liquidity is the ease and quickness of an asset to be bought and sold at an acceptable value, or price that is not below the actual value, or price. Liquidity is a required factor for assets because it gives investors some degree of flexibility to change their minds quickly and at a low cost. Liquidity of an asset depends on two factors: the structure of the market that the asset is traded, and the asset’s character itself. In a market with a number of buyers and sellers and with an acceptable level

of informational efficiency, it will be easier for investors to find an asset to match their preferences. At the same time, the equilibrium market price for assets will be much closer to their actual value, which increases the liquidity of assets in the market. Besides market structure, properties of assets such as price, transaction costs, and maturity influence the liquidity. For example, a financial asset with a longer maturity and a higher price would be less liquid than an alternative asset with a shorter maturity and a lower price.

Assuming that everything else is constant, an increase in the liquidity of an asset results in an increase in the quantity demanded of an asset. Vice versa, a decrease in the liquidity of an asset results in a decrease in the quantity demanded of an asset.

Grounding in the theory of portfolio choice, we can think that the results of changes in supply and demand forces in: (1) the bond market, and (2) the market for money. Bond market and the market for money are important because they are the key term in the formation of interest rates, which is the price of the capital. Equilibrium interest rates in these markets are set according to shifts in the demand curve and the supply curve. Market equilibrium occurs where demand and supply become equal. Therefore, a change in the interest rates reflects a shift in the curves of supply of and/or demand for bonds or money.

Assuming that everything else is constant, an increase in demand makes equilibrium interest rate to increase; on the other hand, an increase in supply makes equilibrium interest rate to decrease.

Assumption of the theory of portfolio choice is that people store their wealth only with: (1) money, and (2) bonds. In other words, wealth in the economy equals supply of bonds plus supply of money; which is also equal to demand of bonds plus demand of money. Either the bond market or

15


the market for money explains the determination of equilibrium interest rates for money. The determination of equilibrium interest rates with the supply of and/or demand for money rather than supply of and/or demand for bonds is explained with the Liquidity Preference Framework, a framework developed by J. M. Keynes. According to this framework, an increase (decrease) in the demand for money would result in an increase (decrease) in the equilibrium interest rate. Further, a decrease (increase) in supply of money would result in an increase (decrease) in the equilibrium interest rate.

important

Economics literature emphasizes the income effect and the price-level effect. A higher level of income results in an increase in the demand of money, and an increase in the equilibrium interest rate and vice versa. An increase in the general price levels results in an increase in the demand for money, and an increase in the equilibrium interest rate and vice versa.

Assume that you are in a hypothetical situation of zero inflation in the economy. Would there be any interest rate?

What is the relation between the demand for bonds/ supply of bonds and interest rates?

Explain the effect of income levels and price levels on the interest rates.

3 Explain how interest rates are determined


Learning Outcomes

FINANCIAL INSTRUMENTS In the financial system, ultimate lenders lend their money to ultimate borrowers for a period of time

in order to gain some return from their investment. On the operational side, borrowers issue financial instruments to sell to lenders in order to obtain financing. Lenders on the other hand, compare financial instruments that are in the market and try to find the best ones in terms of risk/return profile and in terms of market price in order to include these securities to their portfolio and hold them. Their aim is to gain some return.

A security is a financial instrument, which is a kind of negotiable paper, showing claims on future cash flows of the issuer of the security.

Cash flows refer to inflows or outflows of cash related to operating activities, investing activities, or financing activities of issuers.

important

By buying securities, lenders have a claim on future cash flows of the issuer of the securities. Therefore, we can say that financial instruments represent a liability for the issuer, whereas they represent an asset for the buyer.

16


Main Characteristics of Financial Instruments

Lenders (investors) in the financial system compare securities according to some characteristics that affect risk, return, and therefore the market price of securities.

1. Estimability of risk: Risk refers in general to the magnitude and likelihood of unanticipated upside and downside changes that have an impact on a firm’s cash flows, value, or profitability. Risk of a security can be defined as the probability of not being able to get all or part of the returns associated with that security. Risk is calculated using standard deviation and it is also called “volatility”. Volatility and its effects are explained in detail in the forthcoming chapters of this book. Just for now, it would be enough to know that when the probability of actualization of returns from a financial instrument increases, (1) the risk of that financial instrument decreases, and (2) the expected return from that financial instrument increases.

important

The issuer of a security is an important factor for its risk. Government bonds are accepted to have zero default risk as the government has the prerogative of coining money and pays all of its debt.

The interest rate of government bonds is referred to as the “risk-free interest rate”.

2. Maturity: Maturity of a security tells how long the claim on future cash flows of the issuer of a security stands. As the maturity gets longer, the probability of unforeseen events is increased, so does the risk of a security for an investor.

3. Liquidity: In broad terms, liquidity refers to convenience of assets. Liquidity of an asset tells how easy and how quick an asset can

be converted to cash without a significant loss from its value. Liquid securities are considered less risky, and their expected returns are a bit lower than more illiquid securities. Vice versa, risk is considered to be one of the factors that affects liquidity. At the same time, maturity is considered to be one of the factors that affects liquidity.

important

Riskier securities tend to have lower liquidity. Securities with longer maturities also tend have lower liquidity.

4. Splitability: Splitability is a term describing how much minimum amount of money is needed in order to buy a security. Securities high in splitability are more liquid than securities low in splitability.

Splitability is a term describing how much minimum amount of money is needed in order to buy a security.

important

Securities high in splitability are more liquid than securities low in splitability.

Debt Instruments and Equity Instruments

The fundamental classification of financial instruments is based on the type of claims on future cash flows of the issuer of the security. There are two main groups: debt instruments and equity instruments.

Debt instruments represent a claim on future cash flows of the issuer of the security in the form of interest return. Issuer of a debt instrument borrows some amount of funds from an investor (lender), and in return, pays back the principal amount plus interest. The interest may be subject to execution if the issuer company does not pay all or part of

17


it. Issuers of debt securities are either government or private companies. Short-term bonds (treasury bonds) and long-term bonds (government bonds) issued by the government are considered as less risky than short-term and long-term private bonds. Short-term bonds are more liquid than long-term bonds. The most liquid debt instrument is a treasury bond in most of the financial markets around the world.

Debt instruments are also called fixed-income securities by investors because the interest conditions (interest rate, amortization schedule, etc.) are fixed at the beginning of the period. The interest rate is determined as fixed or variable in the issuance.

Equity instruments represent a claim on future cash flows of the issuer of the security in the form of dividends. The most common equity instrument is a private company share of stock. Holders of shares become a “shareholder” to a company, which is a very long-lasting relationship with no maturity date in theory (if we assume that shareholders will not sell the share(s) of the company). Of course, shareholders may always sell

their shares to third parties in secondary financial markets, and have capital gain or capital loss. Stock investors may also enjoy some dividend gain if the company distributes some of the net income to the shareholders in the form of dividends.

important

Unlike debt instruments, the expected return is not certain for equity instruments. The issuer company may or may not pay dividends to shareholders.

If we want to compare private debt instruments with equity instruments, we should primarily look at their risk and maturity:

• Issuer companies are responsible topay interest and principal amount to bondholders. On the other hand, they may or may not pay dividends to shareholders. This makes equity instruments riskier than debt instruments in general.

• Maturity of debt instruments are definite(short or long). However, maturity of a company share is not definite (very very long). This makes equity instruments riskier than debt instruments in general.

Why, most of the time, risk and expected return of stocks are greater than the risk and expected return of private bonds?

What is the relationship between maturity and liquidity?

What are the main differences between debt instruments and equity instruments?

4 Identify the main characteristics of financial instruments


Learning Outcomes

18


FINANCIAL INTERMEDIARIES Financial intermediaries are organizations

that collect savings and channel them to parties in need in financial markets. These intermediary organizations provide ease and efficiency in transferring funds between two parties. Less time and less resources are required to collect and distribute important information in order to make these transactions as these organizations are specialized entities that benefit economies of scale. The variety and functions of financial intermediary organizations change from country to country.

Transaction costs and costs of obtaining information associated with the transfer of funds become lower thanks to intermediary organizations.

We may broadly classify financial intermediaries in two groups as (1) depository financial institutions, and (2) non-depository financial institutions.

Main non-depository institutions are portfolio management companies, insurance companies, unemployment insurance funds, and pension investment funds.

Portfolio management company is a capital market institution founded in the form of a joint-stock company, the main activity field of which is to establish and manage funds. Foreign collective investment schemes established abroad which are their equivalents are also the parts of the main field of activity of the Company. (http://www.cmb.gov.tr)

http://www.cmb.gov.trinternet

Insurance companies are businesses that provide coverage, in the form of compensation resulting from loss, damages, injury, treatment or hardship in exchange for premium payments. The company calculates the risk of occurrence, then determines the cost to replace (pay for) the loss to define the premium amount.

Unemployment insurance fund is a government created fund which is used to assist individuals who have lost their jobs.

Pension investment fund is a mutual fund which is created to invest the contributions collected by the pension company under the pension contract. The type of the pension mutual funds is determined based on the investment instruments they contain; e.g. government bonds and bills, stocks, deposits, and so on.

These funds are managed with long-term investment strategies, and they are considered as long-term investment instruments. (https://www.egm.org.tr)

https://www.egm.org.trinternet

Pension funds are created by pension companies. They do not have a legal entity and they are managed by portfolio management companies.

19


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

In Practice

20


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

21


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

Table 1.2 Total Assets of the Financial Sector in Turkey.

Source: Banks in Turkey 2017 Report

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

The main function of Deposit Banks is to meet deposit and credit needs of households and businesses. Traditional banking involves accepting money from those who have it (depositors) and loaning it to those who need it (borrowers). The difference between the interest that banks earn from loans and the interest they pay for deposits is the income they use to fund their operations and generate a profit (ABA, 2010:12). Legally, deposit banks should be incorporated as a joint stock company in Turkey. From the ownership point of view, deposit banks may be (1) state owned, (2) private owned, (3) foreign owned, and (4) under the Deposit Insurance Fund.

“In 2017, the share of assets of deposit banks in Turkish banking sector was 90 percent, while the shares of development and investment banks and participation banks were 5 percent each. Fifty one percent of total loans extended to large scale companies and project financing, 24 percent to SMEs and 25 percent to consumers. The distribution of corporate loans among manufacturing industry, commercial sector, construction industry and energy sector, transportation and real estate brokerage was 18 percent, 15 percent, 9 percent and 7 percent, 5 percent each, respectively.” (Banks in Turkey 2017 Report).

Development and Investment Banks are organizations, which function mainly to provide credit and/or execute tasks assigned to them through specific codes and similar branches of these organizations in Turkey that are established abroad. “In broader terms, investment banking covers all transactions and organizations which comprise capital formations, including the transfer of existing assets and circulation of shares and debenture bonds” (Celik et al., 2012).

22


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

How many banks are there in Turkish banking system?

How do financial interme-diaries reduce the costs of obtaining information as-sociated with the transfer of funds?

Tell the differences between deposit banks, development and investment banks and participation banks

5 Distinguish between financial intermediaries


Learning Outcomes


23

Sum

mary

LO 1 Describe the financial system

There are five key components of a financial system:1. Ultimate lenders: They are individuals or organizations with an over saving. And, they are ready to

lend all or some of their over savings to the other parties for a specified time period, and in return of a specified or no specified amount of return. Return may be in cash and/or noncash forms.

2. Ultimate borrowers: They are individuals or organizations with a funding gap. They are ready to bear a specified or no specified amount of cost in return of using lenders’ over savings for a specified time period. Bearded costs may be in cash and/or noncash forms.

3. Financial instruments: A financial instrument is a means to transfer funds from ultimate lenders to ultimate borrowers, and back. They represent the rights and liabilities of lenders and borrowers. These instruments are bought and sold through financial markets.

4. Financial intermediaries: Organizations which bring lenders and borrowers together and at the same time contribute to matching the amounts of funds to transfer among them. Otherwise, funds would not be able to be used effectively. Financial intermediaries earn some amount of commission as an income for playing such an important role in the financial system.

5. Legal and administrative regulations: Organizations, which assure that the transactions are made in an easy and orderly manner, and in a secure way. By this, confidence of lenders and borrowers to the financial system is provided, and this results in circulation of funds effectively.

LO 2 Explain the functions of financial markets

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


24

Sum

mar

y

LO 3 Explain how interest rates are determined

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

LO 4 Identify the main characteristics of financial instruments

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

LO5 Distinguish between financial intermediaries

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


25

Test Yourself

1 Which one of the following is an over-the-counter market?

A. Borsa İstanbulB. New York Stock ExchangeC. Chicago Board of Options Exchange D. İstanbul Altın BorsasıE. Kapalıçarşı gold market

2 Which one is the main aim of the Central Bank of Turkish Republic?

A. Transparency of interbank transactionsB. Sustainable supervision of banksC. Effectiveness of the issue policyD. Price stabilityE. Statistical data availability

3 Which of the following terms refers to “information that may affect buying/selling decisions of market participants”?

A. Vulnerable informationB. Important informationC. External informationD. Timely informationE. Excess information

4 A person invests 90 000 TL in a bank for 5 months. If the interest rate is 22%, then how much will be the value of this person’s money after 5 months?

A. 96.650 B. 97.350C. 98.250 D. 99.450E. 100.550

5 A person invested a bank account for a period of 6 years. The frequency of interest is 3 months, and the 3-month interest rate is 2%. After 6 years, the value of that person’s money was 700, 000 TL. How much must the person have invested in the bank?

A. 475.105 B. 465.805C. 455.705 D. 445.405E. 435.205

6 According to “The Theory of Portfolio Choice”, which of the following is not a factor that investors take into account when they make decisions about financial instruments?

A. Historical prices B. RiskC. Liquidity D. WealthE. Expected return

7 I. Riskier securities are in general lower in liquidity, compared to less risky securities.

II. Riskier securities associated with lower expected returns, compared to less risky securities.

III. Securities, which are high in splitability, are more liquid than securities, which are lower in splitability.

IV. Longer-maturity securities are riskier than shorter-maturity securities for investors.

Which of the above statements (I to IV) about the main characteristics of financial instruments are true?

A. I and II B. I andIIIC. II andIV D. I,III and IVE. I,II,III and IV

8 Which of the following financial instruments’s interest rate is called “risk-free interest rate”?

A. Stocks B. Treasury bondsC. Private bonds D. Savings accountE. Warrant

9 Which one of the following is a depository financial institution?

A. Pension investment fundB. Portfolio management companiesC. Commercial banksD. Unemployment insurance fundE. Insurance companies

10 Which of the following can collect deposits?

A. Insurance companiesB. Portfolio management companiesC. Pension investment fundD. Unemployment insurance fundE. Development and Investment bank


26

Ans

wer

Key

for

“Tes

t You

rsel

f”S

ugge

sted

ans

wer

s fo

r “S

elf R

evie

w”

If your answer is wrong, please review the “Components of the Financial System” section.

1. E If your answer is wrong, please review the “The Theory of Portfolio Choice” section.

6. A

If your answer is wrong, please review the “Informational Efficiency in Financial Markets” section.

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

8. B

If your answer is wrong, please review the “Components of the Financial System” section.

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

7. D

If your answer is wrong, please review the “Interest Rates” section.

4. C

If your answer is wrong, please review the “Interest Rates” section.

5. E

If your answer is wrong, please review the “Financial Intermediaries” section.

9. C

If your answer is wrong, please review the “Financial Intermediaries” section.

10. E

What is the role of “decision makers’ attitude towards risk” in the relationship between ultimate lenders and ultimate borrowers in the financial system?

self review 1

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


27

Suggested answ

ers for “Self R

eview”

What is the relationship between the equilibrium market prices of shares in secondary financial markets and prices of shares in primary financial markets?

self review 2

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

Assume that you are in a hypothetical situation of zero inflation in the economy. Would there be any interest rate?

self review 3

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


28

Sug

gest

ed a

nsw

ers

for

“Sel

f Rev

iew

”

Why, most of the time, risk and expected return of stocks are greater than the risk and expected return of private bonds?

self review 4

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

How many banks are there in Turkish banking system?

self review 5

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

Number of Banks in Turkey

Source: Banks in Turkey 2017


29

American Bankers Association. (2010). Principles of Banking, 10th ed., USA.

Berger, A. N., Molyneux, P. and Wilson, J. O. S. (2010). The Oxford Handbook of Banking, Oxford University Press, UK.

Celik, İ. E., Dincer, H. and Hacioglu, U. (2012). Investment and Development Banking and Its Development in Turkey, International Journal of Finance and Banking Studies, Vol.1 No.1, p.39-45.

Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed., John Wiley & Sons, Inc., USA.

Grinbblatt, M. and Titman, S. (2002). Financial Markets and Corporate Strategy, 2nd International ed., McGraw-Hill Higher education, USA.

Madura J. (2015). Financial Markets and Institutions, 11th ed., Cengage Learning, USA.

Mishkin, F. S. (2016). The Economics of Money, Banking, and Financial Markets, 11 th Global ed., Pearson Education Limited, England.

Oxelheim, L. and Wihlborg, C. (2008). Corporate Decision-Making with Macroeconomic Uncertainty: Performance and Risk Management, Oxford University Press, USA.

Pike, R. and Neale, B. (1996). Corporate Finance & Investment: Decisions and Strategies, 2nd ed., Prentice Hall Inc. Europe, Great Britain.

PwC Turkey (2017). Transformation of the Asset Management Industry in Turkey Project, UK’s Prosperity Fund 2016-2017, British Embassy, Ankara.

The Banks Association of Turkey (2018). Banks in 2017, The Banks Association of Turkey Publication No:328, Istanbul.

References

30

Chapter 2After completing this chapter, you will be able to:

Chapter OutlineIntroduction

Characteristics and Types of Bonds

Bond Valuation

Risks of Bond Investments

Key TermsYield to Maturity

EurobondDuration

Convexity Default Risk

Rating

Lear

ning

Out

com

es

Identify risks of bond investments

Explain the main characteristics of bond investments

Describe the logic of bond valuation

31 2

Bond Markets

31


INTRODUCTIONCompanies need funds to finance their

investment and operations, and they have different choices to satisfy their financing requirements: by debt, equity or hybrid financing. Each of these alternatives has its own advantages and disadvantages, and companies may choose one of them or a combination of them. Market conditions and company specific conditions affect the financing decision of the company. If the company prefers debt financing, and the financing need is long term, then issuing bonds is a suitable alternative for the company. Bond is one of the oldest financial instruments, and it is preferred not only by companies but also by the governments.

Bond is a less risky investment alternative than stocks for investors, and it is suitable especially for risk averse investors. It makes regular payments and they are paid before the stockholders in the event of liquidation. Yet, this does not mean that bond investments are riskless. Besides being affected by systematic risk factors, bonds may carry specific risks depending on their types and features. The most important risk associated with the bond investments is default risk. Default risk refers to the possibility that the issuer could lose the coupon or principal payment ability. Investors evaluate the default risk and the other risks, and construct their bond investments. There are many different types of bonds in the financial markets that may be attractive for different types of investors, which are developed depending on the needs of issuers and demand of the investors.

CHARACTERISTICS AND TYPES OF BONDS

Bond is a long-term financial instrument issued by companies or governments, which provides interest and principal payments to the holders on specific dates (Brigham and Houston, 2019, p. 230). It is issued to satisfy long term financing needs, and is suitable for companies especially which do not want to lose management of the company by issuing stocks.

There are two main participants of the bond markets. The first group is the borrowers. Borrowers are the bond issuers such as governments, municipalities, financial and real sector companies.

The second group is the bond investors or holders. They are the institutions or individuals who want to evaluate their savings in the bond markets. By purchasing bonds, they lend their savings to the borrowers in need of funds (Choudhry, 2006a, p. 3).

Although bond is a type of debt financing, differently from the bank loans, it is traded in secondary markets. The most traded type of bonds is the bond that makes regular interest payments and principal payment on the maturity date, which is called conventional bond.

Bonds are redeemed on a specified date. However, based on their type, they can also be redeemed on a specified date when a predetermined event occurs or at some time in between two dates. If it is a callable bond, then it will be redeemed when the company calls the bonds.

Characteristics of BondsThere are some elements that determine the

characteristics of the bonds. These are (Williams, 2011, p. 176);

• Parvalue,• Formofthebond(Bearerorregistered)• Paymentmethod(Couponordiscount)• Coupon payment frequency (annually,

semiannually, quarterly or monthly)• Maturity,• Callfeatureifitiscallable,• Sinkingfundifitisasinkingfundbond,• Creditworthinessoftheissuer.Principal or Par Value: The principal, which is

also referred to as par value, redemption value or maturity value, is the amount that the issuer agrees to repay on the maturity date. Assume a 10-year bond with a par value of $1,000, in this case, the principal of the bond, which will be paid after ten years, is $1,000.

Coupon Payments: Most of the bonds make regular payments to the holders, which is called coupon or interest payment. The amount of the payments is initially specified as an annual

Bond is a fixed-income security and a type of debt instrument.

32

Bond Markets

percentage of the principal (fixed-rate bonds) or as a floating rate, which depends on an external measure such as LIBOR (London Interbank Offered Rate), inflation, currency and gold (Brown, 2006, p. 3). Coupon payments can be made annually, semi-annually, quarterly or monthly. Most of the floating-rate bonds pay coupons quarterly or monthly, while the fixed-rate bonds generally pay coupons annually or semi-annually.

Maturity: Bonds are issued with a maturity date. Maturity or term of a bond is the number of years that the issuer meets the obligations of the bond, and refers to a specified date on which par value (principal) of the bond must be repaid to the holder. Maturity of bond is important, because it determines the yield on the bond.

Types of Bonds Bonds are classified in several ways. The type of

a bond that will be issued is determined depending on the needs of issuer and demand of the investors, and each type is suitable for different types of investorsbasedonitsfeatures.Someissuerswantto reduce the borrowing costs and issue bonds with collateral. Some issuers do not want to providecollateral, so they issue debentures and accept to pay a higher interest rate.

From the perspective of the bondholders,in some cases, put provision may be attractive. Therefore, they accept to receive lower coupon rates. Alternatively, they may choose to buy convertible bonds depending on the market conditions.

Bearer and Registered Bonds: Bonds are divided into two categories in terms of ownership: bearer bonds and registered bonds. Bearer bond is a bond type that the owner is the person who holds it. They have coupons that are presented to a bank for payment. The issuer of the bearer bonds does not know the holder of the bond and who receives thecashflowsof thebond. In theUnitedStates,the issuance of bearer bonds is prevented because investors may escape the tax of interest payments (Melicher and Norton, 2017, p. 256). As opposed

to bearer bonds, the issuer of the registered bonds knows the names of the holders and payments are made directly to the holders.

Straight Coupon Bonds: The most common type of bonds traded in the markets is straight coupon bonds, which provide the holder to receive periodic interest payments and principal on a specified date. The interest payments of these bonds are generally made annually or semiannually, and neither the issuer nor the investor have the right of demanding early repayment (Brown, 2006, p. 9).

Zero-Coupon (Discounted) Bonds: Holders of zero-coupon bonds do not receive coupon payments. They buy the bond at a discounted price, and they receive the par value at the maturity. The difference between the discounted price and the par value becomes the interest payment of the bondholders.

The reason why companies issue zero coupon bonds is that they do not have to make payment until the maturity date, and the reason investors prefer this type of bond is that there is no risk of reinvesting at a lower rate. Yet, there is disadvantage for the holders of the zero-coupon bonds. Although they are not paid until maturity, they pay the taxes of interest earned each year (Burton, Nesiba and Brown, 2015, p. 271).

Government Bonds: This type of bond is issued by the governments and public sector bodies, in order to fund the ongoing operations and the fiscal deficit. Especially, when the tax revenues are not sufficient, governments prefer to fund long-term projects through bond issues. On the other hand, in periods when the economy is depressed, governments try to provide economic expansion by increasing government spending. In order to do this, governments have to find fund resources. In this case, they have two alternatives: increasing revenues or borrowing. Borrowing is a better alternative in depressed periods, since the main way to increase revenues is to increase tax

important

As the maturity of a bond increases, the price volatility of the bond will increase due to the changes in market yields.

Return of a zero-coupon bondholder is the difference between the discounted price and the par value, which will be paid at the maturity date.

33


revenues, and tax increases in such periods deepen economic depression (Williams, 2011, p. 174).

Governments mainly have three borrowing instruments:

• treasury bills which satisfy short-termfinancing needs,

• treasury notes that are mid-term debtinstruments,

• government (treasury) bonds which areissued to satisfy long-term financing needs.

Corporate Bonds: The bonds issued by governments and public sector bodies are named as government bonds, and they are evaluated as risk-free instruments since they carry implicit government guarantee. The other bonds are therefore deemed to be corporate bonds. In this context, a corporate bond can be defined as the debt instrument issued by non-government borrowers. Corporate bonds are accepted as riskier compared to the government bonds, so the coupon rate of these instruments is higher than the government bonds.

As in government bonds, the issuer pays coupons and makes the principal payment at the maturity date for the bonds. If the issuer fails to make the coupon or principal payment, this is called default. In this case, the bondholders can enforce the payments through the legal process (Choudhry, 2006b, p. 88).

Debenture (Unsecured) Bonds, Secured Bonds and Guaranteed Bonds: Debenture bonds are unsecured bonds and payments of these bonds depend on the general credit strength of the issuer. The holders of these bonds are accepted as general creditors of the issuer (Melicher and Norton, 2017, p. 262).

Debenture bonds are typically issued by companies with high credit ratings and have high coupon rates since they carry high default risk. Unlike the holders of debenture bonds, secured bondholders are protected against the default risk via the right to sell the pledged asset. Therefore, a secured bond can be defined as the bond that is secured by a pledge asset of the issuer. These bonds also can be secured with the revenue that arises from the project, for which the bond was issued to provide finance.

Guaranteed bond is a bond issued by a company and guaranteed by another corporation or corporations. The default risk is, therefore, transferred from the bondholder to the guarantor. In the event of default, interest and principal payments of guaranteed bondholders are paid by the guarantor such as banks, insurance companies and governmental agencies (Johnson, 2013, p. 284).

Floating-Rate Bonds: The coupon rate of these bonds change depending on a reference rate. The coupon rate of each period is the sum of quoted margin and the current reference rate. The quoted margin is expressed as “basis point”. The reference rate or benchmark of a floating-rate bond isaninterestrateoraninterestrateindex(Fabozzi,2013, p. 5).

Government bonds can be issued discounted or with coupons, and their maturity can range between 1 and 30 years.

important

Coupon rates of government bonds are lower than the coupon rates of the company bonds, since the return of the bondholders are considered as risk-free return.

The main factor that determines the coupon rate of the corporate bonds is creditworthiness of the issuer.

important

The creditworthiness of the issuer reflects thedefaultriskofthebond.Forthisreason,the bond investors should evaluate the creditworthiness of the corporation in an investment process.

Coupon rates of corporate bonds are higher than the coupon rates of government bonds since the possibility of default in these bonds is higher compared to government bonds.

34

Bond Markets

Assume a bond which pays LIBOR plus 100 basis point semiannually. The coupon rate of this bond will change semi-annually depending on the LIBOR.Forexample,iftheLIBORis4%atthefirst coupon payment period, then the coupon ratewillbe5%(4%+1%).Typically,couponrateincreases as the reference rate increases. However, in some cases, coupon rate moves in the opposite direction of the reference rate. This type of bond is called inverse floating-rate bonds.

Index-Linked Bonds: Index-linked bond is a bond that the coupon payments and in some issues principal payments are linked to a specific index such as Consumer Price Index (CPI). Couponpayments of index-linked bonds may change in each period and coupons may be different from each other due to the changes in the determined index. In other words, return of these bonds depends on the developments in the index (Haan, OosterlooandSchoenmaker,2012,p.142).

Callable and Puttable Bonds: Callable bonds provide the issuer the opportunity of buying his debt prior to the scheduled maturity date in case interest rates fall below the coupon rate of the bond (Martellini, Priaulet andPriaulet, 2003, p. 460).Therefore, the issuer can issue new bonds with a lower coupon rate. If the issuer calls the bond, the price that the issuer will pay is named as call price.

The call price is specified in the indenture. Forsome issues, the call price is the same for all the time frame. Yet for some issues, there are different call prices scheduled depending on the timing of the call.

There are some disadvantages for the holder of acallablebond.Firstofall,theholderisfacedbyreinvestment risk. If the bond is called, then the investor will invest in a bond that gives a lower coupon rate. Secondly, the callable bonds havenegative convexity (see the last explanations about convexity in the last section of this chapter). This means that callable bonds will appreciate less than the traditional bonds when the interest rates fall. Forthesereasons,thebuyersofcallablebondsarewilling to pay lower prices than the traditional bonds.

A puttable bond is a bond that provides the holder to sell the bond back to the issuer at par on stateddatesintheindenture.Putprovisionprovidesadvantage to the holder, if the interest rates exceed the coupon rate. When the interest rates increase, bond prices will decrease, but the put provision will protect the holder from the capital loss. In case the interest rates increase, the holder can sell the bond back and buy a new bond with a higher rate (Drake andFabozzi, 2010, p. 473).On the other hand,usage of put provision will force the issuer to issue a new bond with higher coupon rate. Therefore, puttable bonds are sold at higher prices relative to traditional bonds or have lower coupon rates.

Eurobonds and Foreign Bonds (International Bonds): Eurobond is a bond denominated in a currency that is different from the currency of the country where the bond is issued. They are typically issued by governments, large corporations and internationalinstitutions(Pilbeam,1998,p.324).For example, a bonddenominated inUSdollarsand sold in London is a Eurobond. Eurobonds

One of the most widely used benchmarks for floating rate is the LIBOR (London Interbank Offered Rate), which is the borrowing rate in the London Interbank Market.AnotherreferencerateisthePrimeRate, which is the interest rate that banks charge their most creditworthy customers.

Quoted margin is the rate that the issuer agrees to pay above the determined reference rate.

Index-linked bonds provide protection against inflation. Hence, investors prefer to hold index-linked bonds rather than the conventional bonds if they are worried about the unexpected inflation.

A callable bond is a type of bond, which can be redeemed before the maturity date.

A puttable bond is a type of bond that gives the holder the right of selling the bond back to the issuer on stated dates in the indenture.

35


are named with the currency in which the bond is issued. Therefore, a bond denominated in Japanese Yen and sold in Germany is called Yen Eurobond.

Foreignbond is a typeof bond that is issuedby a foreign company or foreign government. They are denominated in the currency of the country where they are sold. Some of the foreign bondshavespecificnames.Forexample,bondsissuedintheUnitedStatesbyaforeigncompanyarecalledYankee Bonds, the foreign bonds issued in the United Kingdom are called Bulldog bonds (Maple bonds–Canada;Pandabonds–China;Samuraibonds – Japan; Rembrandt bonds - the Netherlands; Kiwi bonds – New Zealand; Matador bonds – Spain;KangarooorMatildabondsAustralia).Theinvestor of a foreign bond undertakes default risk as in other bond types. Even though the default risk on foreign bonds issued by governments is lower, all foreign bonds carry default risk. It is even stated

that recently there is a high default risk even for foreign bonds issued by governments. The possible defaults in some of the European countries support this statement.

Besides other risks of bonds, investors are also exposed to currency risk, if they buy bonds denominated in a currency other than their home currency. They will lose money if the foreign currency decreases against the domestic currency when they convert the foreign currency to domestic currency (Brigham and Houston, 2019, p. 230).

Eurobonds are denominated in a currency that is different from the currency of the country where the bond is issued, whereas foreign bonds are denominated in the currency of the country where they are sold.

Table 2.1 Comparison of Domestic Bond, Eurobond and Foreign Bond.

Type of Bond Place of Issue Currency of Issue Nationality of Issuer

Primary Investors

Domestic Bond Domestic Domestic Domestic Domestic

Eurobond InternationalEurocurrency, Euroyen, Eurodollars,Eurosterling, etc.

Any International

Foreign Bond Domestic Domestic Foreign DomesticSource: Arnold, G. (2015), The Financial Times Guide to Bond and Money Markets, p. 206.

Convertible Bonds: Some of the bonds issued bycorporations provide to the holder the right of changing the bond with another asset. These bonds are called convertible bonds.Forexample,holderofaconvertiblebondcanbegranted to receive the face value in cash or a unit of ordinary stocks of the issuer. This right can be used at maturity or over a specified period depending on the indenture (Bailey, 2005, p. 283). The investors take the face value or convert the bonds into the stocks based on their choices.

important

While Eurobonds are denominated in a currency that is different from the currency of the country where the bond is issued, foreign bonds are denominated in the currency of the country where they are sold.

What are the elements that determine the characteristics of bonds?

Under which conditions should bond investors buy floating-rate bonds?

Tell the importance ofcreditworthiness of the bond issuer for bond investors.

1 Explain the main characteristics of bond investments


Learning Outcomes

36

Bond Markets

BOND VALUATIONThe concept of time value of money must be

understood to calculate the cost of funds, the value of the investments and the yield on an investment such as bonds.

Time Value of Money Time value of money is a critical concept in

understanding many fields of finance. The value of financial instruments and future cash flows of investments is determined by discounting, and future value of money resulting from an investment is calculated by compounding (Kettell, 2002, p. 33)

Timevalueofmoneyintheeasiestwaycanbedefined with the sentence “$1 you have today is more valuable than the $1 that you will have in the future”.Today’s $1 ismore valuable becauseyou may make an investment with this money and obtain interest on it. Therefore, you can have more than $1 after a while. Yet, this is valid as long as the interest rate is strictly positive (Martellini, PriauletandPriaulet,2003,p.43).Anotherreasonwhytoday’s$1ismorevaluablethan$1infutureis the uncertainty of cash flows. In other words, there is no certainty that those cash flows will be obtained in the future. We do not know certainly whether the cash flows will occur or not, when the cash flows will occur and how much cash flows will occur in the future.

Tocompareaninvestmentthatpresentvalueisknown with an investment that future cash flows are known can lead to misleading decisions. The cash flows arising from different investments at different periods of time can be compared in two ways. The present money can be compounded to the future date that the cash flow of the alternative investment will be received or the future money can be discounted to the present day (Hiriyappa, 2008, p. 43).

The formulas of compounding (future value) and discounting (present value) are as follows;

FV=PV*(1+i)n

FVPV= (1+i)n

In the formulas, is future value of cash flow, is present value of cash flow, is the annual interest rate (yield) and is the number of years for which compounding or discounting is done. If the cash flows occur different than annual frequency, and must be revised. For example, for semiannualperiods is divided to 2 and is multiplied by 2, since there are two semiannual payments in a year.

Estimation of expected cash flows of a bond is easier relative to many of the financial assets, and it consists of periodic coupon payments and the principal, which is the par value at the maturity (DrakeandFabozzi,2010,p.514).Thediscountfactor that is used in bond valuation consists of a risk-free rate and a risk premium. Risk-free rate refers to the coupon rate of government bonds, and the risk premium includes economic, industrial and firm level risks.

In this context, the factors that affect the discount rate. Hence the bond value are as follows (Burton, Nesiba and Brown, 2015, p. 288):

• Theeconomicoutlook,• Monetarypolicyofthecountry,• Government’sborrowingneeds,• Inflationaryexpectations,• Thelevelofeconomicactivity,

important

To compare the investment alternatives,wemust know the math of time value of money because the value of the alternatives must be on the same timeline in order to choose the best one.

Today’s$1 ismorevaluable than$1 in thefuture because the future carries uncertainty and today’s $1 can provide return throughthe investment.

The value of a financial asset is the present value of future cash flows expected from the asset.Forthisreason,determinationofpriceof an asset requires an estimation of expected cash flows and an appropriate discount factor, which refers to the required rate of return or required yield.

37


• Thelevelofcapitalinflows,• Thecreditratingofthebonddeterminedcreditratingagencies,• Thecapitalstructureofthecompany,• Companyconditions.In general, value of a bond can be estimated by the following formula;

VB =C

(1+ i)1+

C(1+ i)2

+ ...+ C(1+ i)n

+P

(1+ i)n=

C

1+ i( )tt=1

n

∑⎛

⎝

⎜⎜⎜

⎞

⎠

⎟⎟⎟+

P(1+ i)n

Here, is the value or price of the bond, C is the coupon payment, i is the coupon or interest rate, n is the number of periods until the maturity,Pistheprincipalorparvalueofthebond.If coupon payments are made monthly or quarterly, n and r must be revised according to the payment

frequency.Sincecouponpaymentsareregular,thesumofthepresentvalueofcouponpaymentscanbeestimated by using the present value of the annuity formula.

Assumea30-yearbondwithaparvalueof$1,000,thecouponrateofthebondis9%,therefore,thecouponpaymentswillbe$90($1,000x0.09),Ifthediscountrateis11%,thevalueofthebondis:

VB =$90

1+0.11( )tt=1

n=30

∑⎛

⎝

⎜⎜⎜

⎞

⎠

⎟⎟⎟+

$1,000

1+0.11( )30= $782.4413+$43.6828= $826.1241

Valuing Zero-Coupon Bonds A zero-coupon bond provides the investor a cash

flow equal to the par value, which will be obtained at maturity. Therefore, the value of a zero-coupon bond is equal to the present value of the bond’spar value and it can be estimated by the following formula (Gündoğdu, 2017, p. 363):

PVB= (1+i)n

Assume a 5-year zero-coupon bond which has $1,000parvalue.Iftherequiredreturnis8%,theprice of the bond should be:

1,000 VB= =$680,58 (1+0.08)5

important

If the bond is sold at the price below the estimated value, then it means that the bond is overvalued and it can be purchased. If the bond is sold at the price above the estimated value, then it means that the bond is undervalued and the bondholder can sell the bond.

The estimated value of a bond gives the economic or intrinsic value of the bond; hence, it reflects the fair price for the bond. The investors use this value in investment decisions.

38

Bond Markets

Valuing Bonds with Semiannual CouponsCoupon payments of bonds can be settled annually or semiannually. If the interest payments will be

made semiannually, then the annual coupon interest payment and discount rate must be divided to 2, and the maturity should be multiplied by 2. Therefore, the valuation formula can be revised for semiannual coupon bonds as follows (Brigham and Houston, 2019, p. 246):

VB =C / 2

1+ i / 2( )tt=1

2n

∑⎛

⎝

⎜⎜⎜

⎞

⎠

⎟⎟⎟+

P

1+ i / 2( )2n

Assume a 2-year bond which has $1,000 par value and makes interest payment semiannually with the coupon rate of 10%. In this case, thenominal ratewill be 5% (10%/ 2), interest payment will be $50 ($1,000*0.10/2). Ifthediscount rate is12%(0.12/2=0.06, since the couponpayments are semiannual, the value of bond will be:

VB =$50

1+0.06( )1+

$50

1+0.06( )2+

$50

1+0.06( )3+

$50

1+0.06( )4+$1.000

1+0.06( )4= $956.3489

Accrued Interest, Dirty Price and Clean PriceExcept zero-coupon bonds, the bonds accrue interest on a daily basis, and coupons are paid on the

coupon date. The valuation formulas above can be used only for bonds at the very start of a coupon period. In this case, the dirty price and clean price of the bond are equal.

If the bond price will be calculated at a date between two coupon periods, accrued interest must be calculated (Bodie, Kane and Marcus, 2018, p. 427). The price of a bond including accrued interest is called dirty or full price. In other words, dirty price is equal to sum of clean price and accrued interest. The price without accrued interest is called clean or flat price. The clean price is calculated by subtracting the accrued interest from the dirty price. The accrued interest (AI) can be calculated by the following formula:

Days since last coupon paymentsAI=CouponPayment* Days separating coupon payments

important

While valuing the bonds that pay coupons semiannually, the annual coupons and discount rate must be revised according to the period.

Dirty price of a bond is the price that includes the accrued interest at the settlement date.

The price of a bond at a date between two coupon periods can be calculated by the following steps (Chisholm, 2002, p. 63);

1. Calculate the number of days in the current coupon period.

2. Calculate the number of days from settlement date to next coupon date.

3. Calculate the fraction of the current coupon periodbydividingtheresultofStep2totheresultofStep1.

4. Calculate the price of the bond by discounting the cash flows.

Assume a bondwith a 10% coupon rate thatmatureson15May2021.Parvalueofthebondis1,000. It pays the coupons semiannually and the discount rate is8%. In this case, thepriceof thebond for settlement 10 January 2020 is calculated as follows:

Number of days in the current coupon period is 182 (The date that the last coupon is paid: 15 November 2019 - The date that the next coupon will be paid: 15 May 2020).

1. Number of days from settlement date to next coupon date is 126 (10 January 2020 - 15 May 2020).

39


2. The fraction of the current coupon period is 0.6923 (126/182). This means that the next coupon will be paid 0.6923 period later, the one after will be paid 1.6923 period later, and so on.

3. Thecouponpayment is$50($1,000*(0.10/2))andthediscount rate is4%(0.08/2), since thecoupon payments are made semiannually. The price of the bond is:

VB =$50

(1+0.04)0.6923+

$50(1+0.04)1.6923

+$1050

(1+0.04)2.6923= $1,040.229

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

56AI =$50* =$15.3846 182

Clean Price = $1,040.229-$15.3845 = $1,024.845

Bond YieldsThere are different yield concepts with respect

to bonds. In this context, the concepts of nominal yield, current yield, yield to maturity and yield to call are defined below.

Nominal Yield: Nominal yield of a bond is the coupon rate of the bond, and it does not take intoconsideration thebond’s time tomaturityormarketpriceofthebond(Rini,2003,p.97).Forexample,thenominalyieldofabondwitha10%couponrateis10%(0.10),whetheritissoldatparor not and matures in 2 or 30 years.

Current Yield: Current Yield is the return an investor expects to earn from an investment or financial instrument. Therefore, the current yield of a security is the ratio of investment’s annualincome to the current price of the security. Forbonds, the current yield refers to the ratio of the annual coupon to the market price of the bond. It is not the actual return that the investor receives by holding the bond until the maturity date. (Burton, Nesiba and Brown, 2015, p. 285). Assume a bond with par value of $1,000 and is selling for $920. Ifthecouponrateis6%,thenthecurrentyieldisapproximately6.5%($60/$920).

Yield to Maturity (YTM): There are several measures, which are used to evaluate the return of bonds. One of these measures is yield to maturity, which can be also calculated for the callable and putable bonds.

YTMistherate,whichequatesthebondpriceto the present value of its future cash flows, and it is a measure of the growth rate of the investment (Johnson, 2010, p. 45). It is calculated by using the formula which is used in bond valuation. Yet, this time, the value of the bond is known, and the equationissolvedfor“”thatgivestheYTM.IftheYTMisequaltoorgreaterthantheraterequiredby the investor, then the bond should be purchased.

Regardless of if the bond is sold at par, at a premium or discounted, nominal yield of a bond is the coupon rate of the bond.

The current yield of a bond is calculated by dividing the coupon payment to the current price of the bond

YTM is the rate of return that the investor will obtain if he buys the bond at a certain price and holds until the maturity.

important

YTMofabondistheinternalrateofreturnof a bond.

40

Bond Markets

There is a relation between the price and yield measures of the bonds. If a bond is sold at par value, thenthecouponrate,currentyieldandYTMareequal. If the bond is sold at a discounted price, then the coupon rate will be lower than the current yield, and the current yield will be lower than the YTM. Finally, if the bond is sold at a premiumprice, then the coupon rate will be greater than the current yield, and the current yield will be greater thantheYTM.

Yield to Call (YTC):Sometimes,thoseinneedof funds may issue bonds that give the issuer the right to call back. In this case, yield to call is an appropriate measure to evaluate the return of the bond.YTCistheratethatequalsthepresentvalueof the expected cash flows of the bond to the price plus accrued coupon payments. In general, there is a call schedule for callable bonds, which shows the call prices for each call. The bondholders generally calculateYTCforthefirstcallandfortheparcallthat gives the issuer the right to call the bond at par value.

InthecalculationofYTCfortheparcall,parvalue is considered as the call price, and the coupon payments, which will accrue to the first date at which the issuer can call the bond at par are taken into account at maturity (Drake and Fabozzi,2010, p. 528).

Differently from the current yield, yield to maturity includes all of the cash flows of the bond and takes into account the capital gain or loss of the investor. Additionally, timing of the cash flows are considered in the calculation.

For the bonds sold at par value, YTM isequaltothecouponrate.Forthebondssoldat a discountedprice,YTMwill be greaterthan the coupon rate, and for the bonds sold atapremiumprice,YTMwillbelowerthanthe coupon rate.

CalculationofYTCisthesameastheYTM.The expected cash flows to be used in the calculationofYTCfor the firstcall are thecall price and the coupon payments to the first call date.

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

Under which circumstances do we expect the bond prices to reflect fair values of the bonds? (Remember the Efficient Market Hypothesis)

Tell why bond prices areinversely related with changes in market interest rates.

2 Describe the logic of bond valuation


Learning Outcomes

RISKS OF BOND INVESTMENTSLike other investments, bond investments carry risks. Besides the risks that arise from the economic

conditions, bond investments carry specific risks such as call risk and downgrade risk.

Types of Risks Associated with Bond InvestmentsThe main risk associated with the bond investment is default risk. Default risk refers to the possibility

that the issuer fails to make the payments of the bond. Another risk important for the bondholders is

41


interest rate risk. Changes in the interest rates are important because they directly affect the price of the bond. There are also risks such as currency risk, which depends on the type of bond, undertaken by the bondholder.

Default Risk (Credit Risk): Default risk is the risk that the borrower will not meet the obligation at the agreed time. For bonds, default risk refersthat the issuer will fail to make interest payments and/or principal at the determined dates. When the issuers default, the bondholders can sue for bankruptcy, if the issuers do not file for bankruptcy (Johnson, 2010, p. 147).

There are credit rating agencies such as Standard & Poor’s, Moody’s Investment ServicesandFitchRatingsServicethatevaluatethedefaultrisk and the credit worthiness of bonds. The ratings given by these companies affect the decisions on theinvestors.Tohavearatingdeterminedbythementioned companies increases the marketability of the bonds. On the other hand, many of the large institutional investors establish credit analysis departmentsinordertoevaluatetheissuers’abilityto meet their obligations arising from the bond.

Downgrade Risk: Downgrade risk can be defined as the risk that the rating of the issuer or instrument will be downgraded by a rating agency or more rating agencies, due to the deterioration in the creditworthiness of the borrower. Therefore, the downgrade risk can be considered as a component of credit risk. However, the origin of the downgrade risk is generally an event notably default, and it is estimated depending on the possibility of this event. Credit risk is also associated with the consequences of the event. It considers both the possibility of the event and its potential consequences (Aarons, Ender and Wilkinson, 2019, p. 34).

Interest Rate Risk or Market Risk: Interest rate risk refers to potential losses caused by changes in the interest rates.

The interest rate changes are important especially for the investors who plan to sell the bond before the maturity date (Fabozzi and Mann, 2005, p.22). If the interest rates increase, the investor will sell the bond at a lower price. This risk undertaken by the investor is called interest rate risk or market risk, and it is one of the most important risks of fixed income investments. (The interest rate risk of bonds is evaluated via some measures such as duration and convexity which are presented in the following section) .

Call Risk: Call risk is a type of risk that some bonds are exposed to. Call risk is the possibility that the issuer will buy back the bond before the maturity date. The bondholders undertake this risk if the bond carries a call provision.

Two factors fundamentally determine the callrisk.First of these factors is the lengthof the callprovision. The call risk increases as the length of call provision increases. The second factor is the coupon rate of the bond. While other things are the same, call risk of a bond with a lower coupon rate is lower than call risk of a bond with a higher coupon rate (Robinson and Wrightsman, 1980, p. 157).

The call risk increases especially when the interest rates tend to decrease because the issuer will use the call provision in order to issue new bonds with a lower coupon rate. Yet, if the coupon rate of the bond is low and the interest rates are less volatile, the call risk will be low.

Reinvestment Risk: Investors desire to reinvest their income generated from their investments. In this case, they are faced with the reinvestment risk that arises from the possibility of reinvesting their money at lower rates. This risk is high when the interest rates are volatile. Especially for bond investments, reinvestment risk is higher because the price of the bond decreases as the interest rates increase, and the bondholders sell their bonds at lower prices besides reinvesting their money at lower rates.

An increase in the downgrade risk results in a decrease in the price of the bond.

important

Typically, prices of fixed income securitiesmove in the opposite direction of the interest ratechanges.Forexample,thepriceofabondincreases when the interest rates decrease, and price of a bond decreases when the interest rates increase.

42

Bond Markets

The reinvestment risk in bond investments stems from the need to reinvest the coupons of the bonds (Arnold, 2015, p. 133). The holder may reinvest money arising from the coupon payments at lower rates if the interest rates decrease. On the other hand, if the investor has a callable bond and the interest rates decrease, the issuer will exercise the call provision. In this case, the investor will reinvest the amount higher than the coupons at a lower rate.

Currency Risk (Foreign Exchange Risk): In general terms, currency risk can be defined as the potential loss occurs due to the changes in the exchange rates. The bondholders undertake currency risk when they invest in a bond which pays the coupons and principal in a foreign currency. When the foreign currency that the bondholders will receive as the cash flows of the bond depreciates against the domestic currency, it will take more foreign currency to buy the same amount of domestic currency (Wright, 2003, p. 87). In other words, they will receive less amount of domestic currency when they convert the foreign currency, since the foreign currency goes down in value. There is no problem with domestic currency appreciation, as long as the investor holds the foreign currency. The problem occurs when the bondholder wants to convert the foreign currency to the domestic currency. On the other hand, the domestic currency can depreciate against the foreign currency. In this case, the return of the bondholders will increase, since they will take more money when they convert the foreign currency to the domestic currency.

Purchasing Power Risk or Inflation Risk: This type of risk is associated with the unanticipated changes in the future value of money. Investors who want to protect their investment against this contingency can buy index-linked securities, for which the payoffs are adjusted according to the price changes (Bailey, 2005, p. 298).

Duration and Convexity Duration and convexity are tools that are widely

used to manage the risk exposure of fixed-income investments like bonds.

Duration The maturity of a bond provides little

information about how long it takes the bond to repay the investment. Moreover, it does not give any idea about the sensitivity of the bond to changes in interest rates. It is simple to compare two bonds with the same maturity but with different coupon rates. As the bond with the higher coupon rate will repay the investment faster, theoretically, its value will be less exposed to changes in interest rates. However, when we want to compare two bonds with different maturity and coupon rates, the maturity cannot help us in evaluating two alternatives (Choudhry, 2006b, p. 40).

Zero-coupon bonds do not make payments until the maturity, but coupon bonds provide cash flows before the maturity. The fluctuations in the price of a bond is related to term structure of the bond. Current value of the bond changes due to the changes in the market interest rates and the term. As the time to maturity increases the coupon rate increases, and as the market interest rate increases, coupon payments become more important than the payment of the principal. Therefore, when we want to evaluate the bond investments, we should use a method that considers the time value of money.

Duration is a first order interest rate risk measure and it reflects the sensitivity of the bond to changes in interest rate rates. Duration is a method that gives a weighted average of the time to receive the investment, which uses the present value of cash flows gained from the bond. Besides the principal of the bond, it considers the coupon payments and the timing of these payments. In this context, duration can be defined as the average time that is needed to receive principal and coupons of the bond, which considers the sensitivity of bond to interest rate changes. Duration of an n-year zero coupon bond is n year. In other words, duration of zero-coupon bond is equal to maturity of bond. However, duration of an n-year coupon bond is less than n year because the bondholder receives coupon payments in certain periods until the maturity date.

important

If the foreign currency depreciates, the holders of foreign bonds will receive less amount of money in domestic currency when they convert the foreign currency that stems from the bond investment.

43


Holding other factors constant, duration of a bond increases as the term to maturity increases (Arnold, 2015, p. 351).

Duration is also known as “Macaulay Duration” since the concept of duration was firstly developed by Frederick Macaulay. Macaulay duration iscalculated by multiplying the time (t) until the

receipt of cash flows with the present value of cash flows, and then dividing the sum of these values tothesumofpresentvalueofcashflows(PVCF)(Wright, 2003, p. 177).

For bonds with semi-annual coupons, thecash flows are discounted at half of the discount rate. Macaulay duration formula can be shown as follows:

D =CFt1+ r( )t

* tt=1

n

∑⎡

⎣

⎢⎢⎢

⎤

⎦

⎥⎥⎥/

CFt1+ r( )tt=1

n

∑

Here, represents the cash flows of the bond, r is the discount factor and t is interest period or the time that the investor will receive the payment. Assume a 3-year bond which has $1,000 par value and makes interest payment annually with the couponrateof8%.Thebondissoldatpar.Inthiscase,couponpaymentwillbe$80($1,000*0.08),and the duration of the bond will be:

Duration is a measure of interest rate sensitivity of bond and gives the weighted average time to receive the cash flows of the bond.

important

Duration decreases when the interest rates increase.

Duration of a bond with higher coupon rate is shorter than the duration of a bond with lower coupon rate.

D =

$80

1+0.08( )1*1+ $80

1+0.08( )2*2+ $80

1+0.08( )3*3+ $1,000

1+0.08( )3*3

$80

1+0.08( )1+

$80

1+0.08( )2+

$80

1+0.08( )3+$1,000

1+0.08( )3= 2.782

Duration is calculated as 2.7832 years. This means that the average time needed to receive the cash flows of this bond is 2.7832 years. As expected, the duration of the bond is lower than three years as some of the income is received before the end of three years.

In the duration formula, the denominator, which is the sum of the present values of the coupons and the principal, in fact gives us the price of the bond (Choudhry, 2001, p. 159). Therefore, we can calculate duration for bonds sold at different prices. In this case, the cash flows in the numerator part of the formula are discounted with the yield and later, the value obtained in the numerator part is divided by the price of the bond.

Duration can be calculated for bond portfolios. The duration of a portfolio of bonds is calculated as follows (Johnson, 2010, p. 174):

Dp = wi *Dii=1

n

∑

Assume a portfolio consists of three bonds. The weights ofbondsintheportfolioare25%,35%and40%.Ifthedurations of the bonds are 0.3472, 2.6596 and 1.2835 respectively, then the duration of the portfolio is:

The duration of a portfolio of bonds is equal to the weighted average of durations of the bonds in the portfolio.

44

Bond Markets

Modified DurationThere are many forms of duration focusing on

different properties of bonds, which have been developed to evaluate different types of bonds. One of these forms is modified duration.

Modified duration is calculated under the assumption that cash flows of the bond do not change when the yield changes. For this reason,this measure is not suitable for some types of bonds such as callable bonds and bonds with embedded options(FabozziandMann,2005,p.204).

Modified duration can be calculated as follows:

Macaulay DurationM.D.= 1+yield/k

In the formula, k is the number of coupon paymentsperyear.Forexample,kis1forbondsthat make annual coupon payments, and k is 2 for bonds that make coupon payments semi-annually.

The modified duration for the bond that we calculated the duration will be;

2.7832 M.D.= =2.57701+0.08

In case of yield changes, we can calculate approximate changes in the bond price by using modified duration (Brentani, 2004, p. 76). The change in price of a bond given a change in yield can be calculated by the following formula:

While duration or Macaulay duration reflects the sensitivity of a bond to the interest rate changes, modified duration evaluates the effects of yield changes on the price of the bond.

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

Intheformula,isthechangeintheyieldandisthepresentvalueofthebond.Forexample,iftheyieldincreasesfrom8%to8.2%,thechangeinthepriceofbondwillbe:

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

Thismeans that, if the yield increases from8% to8.2%, theprice of the bondwill fall by about$5.1542.

ConvexityDuration is a first order interest rate risk measure, which uses first-order derivatives. However, convexity

uses second-order derivatives and represents a second order interest rate risk (Choudhry, 2005, p. 41).

Duration does not consider the convexity of bond price with respect to interest rates and estimates the approximate percentage of price change regardless of the way of the change in the interest rate. Yet, for large changes in the interest rates, the magnitude of price changes is different for increasesanddecreases.Forthisreason,durationisagoodmeasure to analyze the effects of small interest rate changes on the bond price, whereas it is not a suitable measure in caseswhereinterestratechangesarelarge.Forthesecases,convexity is the appropriate measure to evaluate the interest rate risk.

While other conditions are the same, the bonds that have higher convexity should be preferred by the investors. The logic is as follows: As the interest rates decrease, the price of a bond that has higher convexity

important

If the interest rate changes are large, the magnitude of price changes will be different for increases and decreases. In this case, convexity is a better measure than the duration.

Convexity measures the nonlinear relationships between bond prices and interest rates.

45


increases more than the price of other bonds. The price of a bond that has higher convexity decreases less than the price of other bonds while the interest rates increase.

Convexity, in fact, shows by how much the duration of a bond will change, when interest rates change and it measures the volatility of the duration (Wright, 2003, p. 178).

The convexity of a bond can be calculated by the following formula:

CX =CFt1+ r( )t

* t * t +1( )t=1

m

∑⎡

⎣

⎢⎢⎢

⎤

⎦

⎥⎥⎥/ 1+ r( )2 *P⎡⎣⎢

⎤⎦⎥

Forsemi-annualcouponbonds,discountfactorisdividedby2(Choudhry,2001,p.185).Assume a 5-year bond which has $1,000 par value and makes interest payment annually with the

couponrateof6%.Thebondissoldat$985andthemarketinterestrateis6.5%.Inthiscase,couponpaymentwillbe$60($1,000*0.06),andtheconvexityofthebondcanbecalculatedasinthetablebelow:

Interest Period (t) Cash Flows (CFt) PVCF t*(t+1) PVCF* t*(t+1)

1 60 56.3380 2 112.67602 60 52.8995 6 317.39703 60 49,6709 12 596.05084 60 46,6394 20 932.78805 1,060 773,6737 30 23,210.2110

25,169.1228

25,169.1228CX= =22.5285 (1+0.065)2*985

The unit of convexity calculated by the given formula is in years; hence, the coupon payments are annually.Forbondswhichmakepaymentsonadifferentfrequency,wecanconverttheconvexitytoyearsusing the following formula:

CXCX years= k2

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

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

Forexample,a100basispoint(1%)changeintheyieldwillchangethepriceofthebondthatwecalculated the convexity for approximately:

1Change in Price= * 0.012 * 22.5285 *100=0.1126% 2

Bond RatingsLenders want to evaluate creditworthiness or repayment ability of the borrowers. They decide if they

will fund the borrower or not depending on the repayment ability. On the other hand, cost or interest rate

46

Bond Markets

of the debt is fundamentally determined by the repayment ability. As with lenders, investors also consider the creditworthiness of the issuer. They decide if they purchase the security or not by evaluating the default riskoftheissuer.Forbondinvestors,creditratingisasuitableindicatorinordertoevaluatethedefaultriskof the issuer. Issuers also want to have credit ratings in order to increase the marketability of their bonds, since ratings reflect trustworthiness of issuers and it is an important process for investors.

Forshort-termdebtswithmaturitylessthanoneyear,credit rating is a forward-looking assessment of default risk. But for long-term debts, besides reflecting default risk, credit rating provides a forward-looking assessment of magnitude of the loss in case of default. The default risk is given as percentage and termed as default rate, and magnitude of the potential loss in case of default is referred to as default loss rate. On the other hand, ratingtransitiontableswhichareprovidedbytheagenciesperiodicallyreflectthedowngraderisk(Fabozziand Mann, 2005, p. 25). Therefore, ratings are suitable indicators for the bond investors to evaluate default risk and possible losses that stem from the investment.

SeveralratingagenciessuchasStandard&Poor’s,Moody’sandFitchratecorporateandgovernmentbondswithrespecttotheissuer’sabilitytomaketheregularcouponpaymentsandprincipalpaymentatthe maturity date (Rini, 2003, p. 58). The agencies monitor the issuers and change the rating if the credit quality changes.

If the credit quality of the issuer improves, then the agency upgrades the rating, and if the credit quality of the issuer deteriorates, then the agency downgrades the rating. The rating agencies also modify the ratings by additional expressions such positive, developing, stable or negative. While positive outlook indicates a possible upgrading in the future, the negative outlook gives the signal of a possible downgrading in the future.

Besides the default risk, credit rating agencies provide information about the downgrade risk of the bonds.

important

Bonds with high ratings are considered safer than the lower rated bonds. If a bond has a very low rating, then investing in this bond is considered as speculative.

DEBT SECURITIES MARKET IN TURKEYht tps : / /www.borsa i s t anbul . com/en/

products-and-markets/markets/debt-securities-market

The Debt Securities Market is comprisedof the Outright Purchases and Sales Market,where the secondary market transactions of debt securities are conducted; the Offering Market for Qualified Investors, where the capital market instruments of the corporations whose equities are traded on Borsa İstanbul Equity Market are issued to “qualified investors” as defined in the capital markets legislation; the Repo-Reverse Repo Market, where repo-reverse repo transactions are conducted; the Repo Market forSpecifiedSecurities,whererepo-reverserepotransactions with specified debt securities are

conducted; the Equity Repo Market where repo- reverse repo transactions are carried out with the shares of the companies that are traded on Borsa İstanbul Equity Market and which are included in BIST30Index;andInternationalBondsMarket,where foreign debt instruments issued by the TurkishUndersecretariat ofTreasury and listedby Borsa İstanbul are conducted. There is also theCommittedTransactionsMarketwheresameday or forward value date buy-sell transactions are realized between the seller party with a commitment to repurchase a predetermined security and the buyer party with a commitment to resell that security and the Watchlist Market where capital market instruments that are previously traded in the Outright Purchasesand Sales Market and decided to be traded in

Further Reading

47


the Watchlist Market pursuant to the Listing Regulations.

Debt securities, securitized asset and income backed debt securities, lease certificates, liquidity bills issued by the Central Bank of the Republic ofTurkeyandothersecuritieswhichareapprovedby Borsa İstanbul Board, which are denominated inTRY and foreign currency canbe tradedontheDebtSecuritiesMarket.

Trading is conducted electronically in theDebt Securities Market via the automatedmultiple price-continuous auction system.

Sub-Marketsof theDebtSecuritiesMarketwere launched on the following dates:

• OutrightPurchasesandSalesMarket; June17, 1991.

• Repo-Reverse Repo Market; February 17,1993.

• Offering Market for Qualified Investors;May 17, 2010.

• Repo Market for Specified Securities;December 17, 2010.

• EquityRepoMarket;December7,2012.• InternationalBondsMarket;April16,2007

(conducted under Debt Securities MarketsinceSeptember13,2013)

• WatchlistMarket;December1,2017• Committed Transactions Market July 2,

2018Central Bank of the Republic of Turkey

and the intermediary institutions, which are members of Borsa İstanbul and Banks can carry outtransactionsintheDebtSecuritiesMarket.

SettlementoperationsarerealizedbyİstanbulSettlementandCustodyBankInc.(Takasbank).

Transactionsareconductedonthefollowingmarkets:

Outright Purchases and Sales MarketFixed income securities are traded on the

Outright Purchases and SalesMarket,which isan organized and transparent secondary market.

Repo- Reverse Repo MarketFixed income securities are sold with a

repurchase agreement (repo) and are bought with a resale agreement (reverse repo) in the Repo-Reverse Repo Market, which is one of the leading organized repo markets in the world.

Repo Market for Specified SecuritiesThis Market provides the opportunity

to realize repo transactions on specified debt securities within the organized market and then to deliver such securities to the buyer. It provides the means to exchange the security in a specified period, ensuring the flow of the securities between the forward and spot markets.

Equity Repo MarketThis market provides a means for carrying

out repo transactions on company shares within anorganizedmarketframework.Sharesacquiredthrough repo transactions are delivered to the buyer for the duration of the contract.

Offering Market for Qualified InvestorsThe Offering Market for Qualified Investors

is the market where the debt securities of the issuers defined in the related CMB Communiqué are issued to “qualified investors” as defined in the capital markets legislation, in accordance with the regulations of the Capital Markets BoardofTurkey.

International Bonds MarketForeign Debt Securities (“Eurobonds”)

issued by the Turkish Undersecretariat ofTreasuryandlistedbyBorsaİstanbularetradedin the International Bonds Market.

Committed Transactions MarketIn Committed Transactions Market, TRY

denominated lease certificates issued by asset leasing companies founded by the Treasuryand asset leasing companies founded by public enterprises assigned by theTreasury, as well asother capital market instruments determined by the Board of Directors of Borsa İstanbul canbe traded. Samedayor forward valuedatebuy-sell transactions are realized between the seller party with a commitment to repurchase a predetermined security and the buyer party with a commitment to resell that security.

Watchlist MarketCapital market instruments that are

previously traded in the Outright Purchasesand Sales Market and decided to be traded inthe Watchlist Market pursuant to the Listing Directive are traded in the Watchlist Market.

48

Bond Markets

Economic worries last year turned out to be great news for bond investors.

https://www.nytimes.com/2020/01/17/business/bond-market-investments.html

Interest rates fell sharply and bond prices rose as recession fears grew through the summer, resulting in the most profitable calendar year for bond fund investors since 2002. Core investments such as the Vanguard Total BondMarketIndexmutualfundandtheiSharesCoreU.S. Aggregate Bond exchange-traded fundgained nearly 9 percent in 2019.

Investors playing it safe in high-quality short-term bonds profited, too. The 3.5 percent gain for theSchwabShort-TermU.S.TreasuryE.T.F.wasmore than a percentage point above inflation. The BairdShort-TermBondfundgained4.7percent.Yet, the bond party of 2019 is expected to give way to a bit of a hangover this year.

“Youdon’tgetthosekindsofreturnstwoyearsin a row unless something really bad happens to the economy and interest rates take another slice down “ said John Mousseau, director of fixed income at Cumberland Advisors, a money manager.

That’s not widely anticipated. Mike Pyle,global chief investment strategist at BlackRock, expects that “the big forces” that set off last year’s bond rally are “going to recede into thebackground.”

After three rate reductions last year in response to concerns about global growth, the FederalReserveisnowsignalingthatitintendstosit tight this year as improving economic data has apparently reduced the likelihood of a recession. “The barriers to cutting rates seem pretty high, and the barriers to raising rates from here are higherstill,”Mr.Pylesaid.

A better global economic outlook should also tampdowndemandforUnitedStatesbonds.Lastyear, when global recession chatter was increasing duringtheU.S.-Chinatradewar,investorsclamoredforthesafetyofUnitedStatesTreasuries,whichhadthe added allure of offering much higher yields than the negative rates paid on government bonds issued by Japan and many European economies.

Theyieldon the10-yearTreasurynote fellfrom a high of 3.25 percent in late 2018 to a low of 1.45 percent in early September.That yieldtumble — which played out in corporate and municipal bonds as well — is what set off the big 2019gainsforbondfundsandE.T.F.s.

Mr. Mousseau expects that the 10-year Treasurycouldrisefromitscurrent1.9percentto2.25 percent this year. “We are back to clipping coupons,” he said. Without falling rates to increase prices — interest rates and bond prices move in opposite directions — returns will be a simple function of the interest bonds pay. That suggests core bond returns of around 2 percent.

While bond investors profited as rates fell, the Fed’s 2019U-turnwas “a big disappointment”for money-market investors, said Ken Tumin,editor of DepositAccounts.com.

After seeing cash rates rise throughout 2017 and 2018 — the first signs of life since the financial crisis for savers seeking safe and liquid income — rates slumped in 2019 in sync with the Fed’s rate cuts. For example, in December2018, the online Ally bank offered a certificate of deposit that guaranteed a 3.1 annual yield for five years, which was well above the rate of inflation. A five-year Ally C.D. bought in December paid a 2.15 percent yield.

Mr. Tumin says high-yield savings accountsfrom online banks and credit unions offer the “most bang for the buck” for savers today. While brick and mortar banks and credit union savings accounts pay less than 0.2 percent on average, there are plenty of online savings accounts with yields ranging from 1.7 percent to above 2 percent.

Despite that risk-free opportunity to bolster cash performance, Christopher Cordaro, chief investment officer of Regent Atlantic financial advisers, says he sees plenty of new clients who are “earning next to nothing at their brick and mortar.”

He says he has taken on clients who had more than $1 million in an old-school bank account with virtually no yield. That inertia works out to a self-imposed penalty of $17,000 to $20,000, which is about what $1 million can earn if it is moved to a high-yield savings account.

In Practice

49


Mr. Cordaro also says savers are probably leaving cash on the table in their brokerage accounts. “Brokerage firms have gone to charging zero commission on trades, but they can afford to do that by basically paying nothing on your sweep account,” said Mr. Cordaro, referring to the cash account where proceeds from trades are parked.

AccordingtoCraneMoneyFundIntelligence,the average brokerage sweep account had a yield of 0.13 percent in December. Money-market mutual funds offered by those same brokerage firms — but not the default option — paid more than 1 percent.

For example, making a low-yielding bankaccount the default option for cash accounts has become amajor revenue generator forSchwab.A$100,000balanceinaSchwabsweepaccounthad a 0.06 percent yield in December. Alert investors who move their cash into a Schwabmoney-market account could earn more than 1.5 percent in December.

“‘Free’ makes people do silly things,” saysMr. Cordaro. “You would be better off paying $5 to trade and have a better sweep account.” Fidelity andVanguard continue to usemoney-market mutual funds, with higher yields than bank accounts, as the default for their investors.

For longer-termbonds, investorsmayneedto accept that they need to emphasize either safety or income. But, no single type of bond is likely to excel at both.

WhileTreasury yields aremeager,Treasurybonds are the best ballast when stocks are falling, and that is worth remembering, more than 10 years after the start of a stock bull market.

Mr.PyleofBlackRocknotedthatwithlowconcern for a sharp pickup in inflation, prices forTreasury Inflation Protected Securities havenot been bid up as much as those for regular Treasuries.Thatmakes2020a“goodentrypoint”to build in some long-term protection to rising prices. Morningstar, the fund research firm, recommends Vanguard Short-Term Inflation-ProtectedSecuritiesandSchwabU.S.TIPS.

For income seekers willing to take onmorerisk,Mr.Pylesaid,high-yieldbondsareareasonable way to generate more income, if you acceptBlackRock’soutlookformoderategrowth,withoutarecession,intheUnitedStatesthisyear.

For example, the Vanguard High-YieldCorporate fund had a current yield of 4.2 percent in December, compared with 1.7 percent for the Vanguard Intermediate Treasury fund.BlackRock also recommends emerging-market bonds, which it says could do well at a time when the global economic outlook is solidifying. The TCWEmergingMarkets Income fundhas a 5percent current yield.

But, high yield is often called “junk,” because it comes with a risk. When stocks are falling, bonds that pay higher yields tend to experience sharp price declines that lead to negative total returns. During the last bear market, the Vanguard High-Yield Corporate fund lost 24percent.TCWEmergingMarketsIncomelost10percent. Vanguard Intermediate TermTreasurydelivered the ballast, gaining nearly 17 percent.

How can investors use the concept of convexity in bond investments?

Associate the duration of a bond with changes in the interest rates.

Tell the difference betweenthe duration and modified duration.

3 Identify risks of bond investments


Learning Outcomes

Bond Markets

50

Sum

mar

y

LO 1 Explain the main characteristics of bond investments

Companies satisfy their financing needs by debt or equity. If the companies need long term financing and decide to fund their investments by debt, bond is a good alternative for financing. Besides companies, bonds are issued by governments and government corporations too. In this context, bond can be defined as financial instruments issued by companies or governments in order to finance long term financing needs. Buyer of bonds receive periodic interest payments and par value of the bond at the maturity date that refers to specified date determined with the indenture. There are different types of bonds issued depending the needs of issuer and demand of the investors. Fundamentally,bondscanbeclassifiedasgovernmentbondsandcorporatebonds.Governmentbondsare the bonds issued by governments and public sector bodies, and other bonds are called as corporate bonds. In terms of entitlement, bonds are classified as bearer and registered bonds. Bearer bond is a bond type that the owner is the person who holds it. But, registered bond is the bond which contains the name of the owner on the bond. Due to the cash flows that the bond provide, bonds types are straight coupon bonds and zero-couponbonds.Straight couponbondsprovide theholder to receiveperiodic couponpayments and principal. But, zero-coupon bondholders buy the bond at a discounted price, and they are paid par value at the maturity instead the coupon payments. Based on the guaranteed they carry, bonds are classified as debenture bonds, secured bonds and guaranteed bonds. While the payments of debenture bonds depending on the general credit strength of the issuer, the payments of secured bonds are secured by a pledge asset of the issuer, and the payments of secured bonds guaranteed bonds are guaranteed by another corporation or corporations. There are also international bonds which are called as Eurobonds and foreign bonds. Eurobond is a denominated in a currency that is different from the currency of country where the bond issued and foreign bond is a type of bond that is issued by a foreign company or foreign government, which are denominated in the currency of the country where they are sold. Besides these types of bonds, there are floating-rate bonds, callable and puttable bonds, index-linked bonds and convertible bonds that satisfy different needs of issuers and the investors.

LO 2 Describe the logic of bond valuation

As in the other financial assets, the value of a bond is present value of the cash flows that will be received from the bond. Therefore, value of a bond is equal to the sum of present value of coupon payments and the principal one that will be paid at the maturity date. Bond valuation process is relatively easier than the other financial assets since the cash flows of the bonds are periodic and principal payment is definitely known. Especially thevaluationof zero-couponbonds isquite simple.Valueofa zero-couponbond is equal tothepresentvalueofthebond’sparvalue.Inthebondvaluation,theimportantpointistodeterminetheappropriate discount rate. The discount rate that will be used in the bond valuation consists of a risk-free rate and a risk premium. Coupon rate of government bonds is used as risk-free rate, and the risk premium is determined by considering economic, industrial and firm level risks. Therefore, the factors that affect thediscountratecanbesortedas: theeconomicoutlook,monetarypolicyofthecountry,government’sborrowing needs, inflationary expectations, the level of economic activity, the level of capital inflows, the credit rating of the bond determined credit rating agencies, the capital structure of the company, company conditions. The effects of these factors may be different depending on the type of bond.


51

Sum

mary

LO 3 Identify risks of bond investments

Just like other investments, bond investments carry risks. One of the most important risks for the bondholders is default risk. Default risk is the risk that the borrower will fail to meet the obligations at the determined dates. The default risk reflects the invest ability of the bond and the bonds with high default risks are accepted as speculative investment vehicles. There are credit rating agencies that evaluate the default risk and give ratings to the bonds. The possibility that the rating of the issuer or instrument to be downgraded by rating agencies is called downgrade risk. Interest rate risk also crucial for bond investments because bond prices move in the opposite direction of the interest rate changes. On the other hand, interest rates are important for the bondholders who received to the coupon payments. Bondholders desire to reinvest the coupon payments. Yet, there is possibility that the investor may reinvest the money at a lower rate and this is called reinvestment risk. Reinvestment risk is high for the callable bonds, since the issuer has call provision. The call provision creates the call risk for the bondholder. Another risk for thebondinvestmentsisinflationrisk.Inflationaffectstherealreturnoftheinvestments.Forthisreason,bondholdersshouldevaluatetheinflationriskintheirinvestmentdecisions.Forbondsdenominatedina foreign currency, currency risk is quite important. Currency risk refers to the potential loss arises from the changes in the exchange rates.

Bond Markets

52

Test

You

rsel

f

1 Which of the following gives the current yield of the bond?

A. The ratio of the coupon periods to the call price of the bond

B. The ratio of the annual coupon to the market price of the bond

C. The ratio of the annual coupon to the put price of the bond

D. The ratio of the coupon periods to the par value of the bond

E. The ratio of the annual coupon to the par value of the bond

2 The rate that equates the bond price to the present value of its coupon payments and principal is called ………..

Which of the following is written in the blank?

A. compound yieldB. yield to maturityC. nominal yieldD. real return E. reference rate

3 ……….. are unsecured bonds, where the payments depend on the general credit strength of the issuer.


A. Corporate bondsB. StraightcouponbondsC. EurobondsD. Bearer bonds E. Debenture bonds

4 Which of the following refers to the rate that issuer agrees to pay above the determined reference rate for the floating-rate bonds?

A. Risk-free rateB. Conversion marginC. Reference rate D. Quoted marginE. Primerate

5 What is the value of a 3-year zero-coupon bond with a $1,000 par value if the required return is7%?

A. 802.25 B. 810.70C. 816.30 D. 856.75E. 903.90

6 Dirty price of a bond is $972.68. If the accrued interest is $17.44, what is the clean price of the bond?

A. 900.12 B. 918.40C. 933.96 D. 947.88E. 955.24

7 A bond portfolio consists of four bonds. The weightsofbondsintheportfolioare15%,20%,30%and35%.Ifthedurationsofthebondsare4.4290, 0.9512, 3.1856 and 1.8348 respectively, what is the duration of the portfolio?

A. 2.4524 B. 2.0854C. 1.948 D. 1.8764E. 1.7936

8 What will be the change in the bond price for a 150-basis point change in the yield, if the convexity of the bond is 18.6489?

A. 18.56% B. 18.97%C. 19.34% D. 20.98%E. 22.52%

9 ……… is the possibility that the issuer will buy back the bond before the maturity date.


A. Default risk B. Market riskC. Call risk D. Reinvestment riskE. Downgrade risk

10 Which of the following is the risk type that is evaluated by the credit rating agencies?

A. Default risk B. Currency risk C. Interest rate risk D. Reinvestment riskE. Inflation risk


53

If your answer is wrong, please review the “BondValuation”section.

1. B If your answer is wrong, please review the “BondValuation”section.

6. E

If your answer is wrong, please review the “CharacteristicsandTypesofBonds”section.

3. E If your answer is wrong, please review the “Risks of Bond Investments” section.

8. D


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

7. A

If your answer is wrong, please review the “CharacteristicsandTypesofBonds”section.

4. D


5. C

If your answer is wrong, please review the “Risks of Bond Investments” section.

9. C

If your answer is wrong, please review the “Risks of Bond Investments” section.

10. A

What are the elements that determine the characteristics of bonds?

self review 1

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

Answ

er Key for “Test Yourself”

Suggested answ

ers for “Self R

eview”

Bond Markets

54

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

self review 2

How can investors use the concept of convexity in bond investments?

self review 3

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

YTM is the rate,which equates the bondprice to thepresent value of itsfuture cash flows, and it is a measure of the growth rate of the investment. It is calculated by using the formula, which is used in bond valuation. Yet, this time, the value of the bond is known, and the equation is solved for “” that givestheYTM.

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Aarons, M., Ender, V. and Wilkinson, A. (2019).Securitisation Swaps: A Practitioner’s Handbook, WestSussex:JohnWiley&Sons.

Arnold, G. (2015). The Financial Times Guide to Bond and Money Markets,Harlow:PearsonEducation.

Bailey, R. E. (2005). The Economics of Financial Markets,NewYork:CambridgeUniversityPress.

Bodie, Z., Kane, A. and Marcus, A. J. (2018). Investments, (11th Edition), New York: McGraw-Hill Education.

Brentani, C. (2004). Portfolio Management in Practice, Oxford: Elsevier Butterworth-Heinemann.

Brigham,E.F.andHouston,J.F.(2019).Fundamentals of Financial Management, (15th Edition), Boston: Cengage.

Brown, P. J. (2006). An Introduction to the Bond Markets,Chichester:JohnWileyandSons.

Burton, M., Nesiba, R. and Brown, B. (2015). An Introduction to Financial Markets and Institutions, (2nd Edition), New York: Routledge.

Chisholm, A. M. (2002). An Introduction to Capital Markets: Products, Strategies, Participants, London: JohnWiley&Sons.

Choudhry, M. (2001). The Bond and Money Markets: Strategy, Trading, Analysis, Oxford: Butterworth-Heinemann.

Choudhry, M. (2005). Fixed Income Securities and Derivatives Handbook: Analysis and Valuation, Princeton:BloombergPress.

Choudhry, M. (2006a). An Introduction to Bond Markets, (3rd Edition), Chichester: John Wiley andSons.

Choudhry, M. (2006b). Bonds: A Concise Guide for Investors,Hampshire:PalgraveMacmillan.

Drake, P. P. and Fabozzi, F. J. (2010).The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management, New Jersey:JohnWileyandSons.

FabozziF.J.andMann,S.V.(2005).The Handbook of Fixed Income Securities, (7th Edition), New York: McGraw-Hill.

Fabozzi, F. J. (2013). Bond Markets, Analysis, and Strategies, (8th Edition), New Jersey: PearsonEducation.

Gündoğdu, A. (2017). Finansal Yönetim, Ankara: SeçkinYayıncılık.

Haan,J.Oosterloo,S.andSchoenmaker,D.(2012).Financial Markets and Institutions: A European Perspective, (2nd Edition), Cambridge: Cambridge UniversityPress.

Hiriyappa, B. (2008). Investment Management: Securities and Portfolio Management, New Delhi: New Age International.

Johnson,R.S.(2010).Bond Evaluation, Selection, and Management, (2nd Edition), New Jersey: John WileyandSons.

Johnson, R. S. (2013). Debt Markets and Analysis, NewJersey:JohnWileyandSons.

Kettell, B. (2002). Economics for Financial Markets, Oxford: Butterworth-Heinemann.

Loader, D. (2002). Understanding the Markets, Oxford: Butterworth-Heinemann.

Martellini,L.Priaulet,P.andPriaulet,S.(2003).Fixed-Income Securities: Valuation, Risk Management and Portfolio Strategies, West Sussex: John Wiley &Sons.

Melicher, R. W. and Norton, E. A. (2017). Introduction to Finance Markets, Investments, and Financial Management, (6th Edition), Danvers: John Wiley &Sons.

Pilbeam, K. (1998). International Finance, (2nd Edition), Hampshire: MacMillan Business.

Rini, W. A. (2003). Fundamentals of the Securities Industry, New York: McGraw-Hill.

Robinson, R. I. and Wrightsman, D. (1980). Financial Markets: The Accumulation and Allocation of Wealth, (2nd Edition), New York: McGraw-Hill.

Williams, R. T. (2011). An Introduction to Trading in the Financial Markets: Trading, Markets, Instruments, and Processes, Burlington: Academic Press.

Wright,S.S. (2003).Getting Started in Bonds, (2nd Edition),NewJersey:JohnWiley&Sons.

References

56


Chapter OutlineIntroductionDefinition and Properties of StocksTypes of StocksStock ValuationStock IndicesMajor Stock Markets

Key TermsDividend

Capital LiabilityIntrinsic Value

Preferred StockGordon Dividend Discount Model

Price-Earnings RatioStock Index

Volatility Spillover

Lear

ning

Out

com

es

Explain models that are used in stock valuation

Discuss the importance of stock markets for economies

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

Discuss the importance of stock indices in investment decisions3

5

1 24

Stock Markets

57


INTRODUCTIONInvestors have several options to invest their

money. They may put their money in a bank, they may purchase a house or invest in financial securities. One of the securities that the investors may invest in is stocks. Stock investment is a risky alternative, but it provides high returns to the investors. Therefore, it is one of the most popular financial instruments in the financial markets. Holding stocks of a company does not make the investor responsible for the operations of the company, but it gives the right of voting in the general assembly and making claims on the profit and assets of the company (Duncan, 2015, p.3). Investors may have these rights according to the type of stocks they purchased. On the other hand, they can obtain capital gain resulting from the difference between buying and selling prices.

From the perspective of a company, issuing stock is a type of equity financing, and it is a good financing alternative especially when the interest rates are high for borrowing. Issuing stock provides permanent financing to the company since there is no specified maturity date, and companies do not have to make regular payments as is in debt financing. Companies choose their financing method and tool by evaluating the economic conditions and the company’s conditions. If the conditions indicate equity financing is favorable, companies may issue stocks.

This chapter consists of four sections. In the first section, basic definitions of stocks and the rights and liabilities of stockholders are given. The second section focuses on types of stocks and features of these stocks. In the third section, stock valuation models and examples regarding these models are presented. The final section provides an overview of stock markets. In this section, information about the stock indices that are used as indicators in the stock markets are given.

DEFINITION AND PROPERTIES OF STOCKS

Stock is a financial instrument that companies issue to raise capital in order to satisfy their financing needs. Stock represents a share in the ownership of the company. From the perspective of the investor, stock is a security that provides rights

such as receiving some share from the profit and participating in the management of the company and (Kuen, 1997, p. 52). A certificate given to the investor shows the ownership of the investor to the company. This certificate may be a physical copy or an electronic copy. In the past, physical copies were needed to prove ownership, but in today’s financial world electronic copies are preferred due to the developments in technology.

Motivations of stockholders may be different. Some of them buy stocks in order to receive dividends and some of them buy to gain from the difference between buying and selling prices.

Stock investments provide two types of return: dividend and capital gain.

Dividend refers to the proportion of net profit that is paid to the stockholders.

The investors, who buy stocks for dividend payment, buy stocks and hold them generally for long periods. They take dividend payments from the profit of the company with respect to their shares. The investors seeking for capital gain try to buy in low prices and sell when the prices go up, as a result, the difference between the prices is the profit of the investor.

There are many factors affecting the return that will be gained from stock investments. One of these factors is inflation. In fact, financial specialists consider stock investments as a hedge against inflation mainly because inflation increases the value of companies’ assets such as buildings, factories and land. Moreover, companies raise the price of goods and services as the inflation rises and increase their revenues. As the stocks provide ownership to the company, this revenue increase is reflected in the return of the stockholder, and thereby investment is protected against inflation. Yet, this situation is not true in all cases. Sometimes rising prices due to the inflation cause decreases in sales and accordingly in revenues of the company. On the other hand, in inflationary periods, the

58

Stock Markets

prices of materials and supplies increase too, and borrowing and labor costs are higher than low inflation periods. Therefore, production costs increase and this leads to decreases in the profit of the company (Scott, 2005, p.146).

Another factor that affects stock prices or returns is interest rates. Interest rates affect the stock price through two channels:the cost of capital and demand for alternative financial instruments. Companies can finance their assets by debt or by equity. If the company chooses debt financing, then the interest rates will determine the cost of capital, and if the interest rates are high the cost of capital will be high. Especially, if the company prefers to borrow with a floating rate, the increases in the interest rates will cause increases in the borrowing costs, and hence the profitability of the company will decrease. This situation may result in decreases in stock prices. On the other hand, increases in interest rates will make the fixed income securities attractive for the investors since stocks and the other financial securities are alternatives to each other. If the return that will be gained from the fixed income securities such as bonds and commercial papers is high, investors may change their portfolios against stocks, and the decrease in the demand for stocks causes decreases in the price of stocks (Apergis and Eleftheriou, 2002, p. 232).

There are also other macroeconomic factors other than interest rates and inflation that have effects on stock prices. The most investigated of these factors in the financial literature are money supply, economic growth, industrial production, exchange rates and real activity.

Rights and Liabilities of StockholdersThe investors who buy the shares issued by the

company are considered as shareholders, and this provides some rights to them as indicated at the definition. Owing stocks imposes some obligations on investors too. These rights and liabilities can be listed as follows:

• Righttodividend,• Righttopreemption,• Righttoliquidationsurplus,• Right to vote and right to participate in

management, • Righttodemandinformation,• Secrecyliability,• Capitalliability.

Right to DividendOne of the most important financial rights of

stockholders is the right to receive share from the net profit. However, this right can be limited by the decision of the general assembly. If the company has profit in the relevant operating period and the general assembly gives approval, the portion of the profit that will be paid to the stockholders is called dividend. Companies generally pay only part of their profits as dividend. They use the remainder to fund new investments of the company (White, 2007, p. 30). Each shareholder has the right to benefit from the profit of the company and to receive dividend from the portion of the profit to be distributed. Companies may distribute their profits as cash or by issuing new shares that will be added to the capital of the company. By dividing the amount of the dividend paid to the number of shares, the dividend per share is calculated.

important

Companies may prefer not to distribute dividends. They may use this fund to finance the new investments of the company that is expected to increase the value of the company.

Right to PreemptionRight to preemption refers to the right of

existing stockholders to purchase new stocks issued in the event of capital increases in proportion to their shares in the existing capital. In other words, in the capital increase the current stockholders have the right of purchasing newly issued stocks in proportion to their existing shares before the stocks are sold to new investors. This right helps the stockholders to keep the control of the company, and prevents the transfer of company management from the existing stockholders to the new ones (Okka, 2009, p. 469). Companies may sell new stocks at a lower price than the market price in order to protect the existing stockholders who exercise the preemption right. If existing stockholders do not exercise this right, companies may sell stocks to new investors.

59


important

The right to preemption is important for the stockholders to keep the management of the company. For this reason, the stockholders of small companies may be granted preemption rights.

Preemptive rights are important especially for small companies that have few shareholders since in case of any capital increase in such companies, the existing stockholders can lose voting rights and management power due to selling new shares to the new investors. However, in large companies, it is hard for new stockholders to take the control of the company since the number of the shareholders is more. In addition, average stockholders of large companies are not interested in their proportionate ownership of the company. On the other hand, it would be difficult in large companies to exercise the preemption rights. For these reasons, stockholders of large companies are rarely granted preemption right (Schneeman, 2010, p. 365).

There are two main purposes of granting stockholders preemption right. The first reason is to protect the power of existing shareholders in the management. Without this protection, the management of a company criticized by a group of shareholders will be changed by issuing large amounts of new shares. In this case, the requests of existing shareholders will be ignored. The second reason is to protect the shareholders against price decreases. The sale of the stocks at a price below the market price will reduce the price of the stocks in hand. Thus, there will be wealth transfer from existing shareholders to the new stockholders. The right of preemption prevents the occurrence of these situations.

Right to Liquidation SurplusOne of the rights of stockholders is the right

to liquidation surplus. This means that the portion of the assets remaining after the debts are paid is distributed to the stockholders in proportion to their shares in the capital of the company in case of liquidation of the company. Yet, the right to liquidation surplus can be exercised only if there is a remaining part after the debts are paid. Stockholders participate into the surplus in proportion to their

shares. If the liquidation surplus is negative, it creates a debt to the stockholder limited to the unpaid capital. If the capital obligation is fulfilled, the debt is not in question.

Right to Vote and Right to Participate in Management

Each of the stockholders has a minimum one voting right. Yet, the voting right of a stock may be increased on condition that granting preference on voting. However, companies can issue stocks which do not carry voting rights. The stockholders may participate in the general assembly through the right to vote and have a say in many operations of the company. Some of these operations are (Varrenti, Cuevas and Hurlock, 2011, p. 191) as follows:

• Decisionstoacceptoramendthearticlesofassociation of the company,

• Decisions such as capital increase, bondissuance, dividend distribution, changing the type of the company, merger and liquidation,

• Appointment and replacement of seniorexecutives such as board members, CEO and auditors,

• Release of the operations of the board ofdirectors and auditors,

• Approvalofannualreports,• Alteration of the rights attached to the

securities issued by the company,Voting and participating rights enable

stockholders to elect and even be elected to the board of directors. The election of the board of directors and supervisory board is carried out by the votes of the shareholders. The members of the board of directors are elected as the representatives of the shareholders. The board appoints and audits the senior staff of the management and acts with management. In many companies, shareholders elect the members of the board according to the majority-vote system. In this case, each member is voted separately, and the shareholders cast one vote for each share they hold.

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Stock Markets

important

Voting rights can be transferred to the second persons by proxy. Therefore, stockholders may try to change the management through the proxy if they are dissatisfied with the operations and the management of the company.

Stockholders may transfer their voting rights to second persons by “proxy”.

Therefore, the management usually tries to get the proxy of the shareholders and often accomplishes this. If stockholders are not satisfied with profitability and other managerial issues, they may try to form a group outside the company by “proxy” in order to change management and take control of the company (Bodie, Kane and Marcus, 2003, p. 8). This situation is known as the proxy war.

Right to Demand InformationRight to demand information refers to the

right of the stockholders to receive information about all types of company operations. This right cannot be prevented or restricted by the articles of association or the decision of any unit of the company. Shareholders may draw the attention of the auditors to matters that they consider as suspicious and may ask for explanations if they deem it necessary.

important

Stockholders have the right to review the profit and loss situation, annual reports and balance sheet within the one year following the general assembly meeting. However, none of the stockholders has the right to learn the company’s trade secrets.

Secrecy LiabilityUnder any circumstances, the stockholders are

obligated to keep the company’s business secrets, even if they leave the partnership. Stockholders who do not fulfill this obligation are liable to

the company for any losses that may arise. The mentioned owners may be penalized with the complaint of the company even if no loss is expected.

Capital LiabilityStocks impose liabilities to the owners besides

providing some rights. One of the most important liabilities is to pay the capital that stockholders committed, both in new establishment and in capital increase. If the company bankrupts or goes into liquidation while the stockholders have not fulfilled their commitments yet, the unpaid portion of the commitments may be requested from the stockholders in order to pay the remaining debts of the company. On the other hand, additional liabilities may be imposed on the stockholders by the articles of association (Korkmaz and Ceylan, 2007, p. 183).

Besides providing rights, holding stocks imposes liabilities to the owners, and these liabilities are known as secrecy and capital liability.

Stock Value DefinitionsValuation is a process that aims to determine

the worth of an asset or a firm. Valuation can be conducted for many purposes such as buy and sell decisions, mergers and company acquisitions. In this context, the value of a stock can be measured for different purposes and in different ways.

Par (Face) Value: Par or face value is a legal term and refers to the minimum amount of money that the stockholders have to pay per share. The par value concept was developed to satisfy the need of lenders to evaluate the company’s solvency. Yet, in today’s financial world, the lenders generally consider the operating cash flows as the source of solvency, and the importance of par value is not as much as the past. On the other hand, par value of a stock generally has no relationship to its market value. In other words, the term of par value has little economic significance. Therefore, the par value of the stocks are quite low. Moreover, in some countries the companies are permitted to issue stocks without a par value (Werner and Stoner, 2007, p. 363).

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Book Value: Book value refers to accounting value reflected in the financial statements. Book value is an historical value and it may be quite different than the market value. It is the sum of par value, paid in capital and retained earnings, but firms generally report it on a per share basis. The book value per share is calculated by dividing the book value of the shareholders’ equity by the number of shares outstanding (Baker and Powell, 2005, p. 104).

Going Concern Value: This value is estimated based on the assumption that the company will continue its operations into the foreseeable future. In this context, going concern value can be defined as the value that result from the company’s operations, assets, customers and workforce as a whole. Determination of going concern value is important especially when a company wants to acquire another (Carey and Essayyad, 2005, p. 45).

Liquidation Value: Liquidation value is the value that remains after all the assets of the company are sold, and the liabilities including preferred stocks are paid off. Liquidation value per share is calculated by dividing this amount to the number of common stocks (Chaturvedi, 2009, p. 94).

Issuance Value: Issuance value refers to the price at which stocks are issued. Typically, stocks are issued at a price above the par value. In some countries, companies are not allowed to issue stocks below the par value.

Market Value: The market value of a stock is the price that stock is traded in the market. For another definition, market value is the price that the buyer accepted to buy and the seller accepted to sell the stock. The market value is determined

by supply and demand. Supply and demand to a stock, hence market value, is affected by many factors such as earnings, growth potential of the company and company size. The market value of stocks listed on stock exchange can be established easily (Chandra, 2008, p. 436).

Intrinsic (Real) Value: The intrinsic valueis obtained by discounting the cash flows that the investor expects to get from the investment in a specified period. Therefore, intrinsic value of a stock depends on the expected cash flows received from the stock, riskiness of the stock and the discount rate which represents the investor’s required rate of return. This value is important especially for the investors and typically used in investment decisions. Investors calculate the intrinsic value and compare it to the market value of the stock. If the intrinsic value is greater than the market value, then it means stock is undervalued. Under this condition, it is expected that the price will increase in the future, so that investors may take a long position in the stock. If the intrinsic value is lower than the market value, then it means stock is overvalued and investors may sell the stock if they hold it or they may short the stock (Stoltz et al., 2007, p. 156).

important

Investors use intrinsic value as a benchmark in order to determine if the stock has a fair price or not. While an intrinsic value greater than the market price indicates an undervalued stock, an intrinsic value lower than the market price indicates an overvalued stock.

How does inflation affect stock returns?

In which markets do market values reflect real values?

Tell the main reasons of companies to issue non-voting stocks.

1 Define the concept of stock and stock value.


Learning Outcomes

62

Stock Markets

TYPES OF STOCKSThere are different types of stocks in the

financial markets that are attractive for different investor types. Each of these stocks has its own advantages and disadvantages, and investors choose them according to their expectations. Some of the investors are willing to take high risks for high returns, while some of them prefer low but guaranteed return. Some of the investors just consider the return of the investment and they do not care about the risks. Therefore, investors invest in alternative types of stocks based on their attitude towards risk and return expectation.

Common StocksThe companies may issue one or more types

of stocks that each has its own rights and features. One of these stock types is common stock. Common stock is the basic type and the most traded one in the financial markets. They are issued to satisfy the company’s financing needs. This type of stock gives the right of voting to the holder in the management decisions (Duncan, 2015, p. 5). Each of the common stocks typically provides one voting right to the holder. Yet, the voting right is significant only if the holder has a majority or significant share of the company. The holders of common stocks also have the right of receiving dividends and right to liquidation surplus.

Ownership of common stock is represented by a certificate with information such as the name of issuer, the par value of the stock, the serial number, the name of the owner of the stock (if it is a registered stock) and the number of shares of ownership. In some cases, common stocks are classified as A type and B type. Differently from B type, A type of common stocks may give privilege in dividend distribution and participating management (Karabıyık and Anbar, 2010, p. 26).

Features of common stocks can be listed as follows (Faerber, 2008, p. 13):

• Holdersofcommonstocksaretheresidualowners of the company since they have voting rights and take risks associated with the company.

• In event of liquidation, they can be paidonly if there is a surplus after the debt holders and preferred stockholders take their claims.

• The financial liability of commonstockholders are limited to the amount of share they have.

• Common stockholders can receivedividends only if all of the obligations of the company are met and the dividend distribution is declared by the board of directors.

Preferred StocksAll of the stockholders have the right of

receiving income in the form of cash dividends from the profit. However, differently from the other stockholders, preferred stock owners have preference on the after-tax earnings and assets of the company if the company goes into liquidation. Another difference that distinguishes preferred stocks from the common stocks is that the dividend payments are usually stipulated for preferred stocks (Kuen, 1997, p. 52). Preferred stocks typically provide a guarantee of receiving fixed dividend payments. Yet, the dividends of common stocks usually depend on profitability of the company, so that payments may change during the holding period. Therefore, preferred stocks are suitable especially for investors who do not want to undertake a high risk. Since they are less risky than common stocks, their return is lower to the common stocks.

Features of preferred stocks can be listed as follows (Gulati and Singh, 2014, p. 208):

• Preferred stocks provide a priority righton profit and company’s assets in case of liquidation in respect to common stockholders.

• The dividends of preferred stocks aregenerally fixed. Due to the first and second features, preferred stocks are referred to as hybrid securities. Yet, the company is not obligated to pay dividends if the earnings are not adequate.

• As it is in common stocks, the preferredstocks represent ownership of the company.

• The dividends of preferred stockholdershave to be fully paid before the dividend payments of common stockholders.

• There are two types of preferred stocks:cumulative and non-cumulative. If the

63


dividends are not paid to the owner of the cumulative stockholder, next period the dividend of this period and the prior one are paid totally. There is no such payment to non-cumulative stockholders. Therefore, the rate of dividend paid to non-cumulative stockholders is usually higher than the dividends paid to cumulative stockholders.

• The ownership status of preferredstockholders is limited with respect to common stockholders. Normally they have not right to vote, they can vote only for decisions that affect their right attached to the stock.

• One of the important features of thesestocks is that they generally have lifetime differently from the common stocks.

Non-Voting StocksA non-voting stock is a security that provides its

holder the rights of other stocks with the exception of voting right. This type of shares are generally presented with the code A. The holders of non-voting stocks cannot vote in the company’s strategic decisions. The reason why the company issues these stocks is to provide funds without losing the management of the company. Therefore, non-voting stocks are suitable especially for family companies. The reason for the investors to buy these stocks is to take dividend payments (White, 2007, p. 28). The

holders of the non-voting stocks receive dividends with the other shareholders in the amount specified in the articles of association. Additionally, it must be paid preferred dividends to the non-voting stockholders at a rate to be specified in the articles of association. The preferred dividends are paid in cash. Unless the preferred dividend granted to the non-voting stockholders are distributed, companies cannot decide to allocate reserve funds, to transfer profit to the following year or to distribute dividends to other stockholders. However, non-voting stocks are not as popular as other stock types. Therefore, the price of these stocks are lower than the others. In order to make them attractive for the investors, companies can issue non-voting stocks which carry the right of purchasing common stocks of the company in a certain period or the right of replacing non-voting stocks with the common stocks at a fixed or variable rate. On the other hand, companies can give privilege to the non-voting stockholders regarding liquidation balance besides the privilege of receiving bonus stocks (Karabıyık and Anbar, 2010, p. 31).

important

Non-voting stocks provide holders the rights, which are provided by the other stocks with the exception of voting rights.

What are the differences between common stocks and preferred stocks?

Identify the advantage of preferred stocks in the event of liquidation.

Tell the importance of pre-emption rights for the company and the investor.

2 Identify different stock types


Learning Outcomes

STOCK VALUATIONStock investors follow stock prices to construct their decisions about investing in stocks. The price of a

stock is determined by the supply and demand forces. The supply and demand for a stock are determined by many macroeconomic and company based factors notably dividend, profitability and capital structure.

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Stock Markets

In many cases, the market price of a stock is different from the real value of the stock. If the market price is below the real value, it is thought that the prices will increase till it reaches the real value, and if the market price is above the real value it is considered as a signal that prices will decrease. The investors, especially seeking capital gain aim to find undervalued stocks, and to do this they have to calculate the real value of the stock. In the valuation process, there are three key elements; expected cash flows, timing of the cash flows and the discount rate. There are models in the financial literature developed to calculate the real value of stocks. In this section of the chapter stock valuation models: the discounted dividend model, price-earnings ratio model, market/book value model and regression model will be explained.

important

Macroeconomic factors such as inflation, interest rate, growth and company based factors such as dividend, profitability and capital structure affect the supply and demand of stocks.

The Discounted Dividend ModelThe discounted dividend model (DDM)

is one of the basic and oldest models used in stock valuation. In this technique, the present value of a stock is calculated by discounting the future dividends or net cash flows obtained from operations of the company (Korkmaz and Ceylan, 2007, p. 250). In practice, the future dividends are mostly used to value stocks. Yet the main difficulty here is to forecast the future dividends. To overcome this difficulty, growth models such as the Gordon Model, two-stage and three-stage models can be utilized or dividends can be calculated by using pro forma financial statements depending on a basis point (Pinto et al., 2010, p. 96). Another problem in applying the discounted dividend model is to determine the appropriate discount rate. The mentioned rate may be determined as a profitability rate that is acceptable for the investor. In the process of choosing the model to be used in

the valuation the type and dividend policy of the company should be considered. The discounted dividend model can be shown as follows:

P̂o =D11+ ks( )

+D2

1+ ks( )2+

D31+ ks( )3

+ ...+ D∞1+ ks( )∞

This equation can be expressed as follows:

P̂ = Dt1+ ks( )tt=1

∞

∑

Here, P̂o is the price calculated by considering expected dividend flows and risk of these dividend flows. However, this price may be different than the market price (Po). If the price calculated by the investor (P̂o) is higher than the market price (Po), the buying decision should be made. In the equation, D1 represents the expected dividend at the end of the first year, D2 represents the expected dividend at the end of the second year, and D3 represents the expected dividend at the end of the third year. In other words, Dt’s represent the expected dividend payments in the future. Since the expected dividend amount may be different for investors, the calculated price may be different. Finally, ks expresses the minimum return expected from the stock.

The Constant Dividend ModelIn the constant dividend model, it is assumed

that the growth is provided by internal funds of the company, and therefore the dividends paid to the stockholders does not change over the time (Dt = D) (Kasper, 1997, p. 38). This model is suitable especially for stable companies and the companies in the maturity stage. For example, blue chip stocks can be valued by using the constant dividend model. The model is also typically used to value preferred stocks, since they generally pay a constant dividend. The price of a stock can be calculated by the following formula:

P̂ = Dks

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important

In constant dividend model, the price of a stock is estimated under the assumption that the dividends paid by the company are fixed.

Assume that the company ABC, which is thought to show zero growth for a long period, paid $ 4.5 per share, and it is expected to continue indefinitely. If the rate of return on similar stock is %12, then ABC stock should be sold for:

P̂o =4.50.12

=$37.5

The constant dividend model is limited because companies may have negative growth values or they may be in the growth phase. On the other hand, companies have life cycles. They are established, grow, mature and decline. Especially newly established companies display high growth rates. In this case, the constant dividend model is not appropriate to value stocks. For the companies in the growth phase two-stage models can be used for valuation (Ehrman, 2006, p.54).

Constant Growth (Gordon) Dividend Discount Model

In the dividend discount model, dividends must be estimated for each future year. In Gordon model, it is assumed that dividends grow forever with a constant rate (g), and the expected return per share is equal to the sum of dividend return and the expected growth rate of the dividend (Bodie, Merton, and Cleeton, 2000, p. 247). Expected dividends for constant growing stocks are calculated by the following formula;

D1 = D0 (1 + g)1, D1 = D0 (1 + g)2, D1 = D0 (1 + g)t

important

In the Gordon dividend discount model, the price of a stock is estimated under the assumption that the dividends paid by company grow forever with a constant rate.

For example, suppose investors expect a 10% increase in dividends annually for a stock which paid $ 5 TL dividend. In this case, the dividend to be calculated after one year for the mentioned stock will be:

D1 = 5 (1 + 0,10)1 = $ 5,5

The second year:

D2 = 5 (1 + 0,10)2 = $ 6,05

The eighth year:

D8 = 5 (1 + 0,10)8 = $ 10,72

If the growth rate (g) is constant, investor can calculate the price of the stock by the following formula:

P̂o =D0 1+ g( )ks − g

=D1ks − g

Here, ks is the minimum return expected from the stock. In order to use the model, ks > g condition is a must. Otherwise, negative stock price will be calculated. On the other hand, it should be noted that the growth rate (g) in the model is assumed to increase at a constant rate forever.

Assume that, DMS Company paid $ 2 dividend per share, and it is expected that the dividends will grow 5% rate every year indefinitely. If is it assumed that the desired minimum return rate is 8% than the price of QWE stock should be:

P̂o =2 1+ 0.05( )0.08− 0.05

=$70

The formula of constant growth dividend model can be arranged as follows based on the calculation of ks ;

ks =D1P̂o

⎛

⎝⎜

⎞

⎠⎟+g

For example the expected dividend amount of XYZ company stock is $ 6 at the end of first year, and the calculated price for the stock is $ 75 TL. If is it assumed that the expected growth rate for the dividends is %20 than the expected return of ABC stock will be:

ks =675⎛

⎝⎜

⎞

⎠⎟+0,20=%28.

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Stock Markets

Price-Earnings Ratio ModelPrice-earnings (P/E) ratio is one of the most

used and best known models in stock valuation in the last decades. It gives an idea to the investor if the stock is fairly valued or not. However, it should not be forgotten that P/E ratios are affected by risks, and ratios may be higher or lower than it should be due to the optimistic or pessimistic investor behaviors. Nevertheless, using this ratio may be a starting point for the investors (Brigham and Houston, 2019, p. 340). If the ratio is low without a readily apparent reason, it means that stock is cheap. In this case, stock is an attractive investment opportunity especially for the patient investors who can wait until the market revalues it (Anderson, 2002, p. 16). The ratio is calculated by dividing the stock market price to earnings per share and shows how much investors are willing to pay for the company’s earnings per share before tax. Investors agree to pay more especially to the earnings per share of the companies which have high growth potential. While providing realistic results in efficient markets, the model gives deviant results for the developing stock markets. The price-earnings ratio is calculated differently for the assumptions that dividends are constant or the dividends grow with a constant rate. Under the assumption that the dividends are constant, the price-earnings ratio is calculated as follows:

important

Price-earnings ratio is affected by risks and investor behaviors, and therefore may be different than it should be. For this reason, investors should be careful particularly in valuing stocks of developing markets.

Pr ice−Earnings Ratio= P0E=

DE⎛

⎝⎜

⎞

⎠⎟

k=Payout Ratio

k

Here, P0 is the market price, E is the earning per share and k is the discount rate or required (expected) return of the stock.

Assume that Company A earned $3.5 per share and paid a dividend of $2.1 per share. If the required or expected return of the stock is 15%, in this case the payout ratio will be 60% (2.1/3.5) and P/E ratio will be:

Price−EarningsRatio= 0.600.15

=4

Under the assumption that dividends grow with a constant rate, the price-earnings ratio can be expressed as a function of payout ratio, discount rate and growth rate. In this case, the price-earnings ratio is calculated as follows:

Price−EarningsRatio= P0Et=

D1Et

⎛

⎝⎜

⎞

⎠⎟

k − g=Payout Ratio

k − g

If payout ratio of a company is 70%, expected return of the stock is 20% and expected future growth rate of the stock is 7%, then the P/E ratio will be:

Price−EarningsRatio= 0.700.20− 0.07

=5.38

As can be seen from the formula, the price-earnings ratio will increase with the increase in the payout ratio. In other words, there is a positive relationship between price-earnings ratio and payout ratio. Similarly, P/E ratio is positively related with the growth rate. However, there is a negative relationship between the ratio and the discount rate.

Market to Book Value ModelSimilar to the price-earnings ratio, market to

book value (MV/BV) ratio can be used in stock valuation as a starting point. While P/E ratio uses income statement for per-share earnings in the formula, market to book value ratio uses balance sheet for book value. If the market to book value ratio is low, it means that the stocks of the company are undervalued and will increase in the future. Therefore, investors may take a long position in the stock. If the ratio is high, it means that price will decrease in the future. In this case, investors should sell the stock if they have it or they may short sell the stock. Yet, it should not be forgotten that the ratio can be misleading. Investors should analyze if the company deserves the ratio, and if the ratio is affected by pessimistic or optimistic behaviors (Lee and Lee, 2006, p.176). The market to book value ratio is calculated by dividing market price per share to the book value per share and can be shown as follows:

67


MV/BV=Market Price per shareBookValue per share

The market to book value ratio is also calculated by the following formula;

MV/BV=MarketCapitalizationBookValue

For example, the stock price of Company MAST is $27 and its book value is $3,000,000. If the number of outstanding stocks is 250,000, then the market-to-book value ratio will be:

MV/BV= 27∗250,0003,000,000

= 2.25

important

In a fully efficient market, the market price of a stock should be equal to the real value of the stock. Therefore, if the MV/BV ratio greater than 1 this indicates that the stock is overvalued, and if the MV/BV ratio less than 1 this indicates that the stock is undervalued.

Regression ModelIn regression models one of the two or more

variables is considered as the dependent variable and the relationships between the dependent and various independent variables are given mathematically. In stock valuation, stock price is taken as the dependent variable and the factors such as interest rates, exchange rates, gold and money supply are considered as the independent variables that are thought to affect the stock price. Based on the relationships between the stock price and the selected independent variables, the value ofastockisdetermined.Regressionmodelcanbeshown as follows:

Yt =∞+β1x1+β2x2+ ...+βnxn+ut

In the equation, Y represents the stock price as the dependent variable, and x1, x2,..., xn variables are the independent factors that affect the stock price.

By using historical data, analysts create the regression equation and then calculate the next price based on their forecasts for the dependent variables. The weak point of this model is the usage of historical data to determine the regression coefficients and not to consider that these may change for different periods.

What are the difficulties encountered when The Dividend Discount Model is used in stock valuation?

Associate The Constant Dividend Model with the blue chip stock valuation.

TellhowPrice-EarningsRatioModel can be used in stock investment decisions.

3 Explain models that are used in stock valuation


Learning Outcomes

68

Stock Markets

STOCK INDICESStock market can be defined as the market

where the stocks are bought and sold. Yet, this definition may not be sufficient because different types of securities are traded in many markets named as stock markets. In this context, the definition may be extended as the market where different securities issued by companies and governments are bought and sold. Therefore, they enable investors to channel their savings into profitable investments and companies provide the funds they need. In other words, they support economic growth by creating a safe marketplace where savings can be channeled.

The main function of stock markets is to bring the companies and the investors together.

Changes in the stock markets have significant effects on the economy. For this reason, the stock markets are closely monitored by the public authorities, and stock indices are established in order to follow changes. Index is an indicator that consists of the movements of one or more variables, and it is used to measure the relative changes and differences. In other words, an index shows time-dependent changes in the values of the underlying variable such as commodity, product, income, financial instrument, economic data, intelligence, physical changes and social data. The main properties of the index are as follows (Medhi, 1992, p. 94):

• Showsrelativechanges,• Showsthechangesinstatisticaldata,• Usuallycalculatedonabasevaluesuchas100.Indices can be expressed numerically and refer

to a particular situation at a given time. They are the tools that allow the complex events to be reduced to numbers and provide approximate information about events and their consequences. Indices give the opportunity of making comparisons between the old and new situations, since they show continuity over time. On the other hand, they allow to compare two or more variables within the same or different period of time and can be used as estimators.

Indices are used as measurement tools in many areas and considered as indicators especially in the field of economy and finance.

In this context, there are too many indices calculated to be used in evaluating different features of the stock markets. In the stock exchange, the indices created to show the price changes of the stocks are called stock market index. Prediction of movement of the stock indices is quite important (Qiu and Song, 2016, p. 1) because it has effect on buy and sell decisions of the investors. Stock market indices provide information to investors about the price movements of secondary market securities.

important

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

The indices provide information about the structure and volatility of the capital markets, and this information has an impact on the decisions of the market participants. On the other hand, stock market indices are regarded as leading indicators for the real economy. For example, large declines in these indices are considered as the signal of economic distress (Cotti, Dunn and Tefft, 2015, p. 804). Especially in developing economies, the decline of stock market indices is considered as one of the crisis indicators. These indices also give investors insight into the price movements of securities in the market. Although they are numerical indicators, stock indices also reflect the expectations of the society for the future of the economy and may provide socio-economic and psychological information. In addition to providing information on mentioned areas, the indices may be used as the benchmark in performance measurement of the fund manager. The gains below the market index is generally accepted as the failure of the managers.

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important

Stock indices are considered as the leading indicators in evaluating economic and financial activities. The sharp declines in these indices may indicate a crisis particularly for developing countries.

The movements of the index contain information on the investors’ possibility of generating earnings from their portfolios. Increases in the index are considered as a signal that stocks’ future dividends will be better than in the past, while decreasing trends lead to a pessimistic picture about future dividends. In other words, indices have an impact on the expectations of the future direction of the stock market. As the developments in the economy affect the companies and the stock market, the indices reflect the news about both the market as a whole and the individual companies or sectors.

Besides being used as an indicator, indices can be used as investment vehicles. In today’s financial

world, there are too many financial instruments issued on indices. The investor who has a prediction on the movements of an index can invest in the index based securities and can make a speculative gain. Investing in indices protects investors especially from the bearish trends. The loss of an index will be lower than the loss of a portfolio constructed of a stock or group of stock (Wild, 2009, p. 95). In other words, index investing reduces the risk since indices are well diversified. Therefore, index investing is a good alternative especially for risk averse investors, and it is getting popular in financial markets. Especially in countries with developed stock markets, the volume of index-based financial products is quite high.

important

Since the indices are well diversified portfolios, index investing is quite popular for the investors especially those who do not have sufficient information about stock investing.

What are the advantages of stock index investing?

Associate the stock market volume with economic growth.

Tell the main benefits of stock indices as investment vehicles.

4 Discuss the importance of stock indices in investment decisions


Learning Outcomes

MAJOR STOCK MARKETSStock markets are one of the most important parts of the financial markets. They provide a link

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

70

Stock Markets

Stock markets contribute to price formation for the financial assets by bringing together a large number of buyers and sellers. The prices in the stock markets are references for many decisions.

The New York Stock Exchange (NYSE) is one of the oldest and largest stock markets in the world. NYSE is an American stock exchange which was founded in 1792. Many securities are traded in this exchange notably corporate stocks, corporate bonds and US Treasury securities. The Treasuries are traded over the counter (OTC), while the stocks are traded on the floor of the exchange. Not only stocks of US companies, but also stocks of companies from the different countries can be traded on this stock exchange. In order to be listed on NYSE, companies must register the securities under the Securities Act 1934 in addition to qualifying under standards of the exchange. Another US large stock market is NASDAQ (National Association of Securities Dealers Automated Quotation) which was founded in 1971. NASDAQ consists of a large inter-connected computer system, and there is no central location as in other stock exchanges (O’Connor, 2004, p. 62).

Tokyo Stock Exchange (TSE) is another large exchange in the world in terms of market capitalization and the number of listed companies. TSE was established in 1878, and is located in Japan. The trading volume in this exchange increased especially after World War II. Despite the significant declines in 2011, the exchange is considered as the world’s third largest stock market (Hafer and Hein, 2007, p. 103). Similar to the TSE, London Stock Exchange is an old stock market,

which was founded in 1895. LSE is located in London, which is the financial center of the world, and it is the largest stock market of Europe. Another European stock exchange accepted as one of the largest stock markets is Frankfurt Stock Exchange (FRA) which is located in Germany. Althoughmost of the securities traded at the exchange are German financial products, the exchange has become more international depending on the increaseinforeignsecuritylistings.Remoteaccessopportunity and cooperation with the other stock exchanges such as Vienna Stock Exchange, Zurich Stock Exchange and London Stock Exchange support the internalization process (Felsenstein, Schamp and Shachar, 2002, p. 99).

The Hong Kong Stock Exchange (HKG), which is one of the most important financial centers of Asia region, is considered one of the largest stock markets in the world. Hong Kong is aSpecialAdministrativeRegion (SAR)ofChina,but it has a free market economy. Foreign investors who have limited allowance to invest in Shanghai Stock Exchange and Shenzhen Stock Exchange, which are the main stock markets of China, can invest in HKG. Therefore, they can invest in China because the Hong Kong economy is connected to the Chinese economy (Smith, et al., 2008, p. 96).

important

The Hong Kong Stock Exchange is one of largest stock markets located in Asia. Although Hong KongisaSpecialAdministrativeRegion(SAR)ofChina, it has a free market economy and foreign investors can invest in HKG.

71


Table 2.1 Major Stock Markets and Indices

Stock Market - Country Index

The New York Stock Exchange - USA NYSE Composite

NASDAQ - USA NASDAQ Composite

Euronext Amsterdam - Netherlands AEX

Euronext Paris - France CAC 40

London Stock Exchange - UK FTSE 100

Frankfurt Stock Exchange - Germany DAX

Tokyo Stock Exchange - Japan Nikkei 225

Shanghai Stock Exchange - China SSE Composite

Hong Kong Stock Exchange - Hong Kong Hang Sang

Bombay Stock Exchange - India Sensex

Toronto Stock Exchange - Canada S&P/TSX Composite

BOVESPA - Brazil IBOVESPA

Volatility and Volatility SpilloverVolatility is a statistical measure of variability

in price or return of a financial variable. Volatility of financial instruments or markets is important because it reflects the risk of the instrument or the market. Volatility is caused by many factors such as new public information, changes in investor behaviors and economic and political developments (Stoll and Whaley, 1990, p. 4).

In stock markets, the large changes are generally followed by other large changes whereas small changes are followed by other small ones. This tendency causes increases in the volatility of the stock markets. Another factor that contributes to the volatility is trading and non-trading days. For example, on Mondays variability of the prices is higher due to the new information arriving 72 hours later. Thirdly, recessions and financial crises are the factors which change the volatility of the stock markets. In such bad economic conditions, volatility tends to be higher than the normal periods. Nominal interest rates is also accepted as one of the major factors that explain the volatility changes in stock markets. High levels of nominal interest rates cause high volatility in stock markets (Rossi,1996,p.3-4).

Volatility is a measure of risk that reflects the variability in price or return of a financial variable.

After the devastating effects of the 1997 Asian Crisis and the following crises, it is seen that crisis that occurred in a financial market can spread to the other financial markets through the financial and economic linkages. This phenomenon is called volatility spillover. For stock markets, volatility spillover can be defined as the effect of a stock market’s volatility on the volatility of another stock market (McAleer and Da Veiga, 2008, p. 2). There are relationships between the volatility of markets. Therefore, one of the major factors that explains the volatility changes in a market is the volatility in other related markets. Especially after the process of financial liberalization, linkages between the countries have increased due to the increases in the financial and economic relationships. This situation increases the importance of determination of the volatility spillovers between the markets. To determine the volatility of the stock market is important for investors, since it reflects the risk of the market. It helps investors to realize the information flows and the risk transfer between the markets and provides valuable information for portfolio and risk management strategies (Lee, Huang and Wu, 2014, p. 328).

Investors should determine the volatility spillovers between the markets in order to determine the volatility of the stock market properly. Volatility spillover is an input in predicting future volatility in both markets (Zhou, Dong and Wang, 2014, p. 722).

72

Stock Markets

important

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

What are the factors that affect the stock market volatility?

Associate volatility spillovers with the process of financial liberalization.

Tell the importance of volatility for portfolio management.

5 Discuss the importance of stock markets for economies


Learning Outcomes

BIST RISK CONTROL INDICESRisk Control Indices are ideal instruments

for the investors who want to limit the volatility of their investment on an equity index and/or a market. Although index options and warrants may be good alternatives for hedging purposes, their costs may increase substantially during the highvolatilityperiods.SincevolatilityofaRiskControl Index is predetermined and limited, costs of derivatives written on these indices would decrease accordingly.

With Risk Control Indices, investors havea chance to invest in an index portfolio which includes repo and underlying index with one transaction. Weights in the portfolio are adjusted daily according to realized volatility of the underlying index. Weights move toward repo index during the high volatility periods and move toward underlying index during the low volatility periods.

BIST Risk Control Indices are calculatedfor the target volatility levels of 10%, 15%,

20%, 25% and %30 for each underlying index. There are various options of target volatility level and investors can choose the underlying index and target volatility level according to their investment strategy and risk perception. AllBISTRiskControlIndicesarecalculatedinboth total and excess return basis. While Excess Return Index series reflects the daily return ofthe underlying index proportional to its weight intheindexportfolio,TotalReturnIndexseriesreflects the return of the index portfolio which includes both underlying index and repo index.

To take advantage of potential return of the underlying index during the low volatility periods, a maximum weight limit of 150% is applied for the underlying index.

Indices are calculated from the closing values of underlying index and repo index. Base date of the indices are December 31, 2003 and base values are 100.

BIST Risk Control Indices Ground RulesRisk Control Indices provide investors the

Further Reading

73


opportunity to invest in an asset class or an index at a predetermined level of volatility. These indices comprise of two components: an underlying asset or index, such as BIST 100, and another asset or index,whichisassumedtoberisk-free,suchasBIST-KYDRepoIndex(Net).Bydynamicallychangingthe weights of the underlying index and the repo index in the index portfolio, it is aimed that the volatilityleveloftheRiskControlIndexisfixedatthepredeterminedtargetvolatilitylevel.Inotherwords, the weight of the underlying index decreased during the high volatility periods and increased during the low volatility periods.

It is possible to limit the volatility of an index portfolio by changing the weight of underlying index in the index portfolio, according to its realized volatility level. This is the basic principle used to constructRiskControlIndices.Accordingly,BISTRiskControlIndiceshavetwomaincomponents;underlying index, which is aimed to be invested at a fixed level of volatility, and another index, which is assumed to represent a risk-free rate of return and used to stabilise the total volatility of the index portfolio. In order to attain target volatility level of the index, weights of these two components are rebalanced daily.

TwotypesofBISTRiskControlIndicesarecalculated;ExcessReturnandTotalReturn.WhileExcessReturnindexseriesreflectsthedailyreturnoftheunderlyingindexproportionaltoitsweightin the indexportfolio,TotalReturn indexseries includes returnofbothunderlyingandrepo indexproportional to the weights in the index portfolio.

Weight of the underlying index is calculated by dividing the target volatility level to the realized volatility level of the underlying index. Target volatility level is determined at the index development stage and remains unchanged through the index life. In order to limit the leverage of the underlying index during the high volatility periods, weight of the underlying index is capped in the index portfolio. Maximumweightoftheunderlyingindexis150%inallBISTRiskControlIndices.

In order to be able to take both short and long term volatility levels into account, the maximum of 21and63dayhistoricalvolatilityvaluesareusedinBISTRiskControlIndices.

TradingcostsareignoredwhilecalculatingthereturnofBISTRiskControlIndices.Indicesarecalculated for the days when both equity and repo/reverse repo markets are open. For the next business day after one or both of these two markets are closed, the last day, where both markets are open, is taken as the previous day (t-1) in the calculation of index return.

BISTRiskControlIndicesareshowninthetablebelow.Everyindexonthetableiscalculatedasboth total and excess return.

BIST Risk Control

Index

Underlying Index Target Volatility Level (%)

Underlying Index Maximum Weight Limit (%)

BIST 30 RK %10 BIST 30 10 150

BIST 30 RK %15 BIST 30 15 150

BIST 30 RK %20 BIST 30 20 150

BIST 30 RK %25 BIST 30 25 150

BIST 30 RK %30 BIST 30 30 150

BIST 100 RK %10 BIST 100 10 150

BIST 100 RK %15 BIST 100 15 150

BIST 100 RK %20 BIST 100 20 150

BIST 100 RK %25 BIST 100 25 150

BIST 100 RK %30 BIST 100 30 150

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

74

Stock Markets

A Funny Thing Happened on the Way to the Stock Market Record

Asset bubbles and the desperate search for profits amid negative rates aren’t laughing matters. Be afraid.

By Peter Coyht tp s : / /www.b loomberg . com/news/

articles/2019-12-19/this-funny-thing-happened-on-the-way-to-the-stock-market-record

Apologies for being churlish in the holiday season, but the let-nothing-you-dismay attitude of the financial markets has me worried. The exuberance feels irrational. Asset bubbles form, remember, when greed overwhelms fear. It’s a truism that bad loans are made in good times when lenders relax their standards. As the American economist Hyman Minsky once put it, stability breeds instability.

Investors get edgy when asset prices are down, but they should be more concerned at times like now, when prices have gone up, up, and up. Through Dec. 17 the S&P 500 index has gained 27% this year. The market feels as frothy as the top of a nutmeg cappuccino.

“We enter the next decade with interest rates at 5,000-year lows, the largest asset bubble in history, a planet that is heating up, and a deflationary profile of debt, disruption, and demographics,” Michael Hartnett, chief equity strategist forBofAGlobalResearch,wrote in arecent note.

There’s a bigger issue here than whether stock and bond prices are too high. The more serious question is whether the economies of the U.S. and other wealthy nations can no longer grow without producing destabilizing bubbles—spikes in asset prices unjustified by fundamentals. Or, worse yet, whether the bubbles themselves are crucial to generating economic growth.

The circumstantial evidence for a dysfunctional relationship between economies and bubbles is troubling. The last time the U.S. jobless rate got down to almost as low as it is now was the late 1990s and 2000. That boom was fueled by

a mania of investment in telecom infrastructure and dot-com startups that ended abruptly at the turn of the century, when glutes formed and prices got too high. The bubble popped. Growth was rescued by a surge of overinvestment in housing, which was pumped up by stupid or fraudulent subprime mortgage lending. The popping of that bubble led to the worst economic downturn since the Great Depression.

Now the funny-money cycle seems to be happening all over again. Interest rates in Japan and Western Europe have broken below what used to be called—naively, we now realize—the “zero lower bound.” Economic historians say this appears to be the first time in the history of the world in which negative interest rates are widespread. Scholars of ancient Mesopotamia are invited to say otherwise.

Are Negative Interest Rates Pumping UpBubbles?

As rates fell below zero in Europe and Japan, U.S. stock markets soared

When rates on safe securities go negative—or ultralow, as they are in the U.S.—investors feel compelled to take on greater risk to get what they consider an acceptable return on their money. They “reach for yield.” Default-prone Argentina found buyers in 2017 for a 100-year government bond. Greece’s 10-year bonds have found takers at yields of just over 1% a year. In the U.S., investors are snapping up risky “covenant-lite” corporate loans that have been stripped of the protections for lenders that ordinarily discipline the borrowers.

“Iamveryworried,” saysMayraRodríguezValladares, managing principal of MRVAssociates, a New York-based consulting and training firm for the financial sector. Banks’ assertions that they have plenty of capital and liquidity to withstand the next downturn aren’t reliable, because “you can’t control fear,” she says. “When fear takes over, it’s hard to stop.”

Bubbles are not all bad. Sometimes it takes the prospect of enormous riches to get people to make investments that end up being good

In Practice

75


for society, even if the investors lose their shirts. That applies to canals and railways in the 19th century, fiber-optic networks in the 1990s, and companies in hot areas such as drones, batteries, solar power, and virtual reality today.

But bubbles also generate waste. The housing bust left hundreds of unsightly and unsafe “zombie subdivisions” across the American West, the Lincoln Institute of Land Policy wrote in a 2014 report, ``Arrested Developments”. The poor and working class suffer the most from boom-and-bust cycles, because they’re the last hired and first fired and are more likely to invest at the worst time, right before things go bad. It’s ironic that at a time of low inflation, there’s been rioting in Chile, Colombia, Ecuador, Iran, Hong Kong, Lebanon, and Sudan over, among other issues, the high cost of living. A bubble in real estate is one of the incitements to protest in Hong Kong, which has the world’s most expensive housing.

So it’s natural to ask why this keeps happening and what, if anything, can be done to take the bubbles out of economic growth. FormerFederalReserveChairmanBenBernankepartly explained it in 2005 when he identified a global savings glut: foreign investors, including the Chinese, were pouring money into the U.S. because their savings far exceeded good investment opportunities at home. Some of those foreign savings, alas, were wasted on those arrested housing developments. Lawrence Summers, a former U.S. Treasury secretary and Harvard president, has built on Bernanke’s theory with the notion of secular stagnation: a chronic, worldwide lack of spending because of the aging of society and the rise of companies such as Apple, Airbnb, and Google that don’t need much physical capital. Summers argues that the economic expansion would ebb if left alone and is being sustained by governments using artificial means: deficit spending and low interest rates.

Minsky, the economist who said stability breeds instability, may have had the most complete diagnosis, even though he died in 1996, before serial bubbles became a thing. Building on the work of others, including the Briton John Maynard Keynes and Michal Kalecki of Poland, Minsky focused on the financial side of the economy—flows of money, not just goods and services.

“Profits,” Minsky wrote in 1992, are “the key determinant of system behavior.” He said financing tends to degenerate from safe (“hedge”), to risky (“speculative”), to outright irresponsible (“Ponzi”). The Minsky moment—not his term—is the collapse of prices when people abruptly realize that financing has become reckless and unsustainable.

There’s a troubling new analysis of where we are today, in the Minsky tradition, called Bubble or Nothing. The 64-page report was issued in September by David Levy, chairman of the Jerome Levy Forecasting Center LLC in Mount Kisco, N.Y. Levy is a former associate of Minsky and the third generation of forecasters in his family. A hedge fund he launched in 2004 to bet on falling short-term interest rates gained 500% for investors before closing in March 2009, shortly after rates bottomed.

When investors reach for yield, as they are now, it’s because they “see no other way to obtain financial returns that are anywhere near their goals,” Levy wrote in Bubble or Nothing. Pension fund managers, for example, feel they have to take risks to fulfill promises to retirees. In 1992 public pension plans assumed they would earn a return of 8%, about what they could get on30-yearTreasurybonds.Reasonable.In2012they were still assuming they could earn almost 8% a year, according to a study by Pew Charitable Trusts, even though the yield on safe 30-year Treasuries had fallen to 3%. Unreasonable.

The core problem, Levy says, is that household and business balance sheets have gotten too big—top-heavy, you might say. He focuses not only on debt, on the right side of the balance sheet, but also on assets, which appear on the left. While having lots of debt is obviously precarious, he says, having too much in assets is also problematic for the economy as a whole. It can indicate overinvestment (too many houses in the Phoenix exurbs) or excessively high valuation of whatever assets exist (so prices are unsustainable).

Americans emerged from World War II with little debt because consumption was rationed during the war years. They owned few assets because private investment had been suppressed and valuation of assets was pessimistically low, with a price-earnings ratio in 1949 of less than 6 for the S&P 500 (it’s 21 now). But balance

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sheets grew. In each successive business cycle, the ratio of debt to income grew as lenders competed for market share. By the 1980s it began to be a problem. Ominously, a growing share of the debt went to buy existing assets rather than new ones: It was inflation vs. creation.

With balance sheets getting too big to fail, the Fed came to the rescue in each recession with interest-rate cuts to reduce the carrying cost of all that debt and to prop up the value of rate-sensitive stocks, bonds, and other assets. It workedlikearatchet.Ratesfellineachsuccessivecycle because the bigger balance sheets grew, the lower interest rates needed to be, Levy says.

True, households in the U.S. have paid down some of their debt since the 2007-09 financial crisis. But the nonfinancial corporate sector has gotten even deeper into hock. “Corporate America’s fragile debt pile has emerged as a key vulnerability,” Oxford Economics Ltd. senior economist Lydia Boussour wrote on Oct. 31. Half of investment-grade corporate bonds are in the lowest tier by credit rating, vs. 37% in 2011. And 80% of leveraged loans are covenant-lite, vs. 30% during the financial crisis, she wrote.

Unfortunately for the would-be rescuers—or enablers—at the world’s central banks, interest rates are about as low as they can possibly get in Western Europe and Japan. (The Fed still has a little room.) The banking system begins to break down at negative rates because depositors, who supply banks with funds, refuse to lose money by leaving it in the banks. At some point they’re better off keeping it under the mattress. “We are very aware of the side effects” of negative rates, European Central Bank President Christine Lagarde said after her first board meeting on Dec. 12.

Lagarde has a bigger problem than does Fed Chair Jerome Powell. She’s up against ratios of private non financial-sector debt to gross domestic product above that of the U.S. The ratios in Australia, Canada, China, and South Korea are, in fact, higher than the ratio was in the U.S. at its 2009 peak, according to the Bank for International Settlements. That’s why Levy predicts the next crisis will begin abroad. “It may not be as bad for the United States as in 2008-2009; it is likely to be worse for most of the rest of the world,” he wrote.

The fix seems simple enough: De-risk balance sheets by allowing the air to come out of asset prices and paying off debts. “The best is to grow out of it gradually and consistently, and it’s the solution to many but not all episodes of current indebtedness,” says Mohamed El-Erian, chief economic adviser to the German insurer Allianz SE and a Bloomberg Opinion columnist.

But as Keynes taught, what works for a single household doesn’t work for the economy as a whole. One person’s savings deprives someone else of income. The business profits that Minsky pegged as the key determinant of system behavior depend on constantly increasing investment in houses, factories, software, etc. And those investments are largely financed with debt.

The only way businesses could make a profit at a time of deleveraging would be if governments took up the slack with massive public spending, as they did in World War II. But even that wouldn’t work if it bolstered the private sector’s confidence and led households and businesses to releverage. The war was a special case. In the U.S., wrote Levy, “that situation included grave household and business fears, great uncertainty, government quotas, outright bans on some kinds of spending, a powerful social force for the population to comply with the government’s programs, massive government deficit spending equal to a quarter of GDP, and hyperdrive economic growth.”

Levy concluded that the inevitable correction to balance sheets, whenever it comes, will produce “serious financial turbulence, systemic credit problems, and generally unsatisfying economic conditions.” He wrote that “by far the trickiest priority” for the government is to rescue the economy without inducing new risk-taking by the private sector, which would generate the problem all over again. A “benign transition,” he wrote, is “next to impossible.”

Given the ugly alternatives, governments are keeping the game going through stimulative fiscal and monetary policy. But for how long? The late economist Rudiger Dornbusch oncesaid, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” —With Enda Curran


77

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mary

LO 1 Define the concept of stock and stock value.

Investors have many alternatives to channel their savings, and stock investing is one of these alternatives. Stock is a security that provides holders the right of receiving share from the profit and participating in management. By investing in stocks, investors aim to receive dividends and obtain a capital gain by finding undervalued stocks. For this purpose, they try to determine the intrinsic value of the stock. Intrinsic value of a stock is the amount of discounted the cash flows that the investor expects to get from the investment in a specified period. There are also different value measures needed for different purposes. One of them is going concern value. Going concern value is the value that results from the company’s operations, assets, customers and workforce as a whole. Par value refers to the minimum amount of money that the stockholders have to pay per share. Book value of a stock is the accounting value reflected in the financial statements. Liquidation value is the value that remains after all the assets of the company are sold and the liabilities are paid off. Issuance value refers to the price at which stocks are issued, and finally, the market value of a stock is the price that stock is traded in the market.

LO 2 Identify different stock types.

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

LO 3 Explain models that are used in stock valuation.

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

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LO 4 Discuss the importance of stock indices in investment decisions.

Financial authorities establish stock indices in order to observe the different characteristics of stock markets. These indices give information to the investors about the structure and the future behavior of the stock market. Changes in the indices are considered as the signals of future movements. While increasing trends reflect a positive atmosphere, decreasing trends indicate a pessimistic picture for the future of the market. Investors also may use the indices as the benchmark in evaluating performance of their portfolios. If the return gained from the constructed portfolio is below the index return, then this means that the portfolio failed. On the other hand, indices are considered as financial instruments. There many index based securities traded in the financial markets. These assets are suitable especially for the investors who do not have sufficient knowledge about the financial markets. Also, investing in index based securities reduces the risk of the investor undertakes since they are well diversified.

LO 5 Discuss the importance of stock markets for economies.

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


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Test Yourself

1 Which of the following is not one of the rights of stockholders?

A. RighttodemandinformationB. RighttopreemptionC.RighttodividendD.RighttointerestE. Righttovote

2 Which of the following items are required to estimate the intrinsic value of a stock?

A. Total liabilities of the company, the discount rate and riskiness of the stock

B. Expected cash flows, riskiness of the stock and the discount rate

C. Total assets of the company, expected cash flows, the discount rate

D. The discount rate, riskiness of the stock and total assets of the company

E. Total liabilities of the company, total assets of the company and expected cash flows

3 Which of the following is not one of the features of common stocks?

A. They provide priority right on the liquidation surplus.

B. They give the right of voting to the holder.C. The financial liability is limited to the amount

of share.D. The holders of these stocks are residual owners

of the company.E. They give the right of receiving dividends.

4 Which of the following is one of the preferred stocks’ features that distinguishes them from the common stocks?

A. They provide interest payments.B. They provide the right to vote.C. They provide the right to dividend.D. They provide priority right on the profit of the

company.E. They represent ownership of the company.

5 TED Company paid $ 3.75 per share, and it is expected to grow yearly at a constant rate of 7%. If the rate of return of similar companies is 13%, what should be the price of TED stocks?

A. $ 62.125B. $ 63.925C. $ 66.875D. $ 69.250E. $ 72.500

6 Earnings per share of Company KAR is$5.4, and $4.2 per share dividend is paid to the stockholders. If the expected return of the stock is 18%, what is the price-earnings ratio of the company?

A. 3.21B. 4.32C. 5.44D. 6.12E. 7.14

7 ……. is an indicator that is used to measure the relative changes and differences in a variable or between the variables?

A. IndexB. CovarianceC.RegressionD. Standard deviationE. Discount rate

8 Which of the following statements is false related to stock indices?

A. They can be used as a benchmark in performance measurement.

B. They provide information about volatility of stock markets.

C. They are regarded as leading indicators for the real economy.

D. They are independent of the expectations of the society for the future.

E. They can be used as investment vehicles.

Stock Markets

80

Test

You

rsel

f

9 ……. is one of largest stock exchanges in the world in terms of market capitalization and the number of listed companies, which was established in 1878 and is located in Japan?

A. Hong Kong Stock ExchangeB. Fukuoka Stock ExchangeC. Tokyo Stock ExchangeD. Shanghai Stock ExchangeE. Shenzhen Stock Exchange

10 Which of the following statements is false related to volatility?

A. There is no relationship between the volatility of financial variables

B. Volatility is affected by new public informationC. There is a positive correlation between the past

and current volatilityD. Volatility is a measure of risk of a financial

variableE. Bad economic conditions increase the volatility


81

Answ


If your answer is wrong, please review the “Definition and Properties of Stocks” section.

1. D If your answer is wrong, please review the “Stock Valuation” section.

6. B

If your answer is wrong, please review the “Types of Stocks” section.

3. A If your answer is wrong, please review the “Stock Indices” section.

8. D

If your answer is wrong, please review the “Definition and Properties of Stocks” section.

2. B If your answer is wrong, please review the “Stock Indices” section.

7. A

If your answer is wrong, please review the “Types of Stocks” section.

4. D

If your answer is wrong, please review the “Stock Valuation” section.

5. C

If your answer is wrong, please review the “Major Stock Markets” section.

9. C

If your answer is wrong, please review the “Major Stock Markets” section.

10. A

Stock Markets

82

Sug

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ed a

nsw

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for

“Sel

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”

How does inflation affect the stock returns?

self review 1

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

What are the differences between common stocks and preferred stocks?

self review 2

What are the difficulties encountered when The Dividend Discount Model is used in stock valuation?

self review 3

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

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


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Suggested answ

ers for “Self R

eview”

What are the advantages of stock index investing?

self review 4

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

What are the factors that affect the stock market volatility?

self review 5

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

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Anderson, K. (2012). The Essential P/E: Understanding the Stock Market through the Price-Earnings Ratio, Hampshire: Harriman House.

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Bodie, Z., Kane, A. and Marcus, A. J. (2003). Essentials of Investments, (5th Edition), New York: McGraw-Hill.

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Carey, O. L. and Essayyad, M. M. H. (2005). Essentials of Financial Management, New Jersey: Researchand Education Association.

Chandra, P. (2008). Financial Management: Theory and Practice, (7th Edition), New Delhi: Tata McGraw-Hill.

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Duncan, W. J. (2015). Stocks: Stocks Trading Basics and Strategies for Beginners, (2nd Edition), CreateSpace Independent Publishing Platform.

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Felsenstein, D., Schamp, E. W. and Shachar, A. (2002). Emerging Nodes in the Global Economy: Frankfurt and Tel Aviv Compared, Springer Netherlands.

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Hafer,R.W.andHein,S.E.(2007).The Stock Market, Westport: Greenwood Press.

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Chapter OutlineIntroductionDerivatives and Derivative MarketsTypes of Derivatives: Forward, Futures, Swap and OptionsBasics of Derivative Pricing and Valuation

Key TermsDerivatives

Underlying AssetForwardFuturesSwapsOptions

Derivative PricingValuation

Lear

ning

Out

com

es

Explain the basic logic of derivative pricing and valuation

Describe derivative marketIdentify forward commitments, future contracts, swaps and options

31 2

Derivative Markets

87


INTRODUCTIONIt is clear that with globalization, a change

process has started in the national economies. Because of this change process, the integration between the economic units has accelerated and the risks to which financial markets are exposed have increased considerably. The inadequacy of traditional instruments in managing these risks paved the way for the development of derivative instruments.

Derivative instruments whose performance is determined by underlying assets are generally classified as forward, futures, swap, and option contracts. The point to be considered here is that there is no need to buy and sell the assets on which the derivative instruments are based. In this context, the underlying assets have an important role in increasing the application efficiency of the derivative instruments.

In this chapter, we are going to define derivatives and their uses. Besides, we compare the characteristics of forward contracts, futures contracts, options, swaps, and the reasons behind emergence of derivative markets and the purposes they serve for the investors. Finally, this chapter discusses the basics of derivative pricing and valuation.

DERIVATIVES AND DERIVATIVE MARKETS

A derivative as defined by Security and Exchange Commission (SEC) is: “a type of financial instrument whose value is derived from another underlying product”. By derivative product, we mean those financial instruments that derive its value from the performance of an underlying (asset). In other words, a derivative is a legal contract that involves two parties, a buyer and a seller who agree to do something for each other. Derivative contracts are recognized by the legal system as commercial contracts and they set the right and obligations of each involved party. For instance, let’s assume that there are two parties, A and B. In the contract, Party A agrees to sell an APPLE stock (AAPL) to party B for $200 after 3 months from now. Here, our underlying asset is AAPL and Party A is obligated to sell this stock to party B after 3 months. The value of this contract is based

on the performance of AAPL. If the value of the stock rises from $191to $200, this contract will be valuable for Party B who is buying the underlying asset for $191. If AAPL price increases to $200 and Party A refuses to sell the stock to Party B, Party B can refer to the related authorities (lawyers, judges, and juries) to step in and resolve this issue.

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

Derivatives are useful instruments in financial markets through which a risk can be transferred from one party to another. Investors use derivatives to hedge risk arising from unexpected changes in the market value of an underlying asset. Moreover, derivatives are helpful in creating trading strategies. Derivatives are more liquid than the underlying asset and less costly in terms of participating in deals and transactions.

Derivatives are high leverage contracts that require a small amount of capital to initiate a derivative related contract.

There are two categories of markets where derivatives are created: Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC). Exchange-traded derivatives are standardized such that its terms and conditions are precisely specified by the exchange where OTC is the customizable contract that can be customized by the involving parties. In other words, derivatives exchange-trade standardizes every term and condition of contracts except their prices. For example, suppose an exchange introduces a standardized contract for metal Gold. It specifies the quality of gold, the quantity of gold, expiration date, and the location where the gold should be delivered. Normally, the price of a derivative contract is defined by buyers and sellers (long and short parties). Chicago Mercantile

88

Derivative Markets

Exchange (CME) is an example of exchange-traded derivatives markets in which contracts such as futures and options are traded. CME is responsible for the clearing and settlement process. Clearing is the procedure by which an exchange settles a transaction and registers the buy and sell parties’ identities. The settlement is the procedure by which an exchange transfers money from one party to another. Since futures contracts are standardized contracts, it makes derivatives more liquid in comparison to OTC markets contracts. Moreover, the price process in the exchange-traded derivatives is more transparent in comparison to OTC markets.

When two parties get involved in a contract on an exchange-traded market, ultimately, one party will make a profit and the other party will lose money. Hence, the clearinghouse of the exchange provides a guarantee to the winning party that if the counterparty refuses to pay, the clearinghouse will pay instead.

important

Exchange-traded derivatives also provide credit guarantee and ensure that there will not be any credit risk.

Any participant that wants to engage in exchange-traded derivative needs to deposit cash usually called margin bond or performance bonds that secures that there will not be any default. The other attribute of cleaning houses is that there are daily settlements and any party, which is in the profit as a result of the performance of the underlying asset, the clearinghouse deducts money from the losing party and adds them to the winner party.

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

important

The OTC contracts are customized contracts, and they are less liquid than exchange-traded derivative contracts. They are also relatively less transparent.

What is the difference between the Exchange-traded derivatives markets and Over-the-counter derivatives markets?

Associate the structure of the derivative market with credit risk.

Tell the differences between forward commitments, and contingent claims.

1 Describe derivatives market


Learning Outcomes

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TYPES OF DERIVATIVES: FORWARD, FUTURE, SWAP AND OPTIONSAs we mentioned earlier, derivatives can be classified into two main groups: forward commitments, and

contingent claims. Forward commitments impose an obligation on both sides of the contract to engage in a future transaction as agreed upon previously, whereas contingent claims give the right but not the obligation to do so.

Forward Commitments Forward commitments can be defined by Pirie (2017) as:

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

To explain this definition, let us recall our previous example in which we assumed that both parties A and B sign a contract that states Party A will sell an APPLE stock (AAPL) to Party B, and Party B commits to buy the stock after 3 months. This type of contract is called a forward contract. In forward contracts, both involving parties agree to do something for one another after 3 months. Both sides of the forward contract agree on the underlying asset (AAPL) at a later point in time (3 months). They have established the identity of underlying (AAPL) and its quantity (1 stock) at a fixed price regardless of what it will cost at the expiration date. Both parties on the manner in which the contract will be executed or will be settled when it expires (whether to deliver the underlying asset physically or pay in cash).

In brief, forward commitments have the following characteristics: • Theyarecustomizedcontractssotosuitbothinvolvingparties’needsi.e.grade,time,andplaceof

delivery. • Thereisnospecificlocationoraddresstotradeforwardcontracts.• Anytypeofcommoditiescanbetradedviaforwardcontracts.There are three different types of forward commitments: Forward, Futures, and Swaps contracts. We

will discuss each type of forward commitments in the forthcoming sections.

Forward ContractsIt is an OTC contract in which a buyer and a seller commits each other to do a transaction on a

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

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

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

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

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Derivative Markets

important

It can be said that both the long and the short parties are engaged in a zero-sum game, meaning that one participant’s gains are the other party’s losses.

Figure 4.1 illustrates the payoffs from both taking long and short positions in a forward contract. From the figure, it is clear that the long wishes the price of the underlying stock to increase above, whereas the short wishes the price of the underlying stock to drop below.

Payo� ($)

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Figure 4.1 Payoffs from taking long positions a forward contract.

Figure 4.2 Payoffs from taking short positions a forward contract.

Even though forward contracts play a significant role in managing risks, there are still some associated problems. One of these problems is counterparty risk. This risk raises when one of the agreement parties refuses to carry out his/her obligation to deliver the underlying asset on the expiration date at the location specified in the forward contract. Let’s consider a forward contract on euro at a rate of $1.1500/€. In the event that the euro appreciates to $1.1600/€ on the expiration date, at that point

whoever has consented to sell euro at the forward rate of $1.1500/€ has a motivation to not carry out his/her obligation. In the event that the euro devalues to $1.1400/€, at that point whoever has consented to buy pounds at the forward rate of $1.1500/€ has a motivation to not carry out his/her obligation. Since the forward contract is signed between two parties without the intermediation of a third party; therefore, there will not be anyone to resolve this matter except if one of the parties ask for the intervention of the court. Here, futures contracts emerge as a solution to forward contracts. Futures contracts present a solution for the default hazard natural in forward contracts through the conventions shown below.

Futures ContractsFutures contracts are the same as forward

contracts except that futures contracts are organized, regulated and managed by an exchange. In other words, futures contracts are standardized. A futures contract as defined by Chisholm (2011) is:

“an agreement made through an organized exchange to buy or to sell a fixed amount of an underlying commodity or financial asset on a future date (or within a range of dates) at an agreed price”.

Unlike forward contracts, futures contracts require the existence of a legally recognized futures exchange that provides, manages and organizes these contracts. On the exchange, not all types of derivatives are allowed, only certain contracts are authorized for trading. Futures contracts can be accessed through both physical locations as well as through an electronic system. The derivative exchange has a mechanism that offers the two parties a guarantee against any default. An organized Exchange has a Clearing house through which it settles daily the losses and gains of futures contracts and protects itself against loss.

The Clearing house requires investors to deposit an initial margin, which is then used in the marking-to-market or settling of changes in the value of contracts on a day to day basis.

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For example, suppose there are two parties, A and B. Party A goes long (buyer) on a contract of Crude Oil (WTI) at $60/Barrel and one contract of WTI is 1000 barrels. Party B goes short (seller) on the same contract. At the end of the day, if the spot price of WTI rises to $61, the Clearing house of exchange the Clearing house attempts to mark the futures contract to the market at $61 known as the daily settlement. The Clearing house determines the final futures trades of the day and designates that price as the settlement price. Party A’s (long) margin account will be marked with $1000 gain and Party B’s (short) account will be marked with $1000 loss. In other words, the $1000 will be transferred to the margin account of Party B to the margin account of Party A. The opposite is true, if the futures price drops to 59, Party A’s marginal account will be marked with $1000 loss, and the $1000 will be transferred to the marginal account of Party B.

important

While transacting on the futures market, it is required that both involving parties must deposit a minimum sum of money as an initial margin in their margin account, typically less than 10% of the futures price to cover possible future losses.

After a contract is bought or sold, both parties are asked to maintain an extra amount in their margin accounts to surplus their initial margin deposits. In other words, the amount of money in margin account must be greater than the initial margin to meet any drop in futures price. At the end of the day, the Clearing house will mark to market and compare each party’s balance with the maintenance margin, and if there was any increase or decrease in futures price, both parties’ margin accounts will be settled accordingly. If the price of a future increase in favor of a long party such that the balance of short party falls below the maintenance margin requirement, the short party will then receive a margin call requesting to deposit additional funds to raise its balance level up to initial margin requirement level. The short party can choose not to deposit additional funds and just close its position. Additionally, through a margin account, an investor can borrow from a broker to buy extra other assets and his/her maintenance margin functions as a deposit with the broker.

Let’s consider the following example, a contract of €125,000 futures is bought at $1.1500/€. To carry out this contract, the exchange asks the buyer to deposit a specific amount of money as an initial margin to compensate for any drop in future prices. At the end of the trading day, if the futures price raise by $0.0010/€ to $1.1510/€, then the Clearing house adds $125 ($0.0010/€*€125,000) to the buyer’s margin account. On the other hand, if the $/€, price drops to $1.14900/€, then $125 will be taken from the buyer’s margin account to the clearinghouse’s, and then to the counter party’s margin account. Through this process, the clearinghouse’s exposure to default risk or currency risk is bounded to the gain or loss from daily fluctuations in the currency price. The Clearing house sets the maintenance margins big enough to cover all daily price volatility except for the unexpected big movements. In case if an investor’s loss is higher than the maintenance margin and the investor cannot meet a margin call on the following day, the Clearing house liquidates the contract and offsets its position.

For instance, on the off chance that a maintenance margin for a €125,000 prospects contract is $2,000. Then, the base dollar value tick of 1 basis point (0.01%) of futures contract is worth $12.50 ($0.0001/€*€125,000/contract) per contract. On the off chance that the futures contract price moves down 1% or 100 basis points, then the value of the contract goes down by $1,250, and thus the investors deposit with the Clearing house reduces to $750. The clearinghouse can recoup 1-day price variations and later calls the investor to re-deposit an amount of $1,250 to maintain the margin at $2,000 level.

SwapsA swap contract can be defined as an OTC

contract between two parties who agree to exchange cash flows on regular dates, where one party pays a variable payment, and the other party pays either a fixed or variable amount calculated on a different basis. Since swap is an OTC contract, it contains terms and conditions such as the identity of the underlying asset, dates of payments, and the procedure of payment that are agreed upon and written in the contract. In currency swap trades, one party trades swaps currency for a fixed interest rate and where another party trades another currency for a floating interest. Traders usually exchange only the difference in interest payments. In swap trades, the principal traded is called notional.

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Currency swaps first traded in 1970 when two financial managers from two different firms in two countries borrowed money in two different currencies and agreed to pay each other’s obligation. Later in 1981, the first official swap was traded between the World Bank and International Business Machines. Since then, investment banks started providing swap services and the volume and liquidity started to grow and “plain vanilla” swaps were introduced. Plain vanilla swaps are the most famous swap contracts that pursue the conventions of the International Swaps and Derivatives Association Butler. Plain vanilla swap for fixed-for-floating interest rate swap is the most popular type of swap that was introduced to the market in the 1980s.

Figure 4.3 shows the growth in swap dealers in the over-the-counter (OTC) derivatives market since 1998. In 2017, interest rate swaps and options, and interest rate forward contracts were highly traded among investors with a $426.65 trillion in notional principal outstanding. Currency swaps, options and forwards contracts were the second most traded contracts with notional principal outstanding of 87.12 trillion.

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

Foreign exchange [B]

Interest rate [D]

Commodities [J] Credit Derivatives [T] Equity [E]

0

250

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USD trn

20182014201020062002

Figure 4.3 (b) Notional Amounts Outstanding in OTC Derivatives Markets ($ trillions).

Sources: International Swap Dealers Association (www.isda.org)

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A firm’s commitment to pay an international counterparty with an asset also contains a swap. These firms use swap to offset position on the balance sheet and records the swap output as interest expense in the profit and loss sheet. In the currency swap, one party trades one type of currency for a fixed interest rate and another party trades another type of a currency for a floating interest.

In comparison to futures contracts, swaps contracts are more prone to default risk in the following aspects: First, a performance bond is not required in swaps contracts, whereas a margin is required in futures contracts, and this tends to give swaps slightly more default risk than futures contracts. Second, the counterparty in swaps contracts are generally a commercial or investment bank, whereas in futures contracts the clearinghouse is considered the counterparty and commercial or investment bank are more prone to default than a clearinghouse. Third, futures contracts are daily marked-to-market and the entire gain or loss is settled from day to day, whereas the settlement in swaps contracts are longer payments is longer i.e. six months. The riskiness of a swaps contracts falls somewhere between the riskiness of futures contracts and the forward contracts. Moreover, swaps are less riskier than straight debt because the principal is not at risk as it is in a loan. In addition, since interest payments depends on the difference between the interest rates, they are less prone to default risk.

In order to illustrate swap contracts, let us consider the following example. Suppose there are two parties, Party A agrees to pay Party B for a fixed rate of 5% I/Y on a notional amount of $100,000 and Party B in return agrees to pay Party A the annual $ LIBOR rate on a notional of $100,000.

LIBOR stands for London Interbank Offered Rate, which is the floating rate used in swap contracts.

Suppose that at the end of the year the LIBOR rate 4.5%, Party A will owe $5000 to the Party B and Party B will owe Party A $4500, and the amount will be netted out and Party A will pay $500 to Party B. Figure 4.4 clearly shows this relationship.

Party A

5%

$ LIBOR=%4.5

Party B

Figure 4.4 Interest rate swap payment.

important

Similar to futures and forward contracts, swap contracts do not require money exchange at the beginning of the contract, the initial value of a swap contract is zero.

Generally, LIBOR are quoted on a Money Market Yield (MMY) or “Actual/360” basis that assume interest accrues over 360 days in a year. Fixed rates are quoted on an “Actual/365” or Bond Equivalent Yield (BEY) basis that assume interest accrues over 365 days in a year. This conversion helps us to compare fixed rate yields with floating rate yields. U.S. Treasury bonds are quoted as fixed rate. The relationship between MMY and BEY is as follows:

MMY = BEY*(360/365)BEY = MMY*(365/360)

Let us consider the following question. If a quote on a U.S. Treasury bond 4.40% BEY, then what is the MMY? We can say that the MMY for U.S. Treasury bond is approximately equal to 4.3% (4.40%)*(360/365).

Let us consider an interest rate swap example. Consider companies X and Y; each company wants to borrow $ 50 million with a 3 year term. Company X wants to finance interest rate sensitive assets, and therefore wants to borrow at floating interest rates. Company X has a good credit ranking and can borrow from the LIBOR rate. Company Y wants to finance non-interest-sensitive assets, so it wants to borrow with fixed interest. Company Y has a low credit ranking and can borrow at 6.5% fixed interest rate. For a 3-year swap, the Swap bank quotes against the dollar LIBOR 6.1—6.2 (if the Swap bank receives LIBOR, it gives 6.1% fixed interest rate; gives LIBOR if it receives 6.2% fixed interest rate).

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Table 4.1 Interest Rates for Company X and Company Y.

Fixed rate Floating rateX %6 LIBORY 6.50% LIBOR + . %20

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

Total cost of Company A = 6.0% + LIBOR - 6.10% = LIBOR - 0.10%

Company X

6.10%

LIBOR

Bank A

Swap Bank

Figure 4.5 Interest rate swap (Company X).

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

Total cost of Company B = -LIBOR + LIBOR +0.20% + 6.20% = 6.40%

Figure 4.6 Interest rate swap (Company Y).

%6.10

LIBOR

Company X Company YSwap Bank

%6.20

LIBOR

Figure 4.7 Interest rate swap (Swap Bank).

Swap Base earns 10 basis points from this transaction.

Total cost of the Swap Bank = -LIBOR + LIBOR - 6.20% + 6.10% = –0.10%

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

Swap Bank

6.20%

LIBOR

LIBOR+0.2%

Bank B

Company Y

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Contingent ClaimsA contingent claim is a derivative that provides a

buyer of option the right to buy or sell an underlying asset at a price previously agreed upon on a specified future date. Unlike forward commitment contracts, contingent claims give the holder of the contract the right, not the obligation to buy or sell an underlying asset. Its payoff also depends on the performance of the underlying asset.

OptionsOptions are contingent claim contracts that

provide the right but not the obligation to buy an asset at a specific price at a later date in the future. In other words, the buyer pays a sum amount of money, known as premium, to the writer of a contract to receive the right to either buy or sell an underlying asset at a specific price at a later date in the future. In options, one side of the contract has the option to carry out the terms and the other side of contracts has obligation.

Option contracts convey most of the characteristics of forward, and futures contract as options can be traded on the OTC markets. They can be customized as well as they can be traded on options exchanges as regulated standardized contracts. The customized options contracts are subject to default risk like forward contract, whereas standardized options are protected by clearing house of options exchange. With an option contract, the biggest money that a buyer may lose on the deal is the option premium of the deal, while the loss that the writer of option may face is virtually unlimited.

Almost all multinational corporations use options as a tool to manage their exposure to currency risk, and exchange rates are the underlying assets in their case.

Based on the right to exercise a buy or sell, options contracts can be divided into two: call options and put options. A call option is the right to buy an underlying asset, while a put option is the right to sell an underlying asset.

Additionally, options can also be divided into two types according to the time when options can be exercised: American Options and European

Options. American Options can be exercised any time up to the expiration date, while European Options are exercised only on the expiration date.

important

Option exchanges are considered to be a zero-sum game in efficient markets. The gain or loss on one side of an agreement precisely counterbalances the gain or loss on the opposite side of the agreement.

Call OptionsAs mentioned earlier, call option is the right to

buy an underlying asset. It offers unlimited upside return with limited downside risk. In order to have a clear picture of call options, let us consider the following example. Suppose there is an investor who buys an American call option of FB stock at a strike price of $160 after 3 months from now. The option premium to initiate the contracts is $5. Suppose that the underlying stock price drops under $160, here the investor decides not to exercise the call option because there is no benefit for the investor to buy FB stock for $160 as the investor can buy the same stock at a lower price in the market. When the investor does not exercise the option, he/she will lose the option premium of $5 he/she paid to initiate the option contract. Due to limited risk, unlimited return, call options are more attractive to investors. On the other hand, if the price of underlying stock FB increases to $165 and then the investor exercises the option, he/she will be able to make $5 profit by buying the underlying stock now at $160 and selling it immediately in the market at $165. We ignore transaction cost in this example.

A call option is in the money, if the market price is above the strike price.A call option is out of the money, if the market price is below the strike price.A call or put option is at the money, if the market price is equal to the strike price.A put option is in the money, if the market price is below the strike price.A put option is out of the money, if the market price is above the strike price.

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Figure 4.8 illustrates the payoff and net profit/loss of an investor exercising a call option. In some cases, an investor may lose money even though he/she exercises the option. For example, if the price of the underlying stock FB is $162 at the expiration date and the investor exercise the option at that price, he/she will still be in loss (($162-$160) - $5) = -$3, when taking the initial cost of the option into account. Therefore, it is important for the investor to take the option premium cost into account while exercising a call option.

ST

C0=-5

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Figure 4.8 Payoff and Profit from a Call Option for Buyer.

In another scenario, when the investor is on the short side of the call option (as the seller or the writer of the contract), the profit that he/she can make is the option premium that he/she receives at the start of the option contract. In our previous example, if the buyer did not exercise the option due to being out-of-money ($155), the profit that the option writer would gain is $5. If the option is in-the-money ($170) and the buyer of the call option exercises the contract, the losses that the option writer would face is $10.

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

The short call is the mirror image of the long call as in Figure 4.9. This is a zero-sum game.

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Long Call

Pro�t

Pro�tShort Call

Figure 4.10 Payoff and Profit from Buying and Selling for call option.

Put OptionsPut option contracts grand their buyers the right

but not obligation to sell the underlying asset. To observe the meaning of put options, let us continue with our previous example. Suppose the investor buys an American put option of FB stock at a strike price of $160 after 3 months from now. The premium to begin with the contract is $5 and the underlying stock price drops under $160, the put option contract is said to be in-the-money and in favor of the investor to exercise it. The investor can make a profit from this contract selling it at a higher price than the market and buying it back with a lower price. On the other hand, if the price of underlying stock FB increases to $165 and it is not in favor of investor to exercise the option, because he/she sells the underlying asset at a lower price than the market and the maximum loss that short position will lose is $5. Figure 4.11 illustrates the payoff and net profit/loss of an investor exercising a long put option.

ST

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170165160155150145140

P0=-5

-10

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

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

ST

Payo�($)

P0=5

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170165160155150145140

-5

-10

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

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

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Learning Outcome

Figure 4.13 Payoff and Profit from Buying and Selling for put option.

How many different types of derivatives are there in the market?

What benefits can options provide for speculators or hedgers?

Tell how futures can be used by companies to manage currency risks.

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


Learning Outcomes

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BASICS OF DERIVATIVE PRICING AND VALUATIONIn this section, we will discuss the impact of underlying assets on derivatives and how we use the

principle of arbitrage in pricing derivatives. As we mentioned earlier, a derivative drives its value from an asset or a rate. Therefore, the value of a derivative depends on an underlying asset or a rate.

If there is any benefit we add that benefit into it, and if there is any risk we deduct that cost discounted at a rate appropriate for the risk assumed. The following equation below exhibits how to calculate the

current price S0 of an underlying asset. The expression E(ST )(1+r+λ)T

is basically the present value (PV) of the

underlying asset. We divide E(ST) which is the expected future price of the underlying asset by the risk-free rate r and the risk premium λ, over the period from 0 to T.

The price of the underlying asset at time t = 0:

S0 =E(ST )

(1+r+λ)T– θ+ γ

where γ (gamma) is PV of any benefits received while holding the asset between t = 0 to T, and θ (theta) is PV of any costs that occur while holding the asset between t = 0 to T.

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

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

The current price of the underlying asset = S0 =100

(1+ 0.1)1– 5+ 2 = 87.90

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

Pricing and Valuation of Forward Contracts

In order to understand the forward contracts pricing and valuation, let us assume the following example. Suppose John owns a stock of FB, whose S0 (spot price) is $100. Sam agrees today to buy from John a share of FC at $101 after 1 month. The terms of the forward contract are as follows:

• Theforwardpriceis$101andthecontractisfor1month.• Thereisnopremiumorinitialpaydownatt=0whenbothpartiesenterintothecontract.After one month when the contract expires, the forward contract can be settled in the following ways:• SamphysicallyreceivestheFBshareandpays$101toJohn.• JohnpaysSamthedifferencebetweenthespotpriceofthestockandpriceagreed-uponprice(ST)

in the forward contract. After one month, if FB share price is $103, then John pays $2 to Sam.However, in case if the stock price goes up to $103, a default risk may emerge in forward contracts.

Sam may become concerned that John may fails to deliver him the FB stock as agreed upon. On the other hand, if the share price drops to $99, John may become worried that Sam may not buy him the FB stock as agreed upon.

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

Agree to pay F0(T) at time T to buy the asaet

Pay F0(T) and receive the asset worth ST

Figure 4.14 Transactions from a perspective of a long party.

Before we go further in valuation of forward contracts, let us explain the key features and notations of:• F0 (T) denotes for the forward price agreed upon at time t = 0. T shows the expiration date of the

contract at time T.• S0 denotes for the spot price at the beginning of the contract. ST denotes for the spot price at the

expiration of the forward contract at t = T. St stands for the price of the forward contract at any time during the life of the contract.

• ThecontractvalueattimetisdenotedasVt(T).• Thereisnopremiumorinitialdownpaymentatt=0whenbothpartiesenterintothecontract.

No party pays anything to the other party.The price agreed upon at the beginning of the forward contract is simply S0 compounded at the risk-

free rate over the contract life.

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

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

T = 112

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

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

The value of a forward contract at expiration from the perspective of a buy (long) party:

Vt(T) = ST – F0(T)

where, ST is the spot price of the underlying asset at the expiration, F0(T) is agree upon forward price. At contract expiration, if ST > F0(T), then the value of the forward contract is positive for the buyer and if St < F0(T), then the value is negative.

The value of a forward contract at expiration from the perspective of a sell (short) party:

Vt(T) = –ST – F0(T)

important

The value of a forward contract is positive to the short party if F0(T) > ST and negative if F0(T) < ST at expiration.

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

-St – F = 105 - 101 = 4.

The value of a forward contract during the life of the contract is estimated with the following formula:

Vt = St –F

(1+r) T –t

This is simply the difference St (spot price)between spot price) at time t, and F(1+r) T –t

(present value

of forward price) for the remaining life of the contract.Suppose that t is 15 days and the spot price (St) is $106, then the value of the contract equals to:

Vt =106 –101(1.1)0.5

= 9.7

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

Pricing and Valuation of Futures ContractsAt the expiration date, if it was written on the contract to deliver physical product to a specific location,

the seller of the contract must deliver the underlying asset to the designated location, and the buyer of the contract is required to pay for it at the spot price.

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

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

Futt d/f = Ft

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

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

Pricing and Valuation of Swap ContractsTo understand the logic behind swap pricing and valuation, let us consider the following example first.

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

101


Net gain to FixedFixed payment

Floating payment

0 1 2 3

-1%10%9%

0%10%10%

1%10%11%

Figure 4.15 3-year plain vanilla interest rate swap.

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

important

The value of a swap at the start of contract is typically zero, and the swap price is determined through replication. The swap price is simply the PV of all net cash flow payments from the swap. Throughout the life of a swap contract, the value of a swap also changes.

Swap rates are locked in for the future like in the case of a forward rate agreement. It is the same as locking in multiple forward rate agreements for different periods at different forward prices.

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

John Tom

Make qual �xed payment FS0(T)

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

Figure 4.16 Replication of a swap.

• First,Johnbuysafloating-ratebondthatpayscouponsS0, S1, q....SN at times t = 1, 2...N.• Then,Johnborrowsmoney(equivalenttoissuingafixed-ratebond)inordertopurchasethis

floating rate bond. The payments for the money borrowed are equal fixed-payments of FS0(t) at t = 1, 2, ...N.

• Thepriceoftheswapistherateatwhichthemoneywasborrowedbyfloater.Byconsideringtheprinciple of no-arbitrage pricing, the fixed rate on the swap should be equal to the fixed-rate bond, which was issued in the second step.

• ThePVoftheexpectedfuturecashflowsisconsideredthevalueoftheswapduringitslifetime.Thefloating payments depend on the underlying rate’s market price.

Pricing and Valuation of Option ContractsThe option-pricing models are mathematical formulas or calculation processes that use certain variables

to calculate the theoretical value of an option. In the option pricing models, the output is the theoretical actual value of an option. If the model works well, the market price (option premium) of the option will be equal to its theoretical actual value. Option-pricing models provide us with the fair value of an option.

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The process of obtaining the theoretical real value of options is called option pricing.

important

Knowing the estimate of the fair value of an option, finance professionals could adjust their trading strategies and portfolios. Therefore, option-pricing models are powerful tools for finance professionals involved in options trading.

Binomial Option Pricing Model and Black Scholes Option Pricing Model are commonly used models for option pricing.

First, the binomial option pricing model, which is a calculation process rather than a formula, will be examined. Then, Black Scholes option pricing model based on a mathematical formula will be discussed.

Binomial Option Pricing ModelThe simplest method to price the options is to

use a binomial option-pricing model. Under the binomial model, we consider that the price of the underlying asset will either go up or down in the period. Given the possible prices of the underlying asset and the strike price of an option, we can calculate the payoff of the option under these scenarios, then discount these payoffs and find the value of that option as of today.

Black-Scholes Option Pricing ModelThe Black-Scholes model is another commonly

used option pricing model which was developed by Fischer Black and Myron Scholes in 1973. The Black-Scholes model was developed mainly for the pricing European options on stocks. The model operates under certain assumptions regarding the distribution of the stock price and the economic environment.

The main variables used in the Black-Scholes model include:

• Priceofunderlyingasset,whichisacurrentmarket price of the asset

• Strike price,which is a price atwhich anoption can be exercised

• Volatility, which is a measure of howmuch the security prices will move in the subsequent periods. Volatility is the trickiest input in the option-pricing model as the historical volatility is not the most reliable input for this model

• Time until expiration, which is a timebetween calculation and option’s exercise date

• Interestrate,whichistherisk-freeinterestrate.

In 1973, Fisher Black and Myron Scholes proved a formula for pricing European call options and put options on non-dividend-paying stocks. Their model is probably the most famous model of modern finance.

important

In general, the higher the historical volatility of the underlying asset, the higher the option price.

How can derivatives be priced?Associate the price of options with the volatility of the underlying assets.

Tell the application cases of pricing and valuation of different tips of derivative agreements.

3 Explain the basic logic of derivative pricing and valuation


Learning Outcomes

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Hedging instruments in emerging market economiesSweta Saxena and Agustín Villar

BIS Papers No 44…………..The FX derivatives market is the most important and most developed in EMEs. The

demand for hedging in the FX market is driven by investors’ desire to invest in emerging market bonds and equities. FX derivatives markets are most developed in countries with deep and efficient spot markets (eg Hong Kong and Singapore). However, they have also developed in some other EMEs (namely Brazil, India, Korea, Mexico, Russia and South Africa). The banking sector is the biggest user of OTC derivatives in EMEs. Among FX derivatives, FX swaps dominate the OTC derivatives market in EMEs as they enable foreign investors to access the local money market. FX forwards are dominant in Korea and Taiwan and are fairly liquid in a few other EMEs (eg Chile, Hong Kong, India, Russia, Singapore and South Africa). Currency swaps constitute a very small share of FX derivatives and are traded mainly in Brazil and Korea. FX options have relatively large trading volumes in Hong Kong, India and Singapore. Offshore trading of many EME currencies is quite significant, with NDFs and options being the main hedging instruments traded in this way.

While the FX derivatives market is quite developed in EMEs, the OTC derivatives market for hedging interest rate risk is rather underdeveloped and mostly concentrated in interest rate swaps. Some reasons for their underdevelopment may include the low level of interest rate risk, which in any event mostly resides with the banking sector and can be handled in other ways. CDS provide a hedge against credit risk, but for EMEs they are mostly concentrated on sovereign entities instead of corporations.

The benefits of hedging exchange rate risks with derivative products come at the price of some risks. In the absence of derivatives markets, speculative attacks channeled through the spot markets can be resisted by the central banks, provided they have sufficient reserves and a banking sector strong enough to withstand high interest rates. However, with derivatives markets, speculators can take virtually unlimited positions in forward and swap markets and reduce the effectiveness of central bank’s intervention (Dodd (2001). Furthermore, as markets become one-sided, dynamic hedging in the derivatives market can amplify market movements. Authorities should bear these risks in mind, even while fostering the development of the derivatives market (Chan-Lau (2005)).

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

In Practice

Derivative Markets

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Sum

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LO 1 Describe derivatives market

There are two categories of markets where derivatives are created, Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC). Exchange-traded derivatives are standardized such that its terms and conditions are precisely specified by the exchange where OTC is the customizable contract that can be customized by the involving parties. In other words, derivatives exchange-trade standardizes every term and condition of contracts except their prices. For example, suppose an exchange introduces a standardized contract for metal Gold. It specifies the quality of gold, the quantity of gold, expiration date, and the location where the gold should be delivered. Normally, the price of a derivative contract is defined by buyers and sellers (long and short parties). Chicago Mercantile Exchange (CME) is an example of exchange-traded derivatives markets. The exchange-traded derivatives also provide credit guarantee and ensure that there will not be any credit risk. On the over-the-counter derivatives markets, investors directly trade legal derivative contracts without involving an intermediary. Such markets are also called informal derivative markets because the engaged parties are not obligated to carry out their promises. Through both buyer and seller of OTC contracts informally agrees to buy or sell derivative contracts, but still, there is the possibility of a default. The OTC contracts are customized contracts and they are less liquid than exchange-traded derivative contracts as well as they are less transparent. It is worth mentioning that the market makers make a profit through the bid-ask spread as they fulfill the needs of both buyer and seller through buying from a seller at one price and selling to a buyer at a higher price.

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

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

LO 3 Explain the basic logic of derivative pricing and valuation

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


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Test Yourself

1 A type of financial instrument , the value of which is derived from another underlying product can be defined as…………………………?

A. mortgageB. forfaitingC. factoringD. franchisingE. derivative

2 Which of the following is an example of exchange-traded derivatives market?

A. Chicago Mercantile Exchange (CME) B. Central Management Europe (CME)C. Canadian Manufacturers and Exporters (CME)D. Continuing Market of Exchange (CME)E. Central Management of Exchange (CME)

3 Which of the following is false?

A. Futures contracts are more liquid than forward contracts.

B. Futures contracts are marked to market.C. Futures contracts allow fewer delivery options

than forward contracts.D. Forward contracts amount are negotiable. E. Forward contracts trade on OTC (Over-the-

counter) derivative market.

4 A put option has a strike price of $135. The price of the underlying stock is currently $142. The put is:”............”.

A. at the moneyB. out of the moneyC. in the moneyD. near the moneyE. put the money

5 A call option with a strike price of $155 can be bought for $4. What will be your net profit if you sell the call and the stock price is $152 when the call expires?

A. $9 B. $4C. $3 D. $0E. -$4

6 The buyer of the forward contract is said to be …………………forward.

A. put B. callC. cross D. longE. short

7 Which of the following statements is false?

A. Interest rate swaps are a form of over-the-counter derivative.

B. A European-style option will give the right to buy or sell at any time up to and including the expiry date.

C. There are two categories of markets where derivatives are created, Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC).

D. Options provide a buyer or a seller the right to buy or sell an underlying asset at a price previously fixed.

E. The value of a derivative depends on an underlying asset.

8 Which of the following cannot be defined as a derivative security?

A. Forward B. FuturesC. Swap D. OptionE. Barter

9 Suppose that the expected future value E(ST) of the underlying asset at t = 1 is 200. The interest rate (risk free rate + risk premium) is 20%, the discounted storage cost for one year is 5, and the discounted benefit from holding the asset for one year is 2. What would be the current price of an underlying asset?

A. 158,66 B. 160,66C. 163,66 D. 169,66E. 173,66

10 Which of the following is not among the main variables used in the Black-Scholes model?

A. Price of underlying assetB. Strike priceC. VolatilityD. Time until expirationE. Euro/Dollar Parity

Derivative Markets

106

Ans

wer

Key

for

“Tes

t You

rsel

f”

Yanıtınız yanlış ise “Derivatives: Definitions And Uses” konusunu yeniden gözden geçiriniz.

1. E Yanıtınız yanlış ise “Types of Derivatives” konusunu yeniden gözden geçiriniz.

6. D

Yanıtınız yanlış ise “Types of Derivatives” konusunu yeniden gözden geçiriniz.

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

8. E

Yanıtınız yanlış ise “The Structure Of Derivative Markets” konusunu yeniden gözden geçiriniz.

2. A Yanıtınız yanlış ise “Types of Derivatives” konusunu yeniden gözden geçiriniz.

7. B


4. B


5. B

Yanıtınız yanlış ise “Basics of Derivative Pricing and Valuation” konusunu yeniden gözden geçiriniz.

9. C

Yanıtınız yanlış ise “Basics of Derivative Pricing and Valuation” konusunu yeniden gözden geçiriniz.

10. E

What is the difference between the Exchange-traded derivatives markets and Over-the-counter derivatives markets?

self review 1

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

How many different types of derivatives are there in the market?

self review 2

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

How can derivatives be priced?

self review 3

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

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Brzychczy, E. (2012). Proposal of using SWAPs by hard coal mining companies in Poland, Gospodarka Surowcami Mineralnymi-Mineral Resources Management, 28(2), 87-102.

Butler, K. C. (2016). Multinational Finance: Evaluating the Opportunities, Costs and Risks of Multinational Operations, John Wiley & Sons.

Chisholm, A. M. (2011). Derivatives demystified: a step-by-step guide to forwards, futures, swaps and options, John Wiley & Sons.

Eun, C. and B.G. Resnick. (2009). International Financial Management, McGraw-Hill, Singapore.

Hull, J. (2012). Options, futures and other derivatives, (8th Ed), Upper Saddle River, NJ: Prentice Hall,.

Lu, T. H., Chen, Y. C., & Hsu, Y. C. (2015). Trend definition or holding strategy: What determines the profitability of candlestick charting?, Journal of Banking & Finance, 61, 172-183.

Pirie, W. L. (Ed.). (2017). Derivatives, John Wiley & Sons.

Sevil, G. (Ed.). (2013). Türev Araçlar, Anadolu Üniversitesi Açıköğretim Yayınları, No: 2913.

References

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

Internet References

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Chapter OutlineIntroductionFunctions of Commercial Banking Sources of Funds and Uses of Funds in Commercial BankingRevenues and Expenses of Commercial Banks Risk Management in Commercial Banking

Key TermsMoney,

Deposits, Loans,

Interest Income, Interest Expense,

Liquidity Risk, Interest Rate Risk,

Credit Risk, Operational Risk

Lear

ning

Out

com

es

Identify revenues and expenses of commercial banks

Describe the main functions of commercial banks

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

Describe the main types of risks that commercial banks are exposed to 3

1 24

Commercial Banking

109

Financial Markets & Institutions 5INTRODUCTION

Banks are one of the most significant foundations of a modern economy. The roots of modern banking date back to the sixth century B.C. The first banking operations existed in Mesopotamia, Ancient Greece and the Mediterranean region, where goldsmith bankers originated to facilitate trade by providing loans to merchants. Later, merchants started to become bankers and merchant banking flourished. Merchant bankers gained dominance during the Roman Empire times. In fact, the origin of the term “bank” is the merchant’s bank, or banco on which money was exchanged in the market. In Italy, merchant bankers such as the Medici family gained economic and political power and financed Italian artists of the Renaissance in the 15th and 16th century. Some Italian Merchant bankers moved their operations to other European cities like London and Berlin and financed the royal families of Europe around the 17th and 18th century. Other bankers followed and the modern banking industry evolved around the banking practices of maintaining deposit accounts, granting loans and processing payments.

Commercial banks or deposit banks collect savings from lenders, deposit them and use these savings to make loans to borrowers. Hence, financial assets of savers are transformed into liabilities for borrowers. In other words, commercial banks make profits by matching savers and borrowers. Commercial banks also play important roles in the economy by bringing small amounts of money together from many savers and re-packaging these funds into larger packages of loans for businesses and individual clients. Moreover, they transform the maturity of funds by borrowing deposits usually with a short term and lending those funds in the form of loans with a long term. They also help diminish asymmetric information problems. They reduce adverse selection problems by collecting information about the creditworthiness of loan applicants. They also reduce moral hazard problems by carefully watching the borrowers.

In this chapter, we discuss the main functions of Commercial Banking, explain how they operate and earn money by identifying their sources of funds and uses of funds as well as their revenues and expenses. We also elaborate on how commercial

banks manage their assets and liabilities and their risks in order to survive and succeed in a highly competitive market.

FUNCTIONS OF COMMERCIAL BANKING

There are various actors in the economy: businesses, households, government, foreigners. Some economic units, the revenues of which exceed their expenditures have a surplus and therefore they save; while some economic units, the revenues of which are not sufficient to cover their expenditures have a deficit and they borrow to finance their deficit. Likewise, some economic units may seek funds to borrow in order to undertake some profitable investment projects. Hence, surplus units or savers would like to invest their savings by lending them to the deficit units or potential borrowers desiring to finance capital investments; whereas deficit units would like to cover their deficit by borrowing from the surplus units.

The financial system brings economic actors together through financial markets and financial institutions and channels those funds between surplus and deficit units. Thus, there is a continuous flow of funds from surplus units to deficit units either directly through financial markets or indirectly through financial intermediaries. Financial intermediaries act like a bridge between lenders and borrowers.

We can classify financial intermediaries or financial institutions as depository institutions and non-depository institutions. Depository institutions include commercial banks, savings banks and savings and loans associations as well as credit unions. Non-depository institutions include insurance companies, pension funds, mutual funds, finance companies and investment banks.

Commercial banks are financial firms, which collect deposits from savers and channel those deposits to borrowers in the form of loans. In other words, commercial banks are depository financial institutions, which specialize in making commercial loans. Commercial banks offer borrowers short-term loans such as lines of credit or overdraft facilities. On the other hand, they offer depositors the ability to withdraw or pay money on demand or on a specific date at a fixed return.

110

Commercial Banking5Hence, commercial banks provide guarantee of money at short notice. Especially, in countries with unreliable stock markets, banks provide people a safe and trustworthy investment opportunity. The most dominant financial institutions in Turkey and in most European countries are commercial banks.

Commercial banks play an important role in the financial system by collecting deposits from savers and making loans to borrowers. Commercial banks facilitate the transfer of funds and enhance efficiency in the economy.

In the case of direct finance, a saver lends money to parties seeking funds without a financial intermediary such as a bank. In the case of indirect finance, a financial intermediary issues its own financial instruments called securities using funds of savers. Indirect finance enables funds of savers to be transferred to borrowers

through financial intermediaries. The existence of asymmetric information in financial markets is the main reason for indirect finance. Asymmetric information exists if one party in a financial transaction has information not possessed by the other party. Asymmetric information may lead to adverse selection problems or moral hazard problems. Those businesses, which seek funds for low quality investment projects are likely to be the ones which desire to borrow most. As savers cannot distinguish between these high quality and low quality potential borrowers due to asymmetric information, they may be less willing to lend their funds. This problem arising from asymmetric information is called adverse selection. Even if savers lend their funds, there is a likelihood that the borrower may act immorally and engage in a behavior such as lax management of the loan that increases risk after the loan is made. This kind of problem, which stems from asymmetric information is called moral hazard.

Reducing adverse selection and moral hazard problems is very costly for savers as they must evaluate the creditworthiness of the borrowers before making the loan and monitor their behavior after making the loan. These processes require time and resources. Financial intermediaries can reduce those asymmetric information problems and save lenders from incurring these costs by specializing in assessing potential borrowers and monitoring loans. By pooling savings together in mutual funds or pension funds and spreading the management costs across a great number of savers, financial intermediaries may permit savers to benefit from economies of scale by reducing the average cost of managing those funds. Hence, commercial banks are able to provide lending to companies at a relatively low rate of return because of the economies of scale they can enjoy compared with the primary investor. These economies of scale include:

• Efficiencies in gathering information onthe riskiness of lending to a particular firm and subsequent monitoring

• Risk spreading across a large number ofborrowers

• Low transactioncostsdue to standardizedsecurities

• Aregularflowofliquiditythroughdepositsor borrowings.

Commercial banks hold financial assets for others and invest those financial assets to create more wealth in the economy.

important

The regulation of the banking sector is the key to maintaining the public’s trust. Governments naturally have laws in place to prevent banks from engaging in dangerous activities.

Households

GovernmentBusinesses

Foreigners

FinancialMarkets

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Financial Markets & Institutions 5

In fact, banks create deposits when they lend money through loans. Instead of giving loans in cash, banks issue checks against the name of the borrowers. The borrowers can draw checks and the people who receive the checks deposit them in other banks. Banks must keep a certain proportion of deposits with the central bank, which is called the legal minimum cash reserve. The remaining portion can be used to make loans and create money.

We can define money as anything that economic actors use as a payment mechanism in economic transactions or debt settlement. We need money since economic actors exchange goods and services in return for money. Although goods and services can also be exchanged directly through a barter system without money, parties involved should bear the costs arising from the time and resources spent in the search of trading partners. High transaction costs and inefficiencies of the barter system encourage people to use something as a standard “medium of exchange”. By eliminating the costs and inefficiencies of the barter system, money enables people to specialize their production and consequently enhances higher productivity in the economy.

Besides providing a medium of Exchange, money provides a way of measuring value as well. We call this function of money as “the unit of account”. Money also allows people to accumulate wealth in a widely accepted “store of value”, which can be used for consumption or investment purposes today or in the future. Money smooths and boosts transactions in the economy by providing a payments system. The mechanisms used in the payments range from gold and silver to paper currency and checks to electronic funds transfers and digital money.

Commercial banks attract funds by issuing securities with characteristics that appeal to the primary investor. They create an intermediate security such as a deposit account or loan and generate opportunities for savers and investors by transforming the risk level, maturity or liquidity and volume of assets.

Business lines in the commercial banking industry can be classified as Retail Banking and Corporate Banking. Retail banking mainly covers individuals and includes financial services such as credit cards and consumer loans as well as mortgages. It also covers very small enterprises, such as those of physicians or home services. Corporate banking transactions cover large businesses and include financial services like overnight loans, short-term loans, revolving facilities, term loans, committed lines of credit or large commercial and industrial loans.

Commercial banks are financial institutions, which can create credit and money.

important

Commercial banks create money or credit against deposits through the money multiplier.

You can watch videos on “the money multiplier” on YouTube.

internet

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Commercial Banking5

SOURCES OF FUNDS AND USES OF FUNDS IN COMMERCIAL

BANKINGThe sources of funds and uses of funds of bank

are shown on the balance sheet of the bank.

The primary source of funds for commercial banks are deposits, whereas the primary use of funds is loans. Besides deposits, other liabilities or sources of funds for commercial banks include borrowings from other financial institutions.

Besides loans, other assets or uses of funds for commercial banks include required reserves against deposits and excess reserves held in the Central Bank, currency in ATMs, deposits with other banks and assets invested in marketable securities such as government bonds, corporate bonds and asset backed securities.

Liabilities and Equity Capital of Commercial Banks

Liabilities are claims on the assets of businesses at a certain point of time. Liabilities of a commercial bank can be categorized as controllable and uncontrollable liabilities. Non-controllable liabilities are the liabilities over which clients have discretion rather than the bank and mainly consists of deposits in the form of demand deposits, checkable deposits, savings deposits and small denomination time deposits. Liabilities, the amount of which can be controlled by the bank are referred to as controllable liabilities. Controllable liabilities include large denomination time deposits and short-term borrowings in the interbank money market.

How do commercial banks reduce asymmetric information problems?

How do banks create money?Tell the difference between Retail Banking and Corporate Banking.

1 Describe the main functions of commercial banks


Learning Outcomes

important

The liabilities and the capital of a commercial bank constitute its sources of funds, while the assets of a commercial bank constitute its uses of funds.

Excess reserves are reserves held by commercial banks above the reserves held to meet reserve requirements of the Central Bank.

An asset-backed security (ABS) is a financial security such as a bond or note, which is collateralized by a pool of assets such as loans, leases, credit card debt, royalties, or receivables.

important

The deposit account held in a bank is an asset for the deposit holder, who is household or firm whereas it is a liability for the commercial bank

113


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

Equity capital or net worth of a commercial bank is the excess of assets over liabilities.

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

Exhibit 5.1 Summary Balance Sheet of a Commercial Bank.

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

Assets of Commercial Banks Assets are items of value owned by businesses at a certain point of time. Those assets include notes and

coins, balances with the Central Bank, inter-bank loans, advances, investments, premises and computers. The most important assets of a commercial bank can be categorized as follows:

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

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Commercial Banking5• Loans• Securities• CashAssets• FixedAssetsAsset composition of commercial banks or how

commercial banks allocate their funds to various uses reflects how banks operate. In general, the proportion of individual loans and government securities is larger in small banks, whereas the proportion of corporate loans is larger for large banks.

The main category of assets commercial banks hold is loans. Loans extended to businesses are called corporate or commercial loans. Banks may sometimes require businesses to pledge some assets as a collateral to secure the loan, so that they can be seized in the event of repayment failure. However, some loans granted to businesses with high creditworthiness are uncollateralized. Banks often extend a line of credit to businesses so that they can borrow up to a limit. A line of credit (LOC) is an arrangement between a financial institution, usually a bank, and a customer that establishes the maximum amount a customer can borrow. Businesses may use this line of credit in the form of revolving credits or spot credits.

Revolving credits are widely used by businesses to finance their short-term working capital needs. These credits are self-liquidating working capital loans, which can be withdrawn and repaid at different points of time within a certain limit. Hence, the balance of the loan fluctuates over time and interest rate applied to the loan may vary over time due to changing market conditions. Interest accumulates based on the fluctuating balance of the loan and is paid at the end of every quarter (end of March, June, September, December). Another common type of loan made by commercial banks are spot credits or term loans, which are offered for a specific amount for a specific time charging a fixed interest. Term loans are generally used for a specific purpose like purchase of machinery.

Banks also make loans to individuals in the form of consumer loans. Consumer loans are granted to finance purchase of autos, houses, home improvements, household appliances or durable consumer goods. Most of these loans are installment credits. Those credits require borrowers to repay the principal and the interest of the loan in equal periodic (monthly, quarterly etc.) installments over

a certain period of time, typically spanning over 1 to 5 years. Interest rates are usually determined as fixed in the credit agreement, though sometimes the interest rates can be variable.

Another instrument through which banks provide credit to consumers is credit cards. Banks designate a certain limit to qualifying customers to allow them use the credit card to make purchases within that limit and pay the credit card debt balance each month at a specific date without interest if customers pay all the balance on time.

Banks also offer loans in the interbank market. The funds lent are returned with interest at the maturity of the loan. Repurchase agreements (repos) are another way of providing short term loans. Banks purchase Treasury securities to sell them back at a later date by the repo agreement. The bank provides short-term financing to the customers and the securities of the customer provides security for the funds lent by the bank through the repo transaction.

Another category of assets includes investments in securities such as government bonds and Treasury bills. Banks own some assets in cash as a medium of Exchange in daily operations. Banks hold some vault cash at their offices to meet withdrawal demands. They also maintain some reserve deposits with the Central Bank as well as deposits with other commercial banks which are called correspondent balances. Last but not the least, banks maintain some fixed assets like land and buildings to carry out their operations.

Loans include commercial loans, consumer loans and short-term loans extended in the interbank market or loans extended through repurchase agreements.

important

Loans granted by commercial banks to businesses and individuals constitute the most significant portion of commercial banks’ assets.

115

Financial Markets & Institutions 5Commercial banks grant loans to households and businesses. Loans granted to businesses are called

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

REVENUES AND EXPENSES OF COMMERCIAL BANKSA commercial bank can earn profit if its revenues exceed its expenses. The main sources of revenue in

the form of interest revenue, commissions and fees for a commercial bank are as follows:• Grantingloans• Investinginmarketablesecurities• Providingcreditcardsanddebitcards• Servicingdepositaccounts• Providingfinancialadvice• Providingwealthmanagementservices• CarryingoutforeignexchangeThe expenses of a commercial bank in the form of interest expense and costs arise mainly from the

following: • Collectingdeposits• Borrowings• Providingfinancialservices

The difference between the average interest rate banks receive on their assets and the average interest rate they pay on their liabilities is called the bank’s spread.

important

Commercial banks attempt to diminish their risks by diversifying their loans and other investments to avoid an unexpected loan default from sinking the entire bank.

Where can you find information about the main sources of funds and uses of funds of a commercial bank?

How does the spread affect the profitability of commercial banks?

Tell the difference between commercial loans and corporate loans.

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


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Commercial Banking5Commercial banks earn interest income on the loans they grant and the securities they invest in.

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

Commercial banks incur interest expense as they pay interest to the deposit holders. Interest expense constitutes the largest proportion of expenses for commercial banks.

Besides interest expense, another significant cost item for commercial banks are the expenses for loss provisions. In case some proportion of loans are not repaid, commercial banks hold a certain proportion of their assets in liquid assets, which are referred to as loan loss reserves. These reserves are depleted, as some of the loans default. Therefore, some additional funds must be allocated to these reserves. These additions to the loan loss reserves are an expense for commercial banks, which are called provisions for loan loss reserves.

Commercial banks also bear operating expenses for real resources such as labor, capital, land to provide banking services.

The profit of a commercial bank is the difference between the total income (the interest income and non-interest income) and the total costs (interest expense, loan loss provisions and operating expenses).

Profit=TotalRevenues–TotalExpenses

important

Loan principal payments are not sources of revenue, while the interest payments on the principle are sources of revenue for commercial banks.

In recent years, non-interest income has become a significant source of revenue, as interest rates have declined and competition has become tougher.

important

In recent years, commercial banks have been cutting their expenditures on real resources by reducing human resources as the industry hasbecomemoredigitalized.(Pleasereferto“Further Reading”)

Which income items are classified as non-interest income of a commercial bank?

Discuss how commercial banks can improve their profitability.

Tell how commercial banks generate revenues.

3 Identify revenues and expenses of commercial banks


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Financial Markets & Institutions 5RISK MANAGEMENT IN

COMMERCIAL BANKING Commercial banks aim to raise shareholders’

wealth by enhancing profitability in order to meet the expectations of their shareholders, just like other businesses. For this aim, they struggle to increase operational efficiency in the short run and optimize risk-adjusted profitability in the long run. Therefore, commercial banks need to ensure that they establish and operate effective risk measurement and management systems in order to assess and mitigate the risks they are exposed to.

Risk can be defined as the potential of loss resulting from uncertainty. For commercial banks, risk denotes negative consequences due to uncertainty of outcomes, which may influence the bank adversely. The uncertainty cannot be removed, but the exposure to uncertainty can be changed.

Effective risk management is vital for commercial banks to strengthen their profitability, to ensure solvency and guarantee survival. Risk management in commercial banks involve the following processes:

• Identificationofrisks• Measurementofrisks• Pricingofrisks• ControlofrisksThe necessary mechanisms and rules to carry

out these processes should be determined clearly and shared within the organization to ensure they are well understood and committed by managers and employees.

The most important types of risks, which commercial banks face, can be classified as follows:

• Interest rate risk, which arises from the different maturity structure of the banks’ assets and liabilities.

• Liquidity risk, which is the risk that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.

• Credit risk, which is the risk of changes in the economic value of the bank’s assets due to unexpected changes in the creditworthiness of counterparties.

• Operational risk, which includes the risk of damages caused by human and technological factors

Interest Rate RiskUsually, banks finance their assets such as loans

or bonds by deposits or issuing other liabilities, the maturity of which is shorter than those assets. The imbalance between maturities of assets and liabilities leads to exposure to the interest rate risk. Interest rate risk stems from changes in market interest rates. Fluctuations in market interest rates influence the profitability of banks.

Risk management in commercial banking necessitates that the risks are identified, assessed and controlled.

An integrated risk management framework to mitigate individual and overall risks can help quantify and allocate the optimal capital and enhance the value creation strategy of the bank.

important

Top managers should participate in the definition of objectives and procedures of the risk management system.

Interest rate risk

Credit Risk

Operational Risk

Liquidity risk

Types of Risks in

CommercialBanking

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Commercial Banking5Interest rate risk is connected with the positions

in the bank’s assets and liabilities portfolio. This risk can be measured by considering the following items:

• Interest-earningfinancialinstruments• Interest-bearingfinancialinstruments• Contractsonbothsidesofthebalancesheet• Derivativeswhosevaluedependsonmarket

interest ratesPrinciples on estimating interest rate risk on

the banking book are established by the Basel Committee (an advisory body whose members are representatives of banking supervisory authorities from major industrialized countries). According to these principles, banks must hold capital commensurate with the level of interest rate risk they undertake.

Commercial banks use the Gap analysis and Duration analysis to measure interest rate risk. Changes in market interest rates affect only interest rate-sensitive assets and liabilities. The main logic behind these concepts is the fact that interest-earning assets and interest-bearing liabilities exhibit different sensitivities to changes in market rates.

The Gap over a given time period (gapping period) is defined as the difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities.

Duration gap is the difference between the average duration of the assets and the average duration of the liabilities of a commercial bank. A positive duration gap implies that the duration of the assets is greater than the duration of liabilities. Thus, an increase in the market interest rates will cause a greater decrease in the value of assets compared to liabilities and consequently the equity of the bank will decrease. On the contrary, a decrease in the market interest rates will lead to an increase in the equity of the bank.

In order to diminish interest rate risk, commercial banks with negative gaps may attempt to make more floating rate loans rather than fixed rate loans. They may also use interest rate swaps to exchange payments from a fixed rate loan to a floating rate loan. Moreover, they may utilize derivatives such as futures and option contracts to hedge interest rate risk.

Liquidity RiskLiquidity risk is the inability of the bank to

meet its financial obligations when they become due. A commercial bank may be unable to meet short-term financial demands, if it experiences sudden unexpected cash outflows due to large deposit withdrawals, large credit disbursements, or unexpected market movements. During the 2008 financial crisis, many big banks in the United States of America failed or faced insolvency issues because of liquidity problems.

important

Changes in market interest rates may also influence the capital of commercial banks as well as the profits of the banks. Duration analysis measures the sensitivity of the bank’s capital to changes in market interest rates.

important

In general, falling market interest rates implies increases in profits and net worth of commercial banks, whereas rising interest rates implies decreases in profits and net worth of commercial banks.

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including derivatives.

important

Illiquidity of commercial banks may lead to reputation risk. Thus, bank managers must ensure that the bank maintains sufficient liquidity.

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Financial Markets & Institutions 5Credit Risk

Credit risk is the risk that borrowers may default on their loans. Credit risk arises because of asymmetric information problems mentioned before. Because commercial banks know less than the borrowers about their financial health, commercial banks may extend loans to risky borrowers (adverse selection). Likewise, borrowers may use the loans for purposes not intended by commercial banks (moral hazard).

The common process for controlling risks is based on risk limits and risk delegations. Limits impose upper bounds to the potential loss of transactions, or of portfolios of transactions. Delegations serve for decentralizing the risk decisions, within limits.

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

Joël Bessis

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

Operational RiskWithin the scope of operational

risk, damages and losses may arise mainly due to the following reasons:

• Infidelityofhumanresources• ITcrashes• Humanerrors• Softwarebreakdowns• Fraud• Electronictheft• Adversenaturalevents• Robberies• Inadequacyoftheprocedures,controlsystemsandorganizationalprocedures

Relationship banking is a strategy used by banks to strengthen loyalty of customers and provide a single point of service for a range of products and services.

important

Banks that do not differentiate risks of their customers would suffer from adverse selection. Overpricing good risks would discourage good customers. Underpricing bad risks would attract bad customers.

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Commercial Banking5

Turkey’s banking sector expected to display strong performance in 2020https://www.dailysabah.com/finance/2019/12/16/turkeys-banking-sector-expected-to-display-

strong-performance-in-2020Turkey’s banking sector is signaling a strong future performance for 2020 after weathering a

challengingperiod in2018-2019with success, according toKPMG’s reportMonday.The sector isexpected to spearhead economic recovery due to its open channels to international financial sources and toshowbetterperformancecomparedtotheotherindustries,accordingtoKPMG’sSectoralOverview2020 Banking report.

KPMG’sFinancialServicesSectorLeaderKeremVardarsaidthatTurkishbankshavemovedtoabetter position in 2019 in terms of having better access to foreign financial assets. “After overcoming the 2018-2019 period successfully, the banking sector’s 2020 focus will now be on preserving its asset quality,”Vardarsaid,addingthattheeconomicactivitybyvarioussectorsrenewedaftertheturbulentperiodwillmake a significant contribution to the banking sector’s profitability.Vardar underlinedthat it was natural for the banking sector to be the first industry to reflect the overall recovery in the economy, which performed better than expectations despite the international pressure over Turkey’s OperationPeaceSpringinSyria,domesticpoliticaltensionsandexpectationsoveracontractionintheeconomy. Having remained under the pressure of internal and external uncertainties throughout the year, the sector kept its asset size at the same level as of the end of the 3rd quarter of 2019 with total assets of the sector reaching TL 4.27 trillion.

Despite the growing assets, profitability failed to show a similar positive performance. The banking sector recorded a profit of TL 36 billion in the first three quarters of 2019, a 13% decline compared to the same period the previous year. Banks’ inability to increase interest margins due to the maturity mismatch played a significant role in the decline in profits,KPMG reported.However, the reportforecasted a 15% increase in net profits thanks to productivity increases and effective cost management in the sector but warned that net interest margins will be limited due to uncertainties over the inflation outlook.KPMGsaidthebankingsector’sstrengthswereitsdiverseandreliableforeigncapitalsources,asset quality, high liquidity as well as strong corporate and technological capabilities, which successfully managed past crises and adapted to new developments. “Despite the high level of liquidity, maturing external debt payments pose certain threats to the sector,” the report warned. Turkey’s proximity to conflict areas in the region and the internal economic dynamics’ increased sensitivity to external threats were cited as potential threats to the banking sector in 2020.

Digital transformation remains to be at the top of the sector’s agenda as many of the Turkish banks have become “digital champions,” leading the adoption of digital technologies. The report said that the banks continue to allocate a significant portion of their investment expenditures and budgets to improve their digital platforms. “The current performance shows the magnitude of the Turkish banking sector’s appetite for digitalization and that the growth will not slow down in the short term,” it added. According toKPMG,Turkishbanksshouldnotonlyseedigitalizationas“enhancedinternetbanking”butshouldconsider automating their internal operations and therefore, optimizing their operational expenses.

Further Reading

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https://corporatefinanceinstitute.com/resources/knowledge/credit/commercial-credit-analysis/The 5 C’s of Commercial Credit AnalysisThe 5 C’s of credit analysis is a basic framework that guides the lender in assessing the creditworthiness

of a borrower. The 5 C’s are as follows:1. CharacterCharacter is an important element of credit analysis, and it looks at the borrower’s reputation

for paying debts. The lender is interested in lending to people who are responsible and needs to be confident that they have the right experience, education background, and industry knowledge to operate the business.

In addition, the lender assesses the borrower’s character by looking at their credentials, reputation, interaction with other people, as well as credit history. It will review the borrower’s credit report to know how much they have borrowed in the past, and whether they paid the credit on time. Most lenders have a base credit score that loan applicants must meet in order to qualify for a specific type of credit.

2. CapacityCapacity evaluates the borrower’s ability to service the loan using the cash flows generated by the

business. The lender wants the assurance that the business generates enough cash flows to able able to make principal and interest payments in full.

The lender will assess the capacity of the borrower by looking at their cash flows statements, credit scores, as well as the payment history of current loans and expenses. It will calculate how repayments are supposed to take place, the timing of repayments, current cash flows, and the probability that the borrower will make successful repayments.

3. CapitalCapital is the amount of money that the business owner or executive team has invested in the

business. Lenders are willing to extend credit to borrowers who have invested their own money into the business, which serves as proof of the borrower’s commitment to the business.

Borrowers with a large capital contribution in the business find it easier to get loan approval because they present a lower risk of default. For example, when buying a home, a borrower who has placed a down payment of about 20% of the value of the house can get better rates and terms for the mortgage.

4. CollateralCollateral is the security that the borrower provides as a guarantee for the loan, and it acts as a

backup in the event that the borrower defaults on the loan. Most often, the collateral provided for the loan is the asset that the borrower is borrowing money to finance. For example, a home acts collateral for mortgages, and auto loans are secured by vehicles. The collateral can also be inventory for the business, real estate property, factory equipment, and working capital.

In Practice

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Commercial Banking55. ConditionsThe condition of the loan refers to the purpose of the loan, as well as the conditions of the business.

The loan’s purpose can be to purchase factory equipment, finance real estate development, or serve as working capital. Loans with a specific purpose are easier to approve than signature loans that can be used for any purpose.

The lender also considers the condition of the environment in which the business operates. The conditions can be the state of the economy, industry trends, competition, etc., and how these factors may affect the borrower’s ability to repay the loan.

Which processes do commercial banks use for credit approval?

How do changes in market interest rates influence profitability of commercial banks?

Which methods may commercial banks use to manage credit risks?

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


Learning Outcomes


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LO 1 Describe the main functions of commercial banks.

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

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

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

LO 3 Identify revenues and expenses of commercial banks.

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

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

The most important types of risks, which commercial banks face, can be classified as follows:• Interestraterisk,whicharisesfromthedifferentmaturitystructureofthebanks’assetsandliabilities.• Liquidityrisk,whichistheriskthatabankmaynotbeabletomeetitscashneedsbysellingassetsor

raising funds at a reasonable cost. • Creditrisk,whichistheriskofchangesintheeconomicvalueofthebank’sassetsduetounexpected

changes in the creditworthiness of counterparties.• Operationalrisk,whichincludestheriskofdamagescausedbyhumanandtechnologicalfactors.

Commercial Banking

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1 Which one of the following is a revenue item for commercial banks?

A. Loan principal repayments B. Loan loss provisions C. Depreciation expense D. Labor costE. Fees

2 Which one of the following is an expense item for commercial banks?

A. Interest on depositsB. Interest incomeC. Trading income D. Credit card commissionsE. EFT fees

3 Which one of the following is a source of funds for commercial banks?

B. Land C. DepositsD. Loans E. Building

4 Which one of the following is a use of funds for commercial banks?

A. Borrowings in the interbank marketB. DepositsC. LoansD. EquityE. Interest income

5 The imbalance between maturities of assets and liabilities leads to…….

A. liquidity risk B. interest rate risk C. market risk D. credit risk E. operational risk

6 The difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities shows the ………….. of the commercial bank.

A. duration B. convexityC. gap D. maturityE. profit

7 What is the difference between the average interest rate banks receive on their assets and the average interest rate they pay on their liabilities?

A. Gap B. SpreadC. Duration D. ConvexityE. Profit

8 What is the difference between the total income (the interest income and non-interest income) and the total costs (interest expense, loan loss provisions and operating expenses) of a commercial bank?

A. Gap B. SpreadC. Duration D. ConvexityE. Profit

9 Which one of the following is a measure of the sensitivity of the bank’s capital to changes in market interest rates?

A. Gap B. SpreadC. DurationD. ConvexityE. Profit

10 The risk that borrowers may use the loans for purposes not intended by commercial banks is associated with ……………

A. liquidity risk B. interest rate risk C. market risk D. credit risk E. operational risk


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nswer K

ey for “Test Yourself”

If your answer is wrong, please review the “Revenues and Expenses of Commercial Banks” section.

1. E If your answer is wrong, please review the “Risk Management in Commercial Banking” section.

6. C

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

3. C If your answer is wrong, please review the “Revenues and Expenses of Commercial Banks” section.

8. E

If your answer is wrong, please review the “Revenues and Expenses of Commercial Banks” section.

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

7. B

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

4. C

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

5. B


9. C


10. D

Commercial Banking

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wer

s fo

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elf R

evie

w” How do commercial banks reduce asymmetric

information problems?

self review 1

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

Where can you find information about the composition of sources of funds and uses of funds of a commercial bank?

self review 2

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

Which income items are classified as non-interest income of a commercial bank?

self review 3Non-interest income is generated by services like trading derivative instruments (futures, options, swaps etc.), printing checks, clearing checks, transferring funds, electronic fund transfer (EFT) services providing ATM (automated teller machine) services, depositing money.

Which processes do commercial banks use for credit approval?

self review 4

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


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Bessis, J. (2015). Risk Management in Banking, Wiley.

Hubbard, R. G. and O’Brien A. P. (2014). Money, Banking and the Financial System,Pearson.

Lipscombe, G. and Pond K.(2002). The Business of Banking,FinancialWorldPublishing.

Miller R. L. and VanHoose D. D. (1997). Money, Banking, and Financial Markets, Southwestern College.

Mishkin, F. S. and Eakins, S. G. (2012). Financial Markets and Institutions,Pearson.

Sironi, A. and Resti A. (2007). Risk Management and Shareholders’ Value in Banking, From Risk Measurement Models to Capital Allocation Policies, Wiley.

References

https://www.dailysabah.com/finance/2019/12/16/turkeys-banking-sector-expected-to-display-strong-performance-in-2020 (accessed on 28/01/2020)

https://corporatefinanceinstitute.com/resources/knowledge/credit/commercial-credit-analysis/ (accessed on 28/01/2020)

http://www.bankingforsociety.be/bank-balance-sheet (accessed on 28/01/2020)

Internet References

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Chapter 6 Investment Banking

Lear

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Explain the roles of investment banks in Mergers and Acquisitions

Identify the main functions of investment banksExplain the roles of investment banks in bringing new securities to market

Explain the roles of investment banks in advising corporations3

1 24

Chapter OutlineIntroductionOverview of Investment Banking Bringing New Securities to the Market Deal Making in Mergers and Acquisitions Advising Corporations

Key TermsInvestment

BankingUnderwriting

Mergers and AcquisitionsAdvising

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INTRODUCTIONFinancial intermediaries, an important part

of the financial system, have evolved with the purpose of lowering transaction costs and allowing small savers and borrowers to benefit from the financial markets. One solution to the problem of high transaction costs provided by financial intermediaries is to pool the funds of many investors together so that they can take advantage of economies of scale, which is the reduction in transaction costs per dollar of investment as the size of transactions increases. The presence of economies of scale in financial markets helps to explain why financial intermediaries have developed and have become such an important part of our financial system.

Financial intermediaries are also better in developing expertise to reduce transaction costs. A financial intermediary becomes an expert in producing information about firms to deal with asymmetric information and adverse selection problems, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the financial intermediary is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The profit that the financial intermediaries earn gives them the incentive to engage in this information production activity. The financial intermediary’s role as an intermediary that holds mostly non-traded loans is the key to its success in reducing asymmetric information in financial markets. These are the most crucial aspects of investment banking firms as a financial intermediary in the financial system (Mishkin & Eakins, 2018, pp. 179-185).

There are two fundamental ways that new financial claims can be brought to the market: direct or indirect financing. In the indirect credit market, commercial banks are the most important participants; in the direct market, investment banks are the most important participants. Investment banks are firms that specialize in assisting businesses and governments sell their new security issues (debt or equity) in the primary markets to finance capital needs (Kidwell et al., 2016, p. 579).

To raise money, corporations usually use the services of investment banks, whose main job is marketing securities and dealing with the securities markets. Investment bankers act as intermediaries between corporations or governments and the general public when corporations or governments want to raise capital (Melicher & Norton, 2017, p. 299).

OVERVIEW OF INVESTMENT BANKING

A generation ago, we had merchant banks operating in a few developed countries, now they have been renamed as investment banks following the US nomenclature. In modern usage merchant banking is occasionally used for the subset of investment banking businesses concerned with using the bank’s capital to facilitate a transaction such as engaging in mergers and acquisitions (Arnold, 2012, p. 81).

Investment banking changed dramatically during the two decades prior to the global financial crisis that started during mid-2007, when market forces pushed banks from their traditional low risk role of advising and intermediating to a position of taking significant risk for their own account and on behalf of their customers. This high level of risk-taking, combined with high financial leverage, transformed the field during 2008, when several major banks failed, huge trading losses were recorded and all large firms were forced to reorganize their activities.

Risk-taking activities of investment-banking firms reduced following large losses that stemmed mainly from mortgage-related assets, bad loans, and an overall reduction in revenues due to the financial catastrophes. This led to an industry wide effort to reduce leverage ratios and a string of new equity capital issuances.

By the end of 2008, five US based “pure-play” investment banks (which did not operate deposit-taking businesses, unlike large “universal” banks such as JP Morgan Chase, which operated a large investment bank, a deposit-taking business, and other businesses) had undergone significant transformations. Goldman Sachs and Morgan Stanley turned into bank-holding companies; the

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US Federal Reserve (Fed) forced Bear Stearns into the arms of JP Morgan to avoid a bankruptcy; Lehman Brothers filed for bankruptcy protection after the Fed and Treasury Department ignored its requests for government support; and Merrill Lynch, presumably to avoid a similar bankruptcy filing, agreed to sell their firm to Bank of America at a significant discount to historical prices (Stowell, 2017, pp. 3-4).

Investment-banking firms are best known as intermediaries that help corporations raise funds. However, this definition is too narrow to accurately explain the many valuable and complicated services these firms provide (Howells & Bain, 2007, pp. 65-66). Despite its name, an investment bank is not a bank in the ordinary sense; that means, it is not a financial intermediary that takes in deposits and then lends them out, but in countries where there is no legislation commercial banks provide investment banking services as part of their daily range of business activities. Countries where investment banking and commercial banking are combined have what is called a universal-banking system. Universal banks are allowed in most European countries (Kidwell et al., 2016, p. 580).

Universal banks are institutions that are allowed to accept deposits, make loans, underwrite securities, engage in brokerage activities, and sell and manufacture many other financial services such as insurance.

Investment-banking firms are mostly involved in security market operations. They employ ‘analysts’ whose job is to study corporate movements and identify corporations as over or under-valued, or as high-growth and low-growth, high-risk and low-risk, etc. The results of the research are served to clients who are often managers of mutual funds.

Sometimes investment-banking firms act as ‘market makers’ in equity or bond markets. Because of this field expertise, they usually handle the issue of new securities on behalf of companies that want to become limited companies for the first time or that want to raise additional capital for

expansion. Their most high-profile activity, which does occasionally bring them into the eyes of the public, involves their negotiating on behalf of clients during mergers and acquisitions or ‘M&As’ (Howells & Bain, 2007, pp. 65-66).

Investment-banking firms and their role in the financial system is very important. For example, executives go to investment-banking firms when contemplating a once-in-a-career business move, such as buying another firm. They do not have the knowledge and skill set themselves to be able to cope with the regulations, the raising of finance or the tactics to be employed, so they apply to the specialists at the bank who regularly undertake these tasks for client companies.

Another area where executives need specialist assistance is in raising money by selling bonds or stocks. Total raised capital can be in the tens or hundreds of millions, and all the details have to be right if investors are to be convinced and the regulators satisfied.

Investment banking firms also assist companies in managing their risks. For example, they may advise a farming company on the use of derivatives to reduce the risk of commodity prices moving adversely, or interest rates, or currency rates. (Arnold, 2012, p. 76).

One characteristic of investment banking firms that distinguishes them from brokers and dealers is that they usually earn their income from fees charged to clients rather than from commissions on stock trades. These fees are usually set as a fixed percentage of the dollar size of the deal being made. Because the deals mostly involve huge amounts of money, the fees can be sizable. The percentage fee mostly is smaller for large deals, from neighborhoods of 3%, and much larger for smaller deals, to the sometimes exceeding 10% (Mishkin & Eakins, 2018, p. 571).

In conclusion, investment-banking firms have three distinctive primary market functions in financial structure and these are as follows:

• bringingnewsecuritiestomarket,• dealmakinginthemergersand

acquisitions,• advisingcorporations.

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Bringing newsecurities to

market

Deal making n M&As

Advisingcorporations

BRINGING NEW SECURITIES TO THE MARKETThe main business of investment banking is raising debt and equity financing for corporations or

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

Preparation for Public OfferingsInvestment banking firms occasionally engage in originating securities. As an originator, the

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

What are the main functions/roles of investment banks in financial markets?

Associate the level of financial development of a country and functions of investment banks.

Tell the difference between brokers or dealers and investment banks in terms of their revenues.

1 Identify the main functions of investment banks.


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The investment-banking firm recommends the types, terms, and offering price of securities that should be sold. It helps the corporation in preparing the registration and informational materials required by the regulator (Melicher & Norton, 2017, p. 300).

For bond issues, in order to reduce the cost of borrowing for their clients, investment banking firms also design securities with aspects that were more attractive to investors but not inconvenient to issuers. They also design security structures for low-quality bond issues, so-called high-yield or junk bond structures.

The investment bank is obviously taking a huge risk at this point. One way that helps it to reduce the risk is by forming a syndicate. Then each firm in the syndicate is responsible for reselling its share of the securities.

A syndicate is a group of investment banking firms, each of which buys a portion of the security issue.

important

Most securities issues are sold by syndicates because it is such a powerful way to reduce the risk by spreading it among many firms.

Investment banking firms advertise upcoming securities offerings with ads called tombstones in business journals. One major and carefully

regulated piece of information is the prospectus, which shows the issuer’s detailed finances and must be provided to each buyer of the security (Mishkin & Eakins, 2018, p. 274).

The prospectus acts as a marketing tool as the firm tries to persuade investors to apply for shares.

important

By law, investors must be presented with a prospectus before they can invest in a new security.

The information in the prospectus allows investors to make intelligent decisions about the proposed project and its risk. This may include far more information about the corporation than it has previously dared to put into the public domain. The content and accuracy of this highly important document are the responsibility of the directors not the regulators. Regulators’ approval implies only that the information presented is timely and fair (Arnold, 2012, p. 380).

Types of OfferingsThe most important types of offering in the sale

of new securities can be classified as initial public offering or unseasoned offering, secondary common stock offering or seasoned offering, and bond offering.

An initial public offering (IPO) or unseasoned offering is a common stock offering issued by corporations that had not previously issued common stock to the public. A secondary common stock offering or seasoned offering is an offering of common stock that had been issued in the past by the corporation (Fabozzi et al., 2014, pp. 274-275).

One of the problems investment banking firms face with IPOs is how to price them, since they are securities that have never been traded. In secondary common stock offerings, there is no prior market price on which to base the offering price. The price for which a security is sold is important to the issuer because the higher the price means the more

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money the company gets. If the security is priced too high, there may not be sufficient demand for the security as expected, and the offering may be canceled or the investment-banking firm may not be able to sell the issue at the desired offering price. In this case, the investment banking firm suffers a loss (Kidwell et al., 2016, p. 587).

The reputation of the investment-banking firm is at stake when it attempts to place the stock of the issuing firm. It is obvious that other corporations that may issue stock in the future will monitor closely its ability to place the stock (Madura, 2015, p. 642). Because of the risk related to pricing and then selling an IPO to investors, the gross spread is higher than for a secondary common stock offering. For traditional bond offerings, the gross spread mostly is even lower than for a secondary common stock offering (Fabozzi et al., 2014, pp. 274-275).

Public Offerings PracticesThere are several different types of arrangement between the investment banking firm and the

corporation in security offerings. Sometimes the financing takes the form of a private placement in which the securities are sold to a tiny number of large institutional investors, such as life insurance companies or pension funds, and the investment-banking firm receives a fee. On other occasions, it takes the form of a public offering, where securities are offered to the public. A public offering might be a best efforts or firm commitment practice:

In the case of a best efforts public offering, the investment-banking firm does the best it can do to place the securities with investors and is paid a fee that depends, to some extent, on its success.

In the case of a firm commitment public offering, the investment-banking firm agrees to buy the securities from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price.

As shown in Figure 6.1., an investment banking firm makes a profit that is equal to the difference between the price at which it sells the securities (offer price) and the price it pays (firm commitment price) the issuer. This difference is called the gross spread, or the underwriter discount. If for any reason it is not able to sell the securities, it ends up owning them itself (Hull, 2012, p. 32).

Issuer InvestmentBank Investors

Securities Securities

Firm CommitmentPrice

O�er Price

Figure 6.1 Firm Commitment Practice.

Source: Melicher and Norton, 2017.

In the sale of new securities, the investment banking firm does not need to undertake the function of buying the securities from the issuer. An investment-banking firm may only act as an advisor and/or distributor of the new security. In the firm commitment practice, the function of buying the securities from the issuer is called underwriting.

When an investment-banking firm buys the securities from the issuer and takes the risk of selling the securities to investors at a lower price, it is referred to as an underwriter.

important

When the investment-banking firm agrees to buy the securities from the issuer at a set price, the underwriting arrangement is referred to as a firm commitment. In contrast, in a best efforts practice, the investment-banking firm agrees only to use its expertise to sell the securities—it does not buy the entire issue from the issuer.

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The fee earned from underwriting a security is the difference between the price paid to the issuer and the price at which the investment-banking firm reoffers the security to the public. This difference is called the gross spread, or the underwriter discount. Numerous factors affect the size of the gross spread. Two major factors are the type of security and the size of the offering (Fabozzi et al., 2014, pp. 277-280).

There is also a phenomenon known as underpricing. Stocks are typically sold to investors at an offering price that is, on average, about 15 percent below the closing price of the stocks after the very first day of trading. This implies that underwriters deliberately (and consistently) sell stocks to investors for merely six-sevenths of their value. (Kidwell et al., 2016, p. 587).

In a private placement, securities are sold to a limited number of investors rather than to the public as a whole. The buyers of private placements must be large enough to purchase large amounts of securities at once. This means that the usual buyers are mutual funds, commercial banks, pension funds, and insurance companies. (Mishkin & Eakins, 2018, pp. 575-576).

Investment banking firms assist in the private placement of securities in several ways. They work with the issuer and potential investors on the design and pricing of the security. Often, it has been in the private placement market that investment bankers first design new security structures. (Fabozzi et al., 2014, pp. 277-280).

The process of taking a security public is summarized in the Figure below.

!Firm decides to issue new securities

Investment bankers and �rm agreeon type and price of security

Firm prepares prospectus with investment bank help

Regulator reviews prospectus

Prospectus is distributed tobrokerage network

Regulator’s approval is received

Securities are bought by investment bank and resold to public

Figure 6.2 Process of Taking a Security Public.

Source: Mishkin and Eakins, 2018.

important

The returns to investors who buy the stocks shortly after the IPO are generally poor.

Private placements are more common for the sale of bonds than for stocks.

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Variations in the Offering ProcessVariations in the United States, the Euromarkets,

and foreign financial markets include the bought deal for the underwriting of bonds, the auction process for both bonds and stocks, and a rights offering for underwriting common stock.

The structure of a bought deal is as follows:• Theleadmanageroragroupofmanagers

offersapotentialissuerofdebtsecuritiesacertainbidtopurchaseapredeterminedamountofthesecuritieswithafixedinterest(coupon)rateandmaturity.

• Theissuerisgivenadayortwo(maybeeven only a few hours) to accept or reject thebid.Ifthebidisaccepted,thatmeanstheunderwritingfirmhasboughtthedeal.

Another variation for underwriting securities is the auction process. The auction form is mandated for certain securities of regulated public utilities and many municipal debt obligations.

The auction process is commonly known as competitive bidding underwriting.

As for a regular IPO, a prospectus is issued and usually there is a road show. In this practice, the issuer announces the terms of the issue, and interested parties submit bids for the entire issue. In a variant of the process, the bidders specify the price they are willing to pay and the amount they are willing to buy. Then the security is allocated to bidders from the highest bid price (lowest yield in the case of a bond) to the lower ones (higher yield in the case of a bond) until the whole issue is allocated (Fabozzi et al., 2014, pp. 277-280).

Auctions potentially overcome two of the problems with a traditional IPO. First, the price that clears the market should be the market price if all potential investors have participated in the bidding process. Second, the situations where investment-banking firms offer IPOs only to their favored clients are avoided. However, the corporation does not take advantage of the relationships that investment-banking firms have developed with large investors that usually enable the investment banking firms to sell an IPO very quickly. One high-profile IPO that used an auction was the Google IPO in 2004 (Hull, 2012, p. 34).

For the shares sold via a preemptive rights offering, the underwriting services of an investment-banking firm are not needed. However, the issuing corporation may use the services of an investment-banking firm for the distribution of common stock that is not subscribed to. A standby underwriting arrangement will be used in such instances. This arrangement calls for the underwriter to buy the unsubscribed shares. The issuing corporation pays a standby fee to the investment banking firm (Fabozzi et al., 2014, pp. 277-280).

The sales function of an investment bank is divided into institutional sales and retail sales. Retail sales involve selling the securities to individual investors and companies that purchase in small quantities.

Investment banking firms must also attempt to satisfy the institutional investors that may invest in the IPO. Investment banking firms recognize that other institutional investors monitor stock prices after offerings to determine whether the initial offer price charged by the investment banking firms was appropriate. If the institutional investors do not gain reasonable returns on their investment, they may not invest in future IPOs. Since investment-banking firms rely on institutional investors when placing shares of newly issued stock, they want to maintain a good relationship with them (Madura, 2015, p. 642).

The higher the price institutional investors pay for the stock being issued, the lower the return they earn on their investment when they sell the stock.

The investment banking firm’s primary concern is to sell the securities as quickly as possible at the offering price (Kidwell et al., 2016, p. 591).

important

The longer the investment-banking firm holds the securities before reselling them to the public, the greater the risk that a negative price movement will cause losses.

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

DEAL MAKING IN MERGERS AND ACQUISITIONSMergers and acquisitions are practices that fall under the investment banking segment. Beginning in the

1980s, mergers and acquisitions (M&as) became one of the most important and highly profitable business activities for investment banking firms. Growth in the M&A business resulted from the large number of firm consolidations driven by technology and the globalization of business (Kidwell et al., 2016, p. 591). Firms with powerful M&A departments compete intensely for the highly profitable activity of corporate mergers or acquisitions. Investment banking firms act on behalf of corporate clients in identifying firms that may be suitable for merger. Large fees are charged for this service (Melicher & Norton, 2017, p. 312).

A merger happens when two businesses come together to form one new company. Both firms are behind the merger, and corporate officers are usually selected so that both companies contribute to the new management team. Shareholders turn in their share for share in the new firm.

In an acquisition, one firm acquires ownership of another firm by buying its shares. Often this process is friendly, and the firms agree that certain economies and synergies can be captured by combining resources. Sometimes, a firm suffering financial stress may even seek out a company to acquire them. At other times, the firm being bought may resist. Resisted acquisitions are called hostile. In these cases, the acquirer attempts to buy sufficient shares of the target corporation to gain a majority of the seats on the board of directors. Then board members are able to vote to merge the target corporation with the acquiring corporation.

Investment bankers serve both acquirers and target corporations. Acquiring corporations require help in locating attractive corporations to pursue, soliciting stockholders to sell their stocks in a process called a tender offer, and raising the required capital to complete the transaction. Target corporations may hire investment bankers to help avoid undesired takeover attempts (Mishkin & Eakins, 2018, pp. 577-578).

Investment banking firms assist in finding merger partners, underwrite any new securities to be issued by the merged corporations, assess the value of target corporations, recommend terms of the merger agreement, and even assist target corporations in preventing a merger (for example, writing restrictive provisions into a potential target firm’s securities contracts) (Cornett & Saunders, 2014, p. 504).

Investment banking firms may suggest steps their customers should take to avoid a merger or takeover. These are known as poison pills. Examples of poison pills are (Hull, 2012, p. 36):

Why is pricing important for IPOs?

Which type of an IPO is riskier for the investment bank, best efforts or a firm commitment?

Tell the difference between a best efforts and a firm commitment IPO.

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


Learning Outcomes

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1. Apotentialtargetaddstoitscharteraprovisionwhere,ifanothercompanyacquiresonethirdoftheshares,othershareholdershavetherighttoselltheirsharestothatcompanyfortwicetherecentaverageshareprice.

2. Apotentialtargetgrantstoitskeyemployeesstockoptionsthatvest(i.e.,canbeexercised)intheeventofatakeover.Thisisliabletocreateanexodusofkeyemployeesimmediatelyafteratakeover,leavinganemptyshellforthenewowner.

3. Apotentialtargetaddstoitscharterprovisionsmakingitimpossibleforanewownertogetridofexistingdirectorsforoneortwoyearsafteranacquisition.

4. Apotentialtargetissuespreferredsharesthatautomaticallyareconvertedtoregularshareswhenthereisachangeincontrol.

5. Apotentialtargetaddsaprovisionwhereexistingshareholdershavetherighttopurchasesharesatadiscountedpriceduringorafteratakeover.

6. Apotentialtargetchangesthevotingstructure so that shares owned by management have more votes than those owned by others.

Poison pills have to be approved by a majority of stockholders. Often stockholders stand against poison pills because they see them as benefiting only management.

Categories of M&AInvestment banking firms provide four categories

of M&A services for which they earn fees: First, investment-banking firms help

corporations identify M&A candidates that match the acquiring corporation’s needs. Large investment banking firms have a global network of industry and regional contacts that can quickly identify potential acquisition candidates and assess their interest in being acquired.

Second, the investment-banking firm does all of the analysis necessary to price the deal once an acquisition candidate corporation is located. These activities include reviewing the target corporation’s financial statements and financial projections;

forecasting the expected future cash flows; evaluating the corporation’s management team; performing due diligence; and, finally, determining the estimated value (price) of the corporation.

Due diligence is checking the validity of all the important information the corporation provided for the potential buyers. The potential buyers want to make sure that if a corporation is purchased, they get what they are promised.

The expected cash flows are the core of the valuation process. Two cash flows must be estimated:

1. thecashflowsoftheacquiredcorporationasastand-alonebusiness,

2. theadditionalcashflowthattheacquiringcorporationcangenerateifitpurchasesthebusiness.

Third, the investment banking firms work with the acquiring corporation management, provide advice, and help them negotiate the deal.

Finally, once the deal is complete, investment-banking firms assist the acquiring corporation in obtaining the funds to finance the purchase. These activities range anywhere from arranging bank loans to arranging bridge financing, underwriting the sale of equity or debt, or arranging a leveraged buyout (LBO) deal.

Bridge financing is just a temporary loan until permanent financing is obtained.

An LBO is where a corporation is acquired by issuing debt and then taken private.

important

Both buying and selling corporations may seek the services of investment banking firms because, for most corporations, M&As are occasional or intermittent events. Therefore, hiring expert counsel is a good business practice.

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The fee charged by investment banking firms depends on the extent of the work they do and the complexity of the tasks they are asked to do. In some cases, the investment-banking firm may simply receive an advisory fee or retainer for its service. In most cases, however, the banking firm receives a fee based on the percentage of the selling price (Kidwell et al., 2016, p. 592).

The mergers and acquisitions businesses require very specialized knowledge and expertise. Investment banking firms involved in this market are highly trained (and, not by chance, highly paid) (Mishkin & Eakins, 2018, p. 578).

ADVISING CORPORATIONSInvestment banking firms often serve as advisers for corporations that wish to restructure their

operations. They conduct a valuation of various existing and potential parts of a corporation so that they can recommend how a corporation should restructure its businesses.

important

Valuation, strategy, and tactics are the key aspects of the advisory services offered by an investment-banking firm.

Investment banking firms commonly suggest that the corporation could benefit from revising its ownership structure. It may recommend a carve-out, in which the corporation would sell one of its units to new stockholders through an IPO. The proceeds of the IPO go to the parent company.

Alternatively, an investment-banking firm may advise the corporation to spin off a unit by creating new stocks representing the unit and distributing them to existing stockholders. Alternatively, an investment-banking firm might recommend that a corporation engage in a divestiture, in which it sells one or more of its existing divisions that suffered recent losses. That means the investment-banking firm may receive a fee for advising and another fee for finding buyers of the divisions that are sold.

Investment banks also commonly serve as sole advisors as well as makers of mergers. They assess potential synergies that might result from combining two businesses, and they attempt to determine whether the synergies would be worthwhile for the potential acquirer after considering the premium that the acquirer will likely have to pay to obtain controlling interest in the target corporation. Investment banking firms may suggest that some of a target corporation’s divisions will not be compatible with the acquirer’s operations. Thus, after a target corporation is acquired, some of its individual divisions may be sold. This process is referred to as asset stripping (Madura, 2015, pp. 645-646).

In addition, investment-banking firms are making increasing inroads into traditional bank service areas such as small-business lending and the trading of loans. In performing these functions, investment-

How do investment banks assess the value of companies to price the deal in M&As?

Associate the fees charged by investment banks with the size of the deal in M&As.

Tell the difference between mergers and acquisitions.

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


Learning Outcomes

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banking firms normally act as agents for a fee. Fees charged are often based on the total bundle of services performed for the client by the corporation. The portion of the fee or commission allocated to research and advising services is called soft dollars. When one area in the corporation, such as an investment advisor, uses client commissions to buy research from another area in the corporation, it receives a benefit because it is relieved from the need to produce and pay for the research itself. Therefore, advisors using soft dollars face a conflict of interest between their need to obtain research and their customers’ interest in paying the lowest commission rate available (Cornett & Saunders, 2014, p. 505).

Other activities of investment banking firms include the management of pension and endowment funds for businesses, colleges, churches, hospitals, and other institutions. Many times, officers of investment banking firms are on the boards of directors of major corporations. Thus, they can offer financial advice and participate in the financial planning of the corporation. Investment banking firms also provide financial counseling on a fee basis.

Not all investment-banking firms engage in every one of these activities. The size of the firm largely dictates the various services it provides(Melicher & Norton, 2017, p. 312).

Ethics in Investment Banking – John N. Reynolds, Edmund Newell

The scope of ethical issues (extract from Chapter 1)…………Understanding ethics in

investment banking is not just about the major abuses identified in high-profile scandals. Individual investment bankers face specific ethical issues as part of their day-to-day activities. These can involve dealing with client-facing areas such as conflicts of interest or presenting misleading information in a pitch, as well as internal issues such as promotion and compensation decisions, misuse of resources and management abuses. Many of these issues can be relatively minor, but, nonetheless, how they are dealt with will be crucial in inculcating ethical decision-making within an investment bank.

When investment banks behave unethically, there can be significant consequences, including making losses or incurring fines. It can also involve criminal cases against individual bankers. Daniel Bayly, Merrill Lynch’s former head of investment banking, received a 30-month prison sentence for his role in a trade by Enron involving Nigerian barges, aimed at misrepresenting Enron’s earnings.

There have been cases where relatively junior investment bankers have received criminal or civil penalties for their involvement in illegal activities. By contrast with the sentence received by Mr Bayly, William Fuhs, a Vice President (a mid-level banker) at Merrill Lynch was sentenced to a longer period of custody – over three years. The New York Times described Mr Fuhs’ role as “a Sherpa” on the deal (a “Sherpa” carries luggage for mountaineers, and this implies that Mr Fuhs’ role was not a leading one). As the case of Jamie Olis, an accountant at Dynegy, showed, sentencing guidelines based on calculations of the level of losses resulting from fraudulent activities can lead to lengthy prison sentences – the original sentence given to Mr Olis was a 24-year prison term (reduced to 6 years on appeal) in relation to a $300 million accounting fraud.

This underscores the importance for investment bankers at all levels to be able to raise legitimate questions about the ethics of what they are being asked to do – both to have a forum to raise questions, and to understand when it is necessary to do so. In extreme cases, the impact of unethical decisions can be very painful…………

Further Reading

Some firms, widely known as boutique investment banks, specialize in a few activities, such as advising companies on financing issues and mergers, but does not raise finance for the firm, or underwrite, or engage in securities trading.

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China Speeds Up Opening of Market to Investment Bank GiantsBloomberg News (15 January 2020)China brought forward the planned opening of its $21 trillion capital market by eight months,

swinging the door open for global investment banks such as Goldman Sachs Group Inc.The New York-based powerhouse, and rivals including JPMorgan Chase & Co. and Morgan

Stanley, will now be allowed to apply to form fully owned units to do a broad array of investment banking and securities dealing in the Communist Party-ruled nation in April, compared with an earlier timetable set for December.

The decision was included in the signing of a trade deal with the U.S., partially resolving a protracted dispute that has weighed on the world’s second-largest economy. China had already committed to a broader opening of its $45 trillion financial markets, which also includes given access to its asset-management and insurance markets.

“China shall eliminate foreign equity limits and allow wholly U.S.-owned services suppliers to participate in the securities, fund management, and futures sectors,” according to the text of the landmark Phase 1 trade agreement released Wednesday.

China said it won’t take longer than 90 days to consider applications from providers of electronic-payments services including American Express Co., Mastercard Inc. and Visa Inc. to handle transactions in the nation. It will remove restrictions to allow U.S.-owned insurance companies into its markets and also open its $14 trillion market to U.S. credit-rating companies.

As a reciprocal move, the U.S. will “consider expeditiously” pending requests by Chinese financial firms including Citic Securities Co., China Reinsurance Group Corp. and China International Capital Corp. It committed to “non-discriminatory” treatment of payment providers such as UnionPay Co. and Chinese credit rating companies.

China is also opening its market to allow more foreign investment into the country’s 2.37 trillion yuan ($344 billion) non-performing loan market, giving U.S. investors direct access to the market as part of its trade deal amid a surge in bad loans.

While Wall Street’s giants and their European counterparts have been present in mainland China for decades, and done deals for the country’s corporate titans, they have until now had limited opportunity to do direct business, having had to operate through joint ventures with local partners. Full ownership would be a final step after they in late 2018 were given the go-ahead to take majority control over their ventures.

Much WelcomeChina has made “significant commitments” in the deal, Jake Parker, vice president at the U.S.-

China Business Council, said in an e-mailed comment. “While China has already in the past year announced many of the commitments on the financial openings in the agreement, the inclusion of specific timelines on when these commitments will be implemented is very much welcome and will improve enforceability going forward.”

UBS Group AG, Nomura Holdings Inc. and JPMorgan already hold a majority in their ventures, while the others are in the process of applying for a 51% stake. It’s unclear if the application process will now move straight to the 100% hurdle.

By dismantling the wall to its financial market, China is counting on foreign financial firms to plow $1 trillion in fresh capital into the nation over the next few years, cushioning a slowdown in the economy and helping a transition to more consumer-led growth model.

In Practice

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The global banks, meanwhile, have a lot to gain in getting access to China’s still-fast growing economy and its increasingly prosperous population. Up for grabs is an estimated $9 billion in annual profits by 2030 in the commercial banking and securities sectors alone, Bloomberg Intelligence estimates.

But they will still need to steer an often opaque and precarious political landscape. After meeting with global banking executives in November, President Xi Jinping warned that China would seek to preserve its “financial sovereignty” even as he committed to the market opening.

China’s official People’s Daily newspaper said in a comment that the deal is generally in line with its direction of advancing reforms and opening up, and will support its need for “high-quality economic growth.”

The newspaper said that the reforms and opening up will be done “at its own pace.”The nation has plans to create investment banking behemoths of its own to compete with the

foreign influx and expand abroad. Right now, China has a fragmented market of brokerages, with about 131 firms and a limited global presence. Their combined assets equal to what Goldman Sachs sits on by itself.

— With assistance by Lucille Liu, and Jun Luo

How do investment banks resemble traditional banks in terms of their advisory roles?

How do investment banks improve the success of M&As with the advisory roles?

Tell the difference between the carve-out and spin off.

4 Explain the roles of investment banks in advising corporations.


Learning Outcomes


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Sum

mar

y

LO 1 Identify the main functions of investment banks.

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

LO 4 Explain the roles of investment banks in advising corporations.

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

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

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

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

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


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Test Yourself

1 Which of the following choices is the main reason for investment banking’s transformation during 2008?

A. High risk taking with high leverageB. Regulated environmentC. Financial globalizationD. China’s rapid economic growthE. FED’s high interest rates policy

2 Which of the following investment banks was filed for bankruptcy at the end of 2008?

A. Lehman BrothersB. Merrill LynchC. Morgan StanleyD. Goldman SachsE. JP Morgan

3 I.Bringing new securities to market

II.Deal making in the mergers and acquisitions

III.Advising corporations

Which of the above choices is/are among the distinctive primary market functions of investment banking firms in the financial system?

A. Only I B. Only IIIC. I and II D. II and III E. I,II and III

4 An investment bank tries to identify corporations that may benefit from a security sale, as......................

A. an originator B. an underwriterC. a regulator D. a issuerE. a syndicate

5 Which one of the following is used by investment banks to primarily reduce risk in public offerings?

A. Forming a syndicateB. Presenting a prospectusC. Implementing poison pills stepsD. Originating the issuerE. Underwriting the securities

6 Which of the following is a type of common stock offering that had been issued in the past by the corporation?

A. Seasoned offeringB. Initial public offeringC. Bond offeringD. Unseasoned offeringE. Commercial paper offering

7 Which of the following terms describes the process when an investment-banking firm buys the securities from the issuer and takes the risk of selling the securities to investors at a lower price?

A. UnderwritingB. Rights offeringC. Auction D. Public offeringE. Private placement

8 Investment banking firms may suggest steps their customers should take to avoid a merger or takeover. These are known as……….…

A. poison pills B. prospectusC. tombstones D. tender offerE. asset stripping

9 Checking the validity of all the important information the corporation provided the potential buyers is………….

A. due diligenceB. originatingC. underwritingD. divestitureE. asset stripping

10 Which of the following activities is among boutique investment banks’ specialized activities?

A. Advising firms on financial issuesB. Market making in IPOsC. Trading securities in secondary marketsD. Providing brokerage servicesE. All of above


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Ans

wer

Key

for

“Tes

t You

rsel

f”S

ugge

sted

ans

wer

s fo

r “S

elf R

evie

w”

If your answer is wrong, please review the “Overview of Investment Banking” section.

1. A If your answer is wrong, please review the “Bringing New Securities to Market” section.

6. A


3. E If your answer is wrong, please review the “Deal Making in Mergers and Acquisitions” section.

8. A


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

7. A

If your answer is wrong, please review the “Bringing New Securities to Market” section.

4. A

If your answer is wrong, please review the “Bringing New Securities to Market” section.

5. A

If your answer is wrong, please review the “Deal Making in Mergers and Acquisitions” section.

9. A

If your answer is wrong, please review the “Advising Corporations” section.

10. A

What are the main functions/roles of investment banks in financial markets?

self review 1

Investment-banking firms have three distinctive primary market functions in financial structure and these are as follows: • bringingnewsecuritiestomarket,• dealmakinginthemergersandacquisitions,• advisingcorporations.

Why is pricing important for IPOs?

self review 2

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


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How do investment banks assess the value of companies to price the deal in M&As?

self review 3

Investment banks:• Reviewthetargetcorporation’sfinancialstatementsandfinancialprojections;• Forecasttheexpectedfuturecashflows;• Evaluatethecorporation’smanagementteam;• Performduediligence;• Determinetheestimatedvalue(price)ofthecorporation.

How do investment banks resemble traditional banks in terms of their advisory roles?

self review 4Investment banks also provide traditional bank services such as small-business lending and the trading of loans. In performing these functions, investment-banking firms normally act as agents for a fee.

Arnold, G. (2012). Modern Financial Markets & Institutions, Pearson Higher Ed.

Cornett, M. M. & Saunders, A. (2014). Financial Markets and Institutions, Mcgraw-hill Education-Europe.

Fabozzi, F. J., Jones, F. J. & Modigliani, F. (2014). Foundations of financial markets and institutions, Pearson Education.

Howells, P. & Bain, K. (2007). Financial markets and institutions, Pearson Education.

Hull, J. (2012). Risk management and financial institutions,+ Web Site (Vol. 733), John Wiley & Sons.

Kidwell, D. S., Blackwell, D. W., Sias, R. W. & Whidbee, D. A. (2016). Financial institutions, markets, and money, John Wiley & Sons.

Madura, J. (2015). Financial Markets and Institutions: With Stock-trak Coupon, Cengage Learning.

Melicher, R. W. & Norton, E. A. (2017). Introduction to finance: Markets, investments, and financial management, John Wiley & Sons.

Mishkin, F. S. & Eakins, S. G. (2018). Financial markets and institutions (Ninth ed.), Pearson Education India.

Stowell, D. P. (2017). Investment banks, hedge funds, and private equity, Academic Press.

References

Suggested answ

ers for “Self R

eview”

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Chapter 7

Lear

ning

Out

com

es

Explain the main objectives of regulations in the financial industry

Discuss the reasons and effects of global financial crises Identify financial crises in Turkey

31 2

Chapter OutlineIntroduction Global Crises Crises in Turkey Regulations in the Financial Industry

Key TermsCrises

FluctuationsBalloonsPanics

DepressionContagionMoratorium Regulation Supervision


Financial Crises and Regulations

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INTRODUCTIONThe concept of ‘crisis’ has been a significant

economic problem for human beings for the last two centuries. We have been observing them more frequently and more severely especially for the last four decades. In this period, with the gradual decline of the governments’ share in the economy since 1970s (with the impact of the Oil Crisis and stagnation), the acceleration of financial liberalization and deregulation activities since the 1980s, and the fact that globalization has accelerated since the 1990s, many developed and developing countries experienced financial and/or economic more frequently than before.

Funding the public sector’s needs in the financing of development may cause fluctuations in the financial system. These fluctuations not only affect the country with financing problems, but also other countries that have close economic relations with this country. These fluctuations may turn into crises. In this context, a crisis may sometimes influence only a country or a region or sometimes affects the whole world. While the former is called local and/or national crisis, the latter refers to a global crisis. These facts have led to the creation of a field of study, particularly on the causes and effects of crises, and the prevention policies of these crises.

In this chapter, firstly a brief history of global economic and financial crises is introduced. Following this attempt, the national crises and the ramifications of the global crises in Turkey are mentioned at a glance. In the last part, an insight into the regulations against financial crises is submitted.

GLOBAL CRISESAccording to Mishkin (2012), “a financial crisis

occurs when an increase in asymmetric information from a disruption in the financial system prevents the financial system from channeling funds efficiently from savers to households and firms with productive investment opportunities”.

Although it is a controversial issue what the concept of crisis refers to, there is a consensus on that there exists four types of financial or economic crises in general:

• moneycrisis• bankingcrisis• externaldebtcrisis• systemicfinancialcrisisA speculative attack on the value of a currency is

called a currency crisis, if it leads to a depreciation of the foreign exchange reserves or a significant rise in interest rates in order to prevent the depreciation of the currency.

A banking crisis arises when the actual or potential bank failures prevent banks from fulfilling their obligations, or when the government is forced to intervene to prevent this failure. An external debt crisis occurs if an entity cannot pay the foreign debts, whether it is a government or private sector.

On the other hand, systemic financial crises are defined as financial distortions that have significant effects on the real economy by preventing the efficient functioning of financial markets (IMF, 1998, p.74-75).

Financial crises are usually caused by the following factors (Mishkin and Eakins, 2012):

• Mismanagementoffinancialliberalization• Asset Price bubbles or booms, meaning

market prices of assets realized aboveeconomicvalues

• High uncertainty, usually followingeconomic downturns or stock marketcrashes

• Currentaccountdeficits• Budgetdeficits• Excessiveborrowingofgovernment• Excessiveborrowingofbusinesses• Vulnerability or fragility of banking

industry

The effects of financial crises, in general, may include:

• Economicdownturn• Deteriorationofcashflows• Declineoflending

The common feature of all types of financial crises is that they have significant fluctuations in financial asset prices (or exchange rate) and unsustainable economic imbalances.

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7 Financial Crises and Regulations

• Deteriorationinthebalancesheetsoffinancialinstitutions

• Deterioration in the balance sheets ofbusinesses

• Currencycrises• Risesindebtburdens• Bankfailures• Companyfailures• Increasedvolatilityinfinancialmarkets• Risesininflationandinterestrates• RisesinunemploymentWe can classify crises in the world as crises prior

to 1980 and crises after 1980.

Crises Prior to 1980For the last 6 centuries, the world economy

has experienced several local and global economic crises. In this section crises and crisis-like incidents such as speculative balloons and/or economic panics prior to the year 1980 are examined briefly.

Financial Crises and Panics Before the 1929 Great Depression

The Tulip Madness occured in a time when the Netherlands lived in the Golden Age. In this period, the prices of newly emerging tulip bulbs have risen to high prices and suddenly hit the bottom. In February 1637, when the tulip madness reached the stage, the onions of some rare tulips were sold to more than 10 times the annual income of a skilled craftsman.

18. Century is called the era of stock market balloons. The first two famous stock market balloons are:

• theSouthSeaCompany(UK),whichwasbasedintheUK,and

• theMississippiCompany (Project),whichwasbasedinFrance.

These two balloons suddenly burst out in 1720 and thousands of unsuspecting investors went bankrupt. Another incident in this century is the Bengalballoon.Thisballoonhascometotheforein India because of the excessive exaggeration of thevalueoftheBritishEastIndiaCompanybeforethecompanytookoverBengal.Thepriceofsharesfell to 122 pounds in 1769, and in late 1769 the Great East India Company went bankrupt.

The first panics were also experienced in this century. During the last 30 years of the 18thcentury, the first panics began to occur. These panics were the precursors of panic that would happen almost every decade in the next century.

The 1772 credit crisis is the first of these panics. This crisis was an indirect consequence of the bankruptcy of the East India Company, and it took place in England in 1772 in connection with the bombingoftheBengalBalloon.

Especially in the 18th century, the companies and institutions were at the center of global affairs. Companies and institutions that influenced sovereignty and commercial factors were the main causes of the bankruptcy of the East India Company andhencetheDutchbanksthatinvestedinthemat that time.

Dutch Golden AgeThe name given in the Dutch historybetween the years 1585-1702. In this period, the Netherlands became one of the world’s leading countries of science, commerce and art.

important

During theTulpMadness, tulipbulbswerebought and sold at a higher price than gold.

The Tulip Madness is often seen as the first recorded speculative balloon.

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The second of these panics occurred in 1792. This panic was basically an economic confidence crisis and took place between March and April 1792.

The last of these three panics occurred in the 18. Century was 1796-1797 panic and the main cause of this panic were the downturn in Atlantic credit markets and the panic that took place in this period led to greater commercial bottlenecks in the UnitedKingdomandtheUnitedStates.

On the other hand, in the 19. Century, firstly The Danish government declared a moratoriumon January 5 1813, after six years of naval wars. Expenditures related to the war dried up the national resources of the country, the employment fell at very low levels and the tax revenues decreased at unprecedently low levels. There were panics every decade in this century, and in the last quarter of the century there was a period of depression that affected thewholeworld,includingtheUSAandBritain.

This depression led to an economic stagnation intheUnitedStatesbetween1873and1879.Intheyears 1819, 1824, 1837, 1947, 1957, 1866, 1873, several panics occurred due to various reasons.

Ultimately, the panic in 1873 turned into aninternational economic crisis in many parts of the world, including the USA and Europe. Insome countries, including Britain, it continuedto the mid-1890s and was named “Long (Great) Depression”. At the end of this process, Britainlostitsleadershippositionintheeconomy(Balı&Büyükşalvarcı,2011).

1929 Great DepressionTheGreatDepressionisthenamegiventothe

economic depression that started in 1929 and con-tinued throughout the 1930s. The depression cre-ated destructive effects in the rest of the world (es-pecially in the industrialized countries), despite the fact that it centers on North America and Europe. The 1929 Crisis was the cause of unemployment, economic contraction, and stagnation.

While World War I was a destruction in terms of defeated states, the victorious states that did not fight in the war on their own territory were saved fromthisdestructiveeffect.TheUSwastheluckiestof these countries because at the same time it had a significant portion of the gold reserves in the world and consequently the countries borrowed from the US to finance restructuringof their economy. Inthis period, the total amountof theUSAcreditswith interest given to 15 countries reached 11.563 Million Dollars.While these debts were makingthe depression more severe in the economies of borrowercountries’, theymade theUnitedStatesboth the supreme power of the world and gave a start to the golden age of the American economy.

Henry Ford’s mass production (Fordist) andhis raising of the wages of his workers to a level well above the time (five dollars per day) led to a further increase in automobile demand. The start of the annual leave caused a revival in the tourism and real estate sector and the vitality of the real estate market, especially in Florida, increased the demand for this sector due to its profitability in the stock market.

During theperiodof1923-29, therewasalsoexcessive mobility in the finance sector. Peoplebelieved that the stock market would continue to rise despite the adverse developments such as the bankruptcy of two banks in a day. Most people withdrew all their savings from bank deposits, and invested in the stock market. While the real estatemarketwas themajority of the stocks, thetwo hurricanes that occurred in 1926 lowered the value of land prices there and left the investors in a difficult position. This was a breaking point for the financial sector and things started to reverse. Another reason for the downturn in the financial sector was the lack of supervision and necessary laws in the sector. There was no banking law to determine how much of the reserves of the banks could be given as loans.

important

World War I was one of the main causes of the Great Depression, causing 10 milliondead, 20 million wounded, and 8 million missing soldiers.

In the period, which is known as the roaring 20s, increasing demand for the electronic goods and automobiles supported serial production of these industrial products.

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In the days of the outbreak of the crisis, the reason for the rapid sinking of the banks was that they traded in the New York stock exchange with the deposits they had collected. The New York stock market went down and the banks went bankrupt. There were also no legal measures to protect investors from fraud. The SecuritiesExchange Commission was founded after the crisis. In the same period, there were also disruptions in the real sector. The prevailing economic view was preparing a suitable ground for the formation of monopolies, which was proposed at the lowest level of economic intervention by the government. As a result, competition decreased and prices and production were affected, and also manipulations in the financial sector were experienced. (Ay &Uçar,2015;Bakırtaş&Tekinşen,2004)

In this context, one of the reasons for the crisis was the excessive financial strength of the companies in America. In the 1870s, there were many large andsmallcompaniesinAmerica.Smallcompanieshad to merge in the face of the difficulties of World War I, and they formed a monopoly after the war. In 1929 the number of conglomerates controlling 50% of the American economy was only 200. This meant that even a single conglomerate bankruptcy would shake the whole economy. A second reason was that the banks were badly structured. There was no law governing the capital markets, reserves and credit ratios of banks. A third reason can be saidtobetheinexperienceofthepresidentHooveradministration in the economy. According to the advocates of this idea, PresidentHoover did notapprove the state intervention of the economy according to the liberal economy concept, which wasprevailinginthe1920s.Butlateron,thesocialcost of not interfering with the 1929 crisis was

huge. When the president decided to intervene, it was too late and the intervention was not successful.

A demonstration of government inexperience was the government’s insisting on adhering to the gold standard. The government refused to print money and followed a tight monetary policy, and economic activity ceased when the money was not available on the market, and the real sector shrank. This means more unemployment, less income. The last reason to be emphasized is that America wasthemajorcreditorof theworld.Inaddition,he demanded that Germany and England pay the compensation they deserve after the First World War as gold. However, the gold stock in theworld was inadequate, and the existing stock was already controlled by the USA. For this reason,the compensation and the payment of credits as goods and services were tried, but this also hit America’s own goods and services sector. As a last resort,theUStriedtoimplementthetariffwalls,but only foreign trade shrank. After all, America could not get back the loans that it gave without any consideration. (Turan, 2011)

Despite speculative danger warnings, manypeople believed that high price levels could remain unchanged. Shortly before the crisis economistIrving Fisher made a famous statement, “Stock prices have reached what looks like a permanently high plateau” (Teach, 2007). On October 29 1929, -also known as ‘The Black Tuesday’-, the price of shares went down for a full month at an unprecedented rate. With the collapse of 1929, the RoaringTwentiescametoanend.

With the collapse, wide-ranging and long-term problems began for theUnited States.Theambiguous environment also affected the jobsecurity of the employees. As American workers faced insecurity about their incomes, consumption also declined.

The1929Wall StreetDepression (October1929)ortheGreatDepressionwasthemostdevastatingfinancialcollapseeverseeninUShistory to that date when its consequences were taken into account.

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Declines in stock prices led to significantmacroeconomic problems such as:

• diminishingcredits,• closureofworkplaces,• firingofworkers,• bankruptcyofbanks,• decliningmoneysupply,• othereconomicallydetrimentalevents.

Although it started at different times in various countries, it is argued that the Great Depressionstarted around 1929 and continued until the late 1930s or early 1940s. Although some of the country’s economies began to recover in the mid-1930s, in many countries, the negative effects of the GreatDepressionlasteduntilthebeginningoftheSecondWorldWar.(Balı&Büyükşalvarcı,2011)

Crises After 1980The world debt crisis emerged on 12 August 1982

when Mexico declared a moratorium. Following this incident, many developing countries, mainly Latin American countries, declared moratorium and thus the world recognized the existence of the global debt crisis.

The effects of the crisis were the rise in interest rates, increase in recession in the economies and the sudden capital outflows. There were various solutions to the global debt crisis: Baker’s plan,

Brady’s plan, legal and political regulations and debt-equity changes.

Someofthedebtcrisesfrompasttotodayareasfollows(Yavuzetal,2013;Ulusoy,2012):

• ThecrisisinSoutheastAsiain1990s,• TheMexicancrisisin1994,• The crisis in Russia in 1998 -which is a

classicbadmanagementcrisis-,• ThecrisisinArgentinain2000,• EuropeandebtcrisisthatstartedinGreece,

Portugal and Ireland in 2010 and laterincludedItalyandSpain.

1980 Global Debt CrisisAfter World War II, emerging economies

started to receive debts from the international market and a worldwide debt problem did not arise untilthelastquarterofthe1970s.But,sincethelast quarter of 1970s, especially in Latin American countries a debt problem arose. Shortly afterthat, an international debt crisis broke out. These crises occurred not only due to national policies, but they also had international aspects. The debt crisis threatened the international financial system and a number of plans were devised, namely Brady andBaker plans.Also, newmethods suchas debt decreasing and debt delaying started to be implemented. (Akdemir, 2003, p.1)

In October 1973, with the start of the Arab-Israeli War, Arab states stopped oil shipments to theUSandWesternEuropeancountries.Shortlyafterthat,OPECincreasedoilpricesdramatically.The oil demand that grew in 1973 and the lack of and alternative energy sources caused western economies to experience a significantly expensive cost. This development caused inflation and balance of payments problems around the world as the crisis increased developed countries’ production costs very rapidly. As a result, inflationary pressures in developing countries increased steadily and the crisis began to be felt more deeply (Akkaya, 2010).

The second oil crisis repeated economic problems of the first oil crisis. The second oil crisis which broke out in 1979-80 further increased the current account deficits of undeveloped countries which did not export oil. In conclusion, towards the end of 1970s, with the effect of the oil crises, the fact that the developing countries started to experience difficulties to pay their external debt were the first signs of the global debt crisis.

important

The financial collapse caused by the Great Depression initiated a ten-year economicslowdown affecting all western industrialized countries.

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Weaker production structures and increasing costs emanating from the actions of the OPECfurther increased the balance of payment deficits of the undeveloped and developing countries. On the other hand, some of these countries applied to Ponzi finance and thus tried to pay back its existing debts through new debts. When the signs of the international debt crisis emerged, the debtors (lenders) made some arrangements in lending policies (such as floating interest rates) to guarantee their receivables as well as to encourage borrower countries to set up and mobilize effective external debt management mechanisms to repay their debts (Karagöz,2006,p.99).

In 1982, Mexico declared that it had temporarily suspended its external debt service and thus triggered the global debt crisis. In this period, thirty-four underdeveloped countries could not fulfill their debt services.

There are some external and internal reasons behind this crisis. Among the external factors, there areinternationalconjuncturalchanges,changesininternational credit markets and fluctuations in exchange rates. First of all, the post-war positive economic conjecture began to reverse from themid-1970s. The fixed exchange rate system introducedbytheBrettonWoodssystemendedin1971, and oil prices rose four times after the oil

crisis. The second oil crisis made the debt service of oil-importing countries troublesome.

Duringtheten-yearsperiodbetween1973and1982, the additional costs caused by the increase in oil prices reached considerable dimensions. On one hand, the developing oil importer countries were forced to pay higher oil bills; on the otherhand, the contraction in western markets reduced the import capacities of these countries. This, in turn, led to the reduction of investments and the pause of economic development. Also, in this period the tight monetary policy imposed by the US boosted the funds’ return to the US due tothe impactof the increase inUSdollarexchangerate. Then again, since the second half of the 1970s, there had been a change in the structure of international credits. Moreover, in countries where the income level was not high enough to realize a net transfer, repayments of debts caused a decrease in the resources to allocate to investment or other social spending. Therefore, after 1982, the debt crisis was gradually turning into a growth crisis. As a result of the fall of the growth and the expected decrease in investments, the produced resources reduced and the dependence on external financing increased(Sarı,2004).

Duringtheprocess,solutionssuchasBakerPlanandBradyPlanweredeveloped.Also,theParisCluband the London Club were regarded as potential places for the solutions of the debt problems. In this period, ‘Paris Club’ was the place of official borrowing negotiations, while private sector debt restructuring mostly took place in London Club.

From 1985 onwards, all plans to overcome the external debt crisis brought important duties to the developed countries, generally by taking

Ponzi finance is a type of financial fraud based on the principle of continuous fund raising from newcomers to the system.

From the beginning of the 1980s, a number of developing countries began to experience a debt crisis. The Mexican moratorium in August 1982 gave a start to the period which is called the “Debt Decade” in the economic literature. This country was followed by some other Latin American countries such as Brazil, Chile and Argentina, and someAfrican countries.

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the attitudes of the IMF and commercial banks to the forefront. For this reason, these plans have experienced many difficulties in implementation andcouldnotbecompletelysuccessful(Sarı,2004;Çalışkan,2003).

2008-2009 Global Financial and Economic Crisis

In the aftermath of September 11 2001, duetotheeconomicdownturnintheUS,theCentralBank reduced the interest rate, which was 6.5%in 2001 to 3% in 2003 to stimulate the country’s economy. As expected, this fall in interest rates also affected the interest rates applied to housing loans. Demandforthissectorhasincreasedsignificantlyas low inflation rates and low interest rates reduced the cost of acquiring a house.

Increased demand has also led to an increase in housing prices. For example, a house worth 100,000 Dollars in 2000 reached at a value of160,000 Dollars in 2007. Increasing housingprices during this period have also made housing amajorinvestmentinstrument.Theratioofhouseownership, which was 64 percent in 2004, increased to 69.2 percent in 2006 due to speculative housing purchases. With the impact of low interest rates, financial institutions took more risks and started to market the mortgage loans for low-income householdsinordertoearnmoreprofits(Kutlu&Demirci,2011:122).

Another reason for this crisis was the lack of transparency.AccordingtoMehrezandKaufmann(2000), if financial liberalization is accompanied with poor transparency, such a situation increases the probability of a financial crisis. As transparency increases, less financial crises occur.

In some relevant literature, developing countries have often been described as less transparent, but ironically, the recent global crisis started in the “developed world” where transparency is supposed to be the greatest. That shows us that developed economies are also not transparent enough and it is also necessary to redefine the definition and criteria of “transparency”. In this crisis, what kinds of assets banks and brokers have, what their value is, and who their bankers are were not sufficiently transparent. These problems have made it difficult for companies such as Lehman Brothers, whichhave complex commercial contracts that can be called derivatives, to calculate and analyze the resulting risk of bankruptcy.

Non-objective behaviors of the credit ratingagencies were another factor that escalated the financial crisis. One of the most important examples of this was the conflict of interest between rating agencies and companies. Ratingagencies that give credit notes to banks and other financial institutions are funded by these companies. Therefore, the ability of rating agencies tomakeobjectiveassessmentsisdiminishing.Onthe other hand, rating agencies are not always able to determine the financial problems of firms. Sometimes they can see the problem partly orvery delayed. For example, until a very short time before Enron’s bankruptcy filing, the rating agencies could not determine that the company was problematic. Of course, there is also the effect of the financial statements prepared by Enron in contradiction to this fact. Rating agencies maynot have information about underlying assets as well as banks and instrument designers who design financial instruments. Another problem is that rating agencies only rate the default risk. However,theliquidityriskmustalsobemeasured.Customers of ratings agencies are not aware of this narrow scope of rating services.

important

Regulatory supervisory agencies, especiallyFederalReserveSystem (FED),were late intaking measures against the changing the risk environment and this was one of the reasons behind the 2008-2009 global financial and economic crisis.

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In the last financial crisis, the rating agencies did notworkveryeffectivelyeither.However,afterthefinancial crisis began, credit ratings were lowered. Duringtheone-yearperiodfromthethirdquarterof 2007 to the second quarter of 2008, ratings of mortgage-backed securities of $ 1.9 trillion were lowered by two major rating agencies (Alantar,2008).All thesewere seriousproblemsof theUSeconomysincetheCreditRatingAgencies’analyses,the credit notes they give and their situation assessment statements can affect the money and capitalmarketsseriously(Pirdal,2017,p.121).

Due to the reemergenceof the financial crisisin the real economy, the global financial crisis hadverysevereresults.TheUSfellintoeconomicstagnationinDecember2007.Growthratesinboththe developed world and developing countries also decreased. The global crisis significantly affected the unemployment rates. Especially in the USand developed economies, the upward trend was striking. The rise in inflation in 2007 and 2008 was not only due to the financial crisis. In this period, increases in oil and food prices led to significant inflationary effects. Especially in developing countries where energy demand was increasing, inflation rates increased rapidly.

Another consequence of the financial crisis was the increase in regulatory requirements, especially in developed economies. New regulations were implemented on lightly regulated risk instruments

such as hedge funds. The thesis of solving all the problems of the market by itself or with self-regulationwas no longer spoken (Alantar, 2008;Verick&İslam,2010).

Inshort,theglobalcrisisintheUSbeganinthefinancial sector, then leapt to the real sector and spreadthewholeeconomyovertime.Unrequiteddebt led to the bankruptcy of financial institutions, consumer confidence was shaken in the market and the financial crisis was transmitted to the real sector as demand in the real sector contracted (Önder, 2009, p.17).

As the global crisis caused liquidity and confidence problems, short-term money movements such as direct foreign capital inflows and portfolio investments also decreased (Engin &Yeşiltepe,2009,p.17).Moreover,arrangementsaimed at preventing the adverse effects of the global crisis have led to budget deficits and increases in the borrowingsofEUcountries(Oskay,2010,p.72).

2010 European Sovereign Debt Crisis The financial crisis which broke out in the

USrealestatemarket in the secondhalfof2007became global crisis in 2008 with the bankruptcy of “Lehman Brothers” in September 2008. Thecrisis has brought a serious recession in the economies of almost all countries worldwide and finally in Europe. The global crisis resulted in serious increases in public deficits and debt stocks inEuropeanUnion(EU)countriesandbecameathreat of sustainability of public finances in many member states.

As a matter of fact, the debt crisis that broke out in Greece in the second quarter of 2010 threatened the future of other Eurozone countries and even the economic and monetary union in a short time. The fact that some member states, especially Germany, were reluctant to help Greece, caused panic in the markets and, as a result, the public finance and banking sector in Ireland, Portugal, Spain and Italy faced threats to driftinto the debt crisis. Consequently, the debt crisis in Greece once again revealed the importance of effective and responsible debt management, especially for emerging economies. (Yavuz et al, 2013;Oskay,2010)

The reason for the start of the crisis was that housing loans given with low interest rates, which were not paid back to the banks when the due dates came.

important

While the rise in housing prices was one of the most important reasons of the global financial crisis, the decline in housing prices was among the most important results of this crisis. In the US, since the beginningof 2007, housing prices have decreased significantly.

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Historically,financialcriseshavebeenfollowedbythedebtcrises(Hilsenrath,2010).Decreasesinrevenues led to increased budget deficits and huge budget deficits increased the level of public debt. The increase in public debt also brings down rating notesthatgivenbycreditratingagencies(Kılıç&Bayar,2012;Reinhart,2009).Inthiscontext,thespeculativebubbleintheUS,whichgrewrapidlyinthe housing market during the second half of 2006, started to decline in the second half of 2006, and was transforming into a global financial crisis, affecting the banking and insurance sectors, investments and trade since the second half of 2008.

AfterSeptember2008,theshockwavesspreadall over the world through the channels of trade and finance, and almost all countries were affected. Although the most painful period of the crisis was relativelyshort,justasasevereheartattack,itlastedfor long enough to cause permanent damage to the industrialized countries that were at the center of the crisis. In this framework, the damage was in threemainforms(Dadushetal,2010:1):

• risingpublicdebts,• fragilebankingsector,• agreatamountofliquidityoverhang,which

willneedtobewithdrawn.There was a significant capital outflow in

developing and emerging economies with the withdrawal of liquid investments, which is supposed to support the financial institutions’ balances. Global export volume decreased by about 25 percent between April 2008 and January

2009, and prices of commodities also fell by at least 50percent (Braga&Gallina, 2011, p.1-2).Publicdebts also increased significantly in2008-2009 as a result of the global financial crisis. Numerous factors, such as economic stimulus packages in connection with the financial crisis, the expropriation of private sector debts and the decline in tax revenues, have led to an increase in public debt (Kılıç&Bayar, 2012). In developedeconomies, budget deficits, which amounted to 1.1percentofGDPin2007,roseto8.8percentin 2009 and in emerging economies which were fiscally balanced the deficits rose from 0 percent to4.9percentoftheGDPinthesameperiod,forinstance. (IMF, 2010, p.8)

When the Eurozone debt crisis is evaluated in a general sense, it is seen that there are structural reasons and coordination problems of economic policies behind the crisis (Kılıç & Bayar, 2012,p.56). In this context, governments increased government spending due to their support for reducingtheeffectsoftheglobalcrisisintheEUcountries. On the other hand, tax revenues also declined due to the stagnation in the markets in these countries. This led the EU countriesto face serious budget deficits and increases in the borrowings. The decline in countries’ credit ratings, the pressure on the stock exchange, the rise of sovereign state treasuries and credit debt clearing agreements were among the other reasons for the European debt crisis (Yavuz et al, 2013: 134).

On the other hand, the fact that the European CentralBankloweredthegovernmentdebtinterestratepremiumsofGreece, Ireland,Portugal, Italy,and Spain encouraged these countries to spendexcessively. The borrowing funds used to fund the current expenditures in these countries were not canalized into productive areas. The rising debt stocks caused a decline in credibility of these countries and as a conclusion, the cost of borrowing forthesecountriesincreaseddramatically.(Kılıç&Bayar,2012)

The debt crisis that emerged in the second quarterof2010 inGreece,Portugal and Ireland,which are described as European periphery countries,spreadoverItalyandSpain.Thisposedamajorriskintermsofglobalgrowthandfinancialstability, especially in the Euro Zone countries. Although Italy did not have a problem of debt

important

The high degree of integration of the financial and real sectors of the EU member statesincreased the level and speed of influence of the2010EuropeanSovereignDebtCrisisonthe countries.

Financial crises are associated with four deadly D (economic downturns, revenuesdown, debt, downgrade). They are generally followed by banking crises, sharp economic collapses and downturns in public revenues.

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rolloverintheshortrunandeventhoughSpainhasapositivefinancialperformance,thespillovereffectofthedebtproblemtothesetwocountriesraisedconcerns.(Değerli&Keleş,2013,2).Inthisframework,inGreece,Iceland,Ireland,PortugalandIrelandthefinancialmarketswereunderpressureduringthecrisis.(Arezki et al, 2011, p.3).

In solving the debt crisis that emerged in the Euro Zone in the spring of 2010 European Monetary Union’smonetary and fiscalpolicieswerenot effective.Thedebt crisis in the2010Euro zone causedmajormovementsintheyieldofbondsandmajorchangesintheeuroandothercurrencies(VonHagen,2010).InordertoachievecertaingoalsoftheStabilityandGrowthPact,whichisapartoftheMaastrichtAgreement, the budget deficits rose excessively and the governments were held responsible for this situation.

In fact, at the core of the European debt crisis there was foreign debts of the European Countries. The EuropeanUnion’s reformproposals included controlling the national governments’ fiscal policies and

increasing bank regulations.When the banking crisis in the private sector took

place, especially in countries such as Ireland and Spain,governments rescued the private sector by purchasing private debt in exchange for public debt. Consequently, taxpayers became in a position of debtors to foreign investors. For example,thestructuralbudgetdeficitinIrelandandSpainwas relatively low and in fact in these countries the private sectorwasthemaincauseofthedebtcrisis.(Stein,2011)

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

Crises Prior to 1990InOctober1929,agreateconomiccrisisstartedintheUSandaffectedalltheworld.Duringthisera

the financial industry did not exist in Turkey yet. Turkish economy was mainly based on the agricultural sector. Yet, at the advent of the 1929 great depression, the agricultural sector had collapsed due to taxes,primitivenessandthedamagecausedbythewar.Duringthecrisis,duetotheintenseimportsofminorities and lowering prices of agricultural products, Turkey had a relatively high level of foreign trade deficit and the value of the Turkish lira decreased rapidly. Additionally, the first installment payment

important

TheStabilityandGrowthPact,theMaastrichtTreaty, and the European Union focusedon the government debt and budget deficit ratios ignoring the “excessive” debt ratios in the private sector and this situation triggered crisis in the financial sector.

How did the the 2008-2009 Global Financial and Economic Crisis influence the economies of the developed and developing countries?

Associate the usage of derivatives and the 2008-2009 Global Financial and Economic Crisis.

Tell how the behavior of rating agencies affected the 2008-2009 Global Financial and Economic Crisis.

1 Discuss the reasons and effects of global financial crises.


Learning Outcomes

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of the debt inherited from the Ottoman Empire became due. As a result of these undesirable developments, an economic crisis broke out in the country. In this process, the public was encouraged to use domestic goods. Industry and agriculture congressesledbyAtatürkwereorganized.Savingsmeasures were taken. On 30 November 1930, the “Economic Depression Tax Law” was accepted.Due to the smallnumberofdomestic capitalistsin the country and their insufficiency in private enterprises, large industrial investments led by the state were established via state capital without external loans and aimed to recover in the country. The country was able to get rid of the negative repercussions of the 1929 economic crisis with these actions and decisions.

In this context, between 1930-1939, the economic policies implemented in Turkey were based on protectionism and statism. It is also appropriate to describe these years as the first industrialization period. Indeed, the crisis of 1929 created an opportunity for industrialization for undevelopedcountries(Boratav,2015).

1946 was a turning point for Turkish economy. In 1946, Turkish economy was no longer protectionist and independent, but it was an open economy, which depended on foreign credits (Boratav, 2015: 96). In 1946, the firstbig devaluation in the history of Turkey was carried out. This decision caused cost inflation to increase. Imports were increasing rapidly, thus the foreign trade deficit was also rising. There was a temporary recession and contraction in the markets. Industrial projects were adjourned.TheGovernment ruled by Recep Peker resigned anditwas replacedbyHasanSakaon10September,1947. The economy was again in a bad condition in 1948. In the general elections held in 1950, theDemocratPartycame topowerwith53%ofthe votes. New lands were opened to agriculture. Duetothegoodclimaticconditions,productivityinagriculturealsoincreasedexportprices.Duringthis period, foreign aid also increased and the 1946 crisis was overcome. This crisis was largely a result of World War II.

In the early 1950s, climate conditions in the country made agriculture unfavorable. Thus, Turkey’s export ratio decreased because the country was an agricultural product exporter. The increase

in the input prices of the products whose raw materials came from abroad also increased the prices in the domestic market. In addition to these reasons, the unplanned investments, the political conditions inside, the increase of the foreign debt burden and the public deficits caused the country to experience double-digit inflation. Also, the KoreanWar increased rawmaterial prices in theworld market. Therefore, the costs of the factories using imported input also increased. The increasing inflation with other negative conditions caused another crisis in 1954. The 1954 crisis was overcome by temporary measures. In 1958,Turkey’s external debtduewas256milliondollars.However,Turkeydid not have the resources to pay the foreign debt. A foreign exchange crisis occurred in the country. Unemployment, budget deficit and foreign tradedeficit grew. The factories in the country had come to the point of closure as they could not provide imported inputs. Turkey in August agreed to implement a stabilization program with the IMF practices.OECD,IMFandWorldBankprovidedloans with suggestions. These suggestions were implemented immediately. The value of the Turkish Lira was reduced. The prices of the products of the state-owned enterprises in the domestic market were raised. Efficient and short-term investments were given priority. Efforts to achieve decreased budget deficits were increased.

In 1964, foreign currency inflows from exports and transfers from workers’ abroad could not be realized due to the excessive value of TL. There was a short-term economic crisis in the country this year. The government contacted the IMF and implemented IMF policies. The Arabic countries agreed to increase the price of oil dramatically in 1973. Foreign trade deficit increased. Additionally, tourism revenues decreased in that era as well. The government entered a foreign currency bottleneck. To overcome this bottleneck, high-interest loans were borrowed from the outside. With the help of temporary measures, the crisis was overcome. Turkey simply tried to postpone the negative effectsofthiscrisisandachievedit(Boratav,2015,p.131). Turkey’s debt, which was 1.8 billion dollars in 1970, increased to 10 billion dollars in 1977. In 1978, the share of short-term debts in total debt reached 52 percent. The crisis broke out in 1978. As a continuation of the above factors, the fact thatOPECcountriesincreasedtheiroilpricesby

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150%completelydestroyedtheeconomy.OPECmembers increased oil prices by 150 percent for the second time in 1979 and 1980. Inflation and unemployment increased.

As a result of all these developments, the 1980 transformation took place and a liberal economy was adopted. In 1986, there was another crisis because of the factors such as the economic imbalance due to the increase in public expenditures and the decrease in export revenues and workers’ remittances. In this period, tight monetary policy policies such as convenience to foreign capital, privatization and freedom in foreign exchange transactions were implemented. After these measures, Turkey started to experience serious financial crises more frequently.

Crises After 1990Over-regulation policies implemented in the

financial markets in the pre-1980 period left its place to the financial liberalization process and deregulation practices in the 1980s. The globalization trend that emerged as a result of the technological developments and liberalization movements caused financial markets to take on a more sensitive structure. In this context, especially with the globalization movements in the 1990s, many financial crises broke out in the international financial markets.

After 1994, November 2000, and February 2001 crises, Turkey implemented a number of regulatory programs for the prevention of financial crisis.TheBankingSupervisoryBoard,thesecondfinancial regulation institution, was established in 1999 after the Capital Markets Board. Withthe establishment of the Banking SupervisoryBoard, the management complexity in theimplementation of financial policies disappeared and policy implementations were collected under the management of this institution (Bahar &Erdoğan,2001,p.2).

1994 and 1997-1998 CrisesThe financial liberalization process, which

began with the decisions of January 20, 1980, caused a major financial crisis in 1994 at theend of 14 years. There had been an increase in foreign capital inflows to Turkey together with the

liberalization of capital movements since 1989. Short-term foreign trade balance deficits, publicborrowing in need of funds and the increase of portfolio investments in pre-crisis years exhibited a significant increase (Seyidoğlu, 2003, p.146).This increase in hot money inflows led the open positions of banks to grow. This public sector financing deficit and current account deficit were the basis of the 1994 crisis. The Gulf War and the European Monetary Crisis prior to 1994 put the external financing conditions in a risky position (OktarandDalyancı,2010,p.12).Thiseconomicpicture carried Turkey to the 1994 Currency crisis.

Turkey overcame the crises in a short time thanks to the effects of the 1994 crisis stabilization programs. Foreign capital inflows recorded an accelerated increase in the period 1995-1997, and this increase was replaced by a decline after theRussiancrisis thateruptedin1998(Bahar&Erdoğan,2001,p.2).

Regarding theAsiancrisis, the factors suchasthe lack of market discipline regarding the financial sector and the lack of transparency caused the crisis to deepen and not to be fully understood initially. This also limited the effects of the measures. While the 1997 Asian crisis hit Turkish economy through capitalchannels,the1998RussiancrisishitTurkeythrough foreign trade channels.

The main reasons for the 1994 and 1998 crises were(BDDK,2010).:

• existenceoftheunsustainabledebtburdenin an economic atmosphere, where therewashighandvolatileinflationandunstablegrowth performance

• structural problems, especially financialmarkets, which could not be resolvedpermanently

important

During Turkey’s currency crisis in 1994,output fell 6 percent, inflation rose to three-digit levels,theCentralBanklosthalfof itsreserves, and the exchange rate (against the U.S.dollar)depreciatedbymorethanhalfinthe first three months of the year.

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November 2000 CrisisThe crisis of November 2000 was a financial

system crisis and the main reason for this crisis was the banking sector. Banks’ attempts to closetheir open positions caused public and private banks to enter into borrowing rush. Turkey started to increase the risk premium on the borrowing rate in the external market, which made foreign borrowing difficult.

In addition to the problems of the banking sector, the lack of trust in the stability program, which was implemented under the standby treaty signed with the IMF in 1999 with the main goal of reducing inflation, accelerated the process towards theNovembercrisis(Bahar&Erdoğan,2001,p.12).

February 2001 CrisisThe markets, which were already sensitive due

to the November 2000 crisis, turned upside down with the speculative effects of the political crisis between the President and the Prime Minister.The pressure on the exchange rates increased because of the people attacking the TL positions in the November crisis. There was a severe foreign currency attack in February, and a 40 percent increase was observed in the dollar exchange rate of the first 10 days of the crisis (Ongun, 2002, p.73).TheCentralBankintervenedinthemarketat the expense of melting its reserves for the two days following the crisis. Yet on February 22, it was forced to declare that the exchange rate anchor was abolished and the floating rate was adopted (GüloğluandAltunoğlu,2002,p.25).

In this process, Turkey experienced both an economic and financial crisis at the same time facing the due date of the debt rollover problems. The payments system collapsed and the securities and money markets transactions stopped, especially because the state banks could not fulfill their obligations in themoneymarkets (BDDK,2009, p.3).

With the crisis of February 21, 2001, the program dated December 9,1999 completelydisappeared. A loss of 6 billion dollars was declared fromtheCentralBank,overnightinterestratesinthe Interbank market exceeded 6000 percent. On average, it was realized as high as 4000 percent. In the face of these developments, the exchange rate was left to fluctuate.

The crisis that started in the banking sector on November 22, 2000 turned into a currency crisis on February 19, 2001 and took on the character of twin crises.

important

The 21 February 2001 crisis, which was also a foreign currency crisis, was mainly caused by high increases in the current account deficit.

What was the main reason behind the November 2000 crises?

Associate political crises and financial crises considering the February 2001 crises.

Discuss the importanceof the banking sector’s financial strength to avoid financial crises.

2 Identify financial crises in Turkey.


Learning Outcomes

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REGULATIONS IN THE FINANCIAL INDUSTRY

Regulation,ingeneral,isaformofgovernmentintervention in economic activity and interference with the working of the free-market system (Moosa, 2015). The regulation of financial institutions has been growing rapidly in many countries due to the two main reasons.

The first one is the expanding freedom of financial markets (including the progressive relaxation of restrictions on the types of business, which financial institutions can undertake). In this sense, boundaries between commercial, saving and investment banks, between the banks and the securities houses and between the banks and the insurance companies were dissolving. Furthermore, new financial instruments and services have developed. At this point, it should be noted that extending an institution’s range of activities reduces its riskiness where the correlation between the returns on different activities is not strong.

The second cause of the proliferation of financial regulations is the regulation itself. If a regulation is imposed on a particular financial sector, sooner or later, there will be a necessity for regulation to be applied to other types of institutions whose activities compete with it in one way or another. The pressure for a so-called ‘level playing field’ is also seen in the attempt to impose common standards internationally, irrespective of whether uniformity is appropriate to institutions and economies with different degrees of riskiness. Moreover, the failure of existing forms of regulation to prevent institutional collapse, fraud or other abuse tends to generate a demand for still tightercontrol(Rose,1995).

Financial RegulationsSincewearefacedwithasymmetricinformation

problems in financial markets, regulations became a factof life.Regulation isconcernedwithchangingthe behaviour of regulated institutions.Regulatoryframeworks in regarding financial institutions utilize:

• Disclosure requirements (disclosureof financial statements and relevantinformation)

• Depositinsurance• Capitalrequirements• Supervision• Assessmentofriskmanagement• Restrictionsoncompetition

The main objectives of imposing financialregulations are as follows (Llewellyn, 1999):

• tosustainsystemicstability,• to maintain the safety and soundness of

financialinstitutions,• toprotecttheconsumers.

International Financial RegulationsThe Basel Committee - initially named

the Committee on Banking Regulations andSupervisory Practices - was established by thecentral banks Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and bankingmarkets(notablythefailureofBankhausHerstatt in West Germany). Basel Committee,headquartered at the Bank for InternationalSettlements in Basel, was established to enhancefinancial stability by improving the quality of banking supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters.

Governments and central banks have tended to act on the assumption that the increasing freedom of financial markets must be accompanied by an increasing supervision of financial institutions.

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Since its inception, the Basel Committee hasexpanded its membership from the G10 to 45 institutionsfrom28jurisdiction.StartingwiththeBaselConcordat, first issued in1975andrevisedseveral times, the Committee has established a series of international standards for bank regulation, most notably its landmark publications of the accords on capital adequacy which are commonly known as BaselI,BaselIIand,mostrecently,BaselIII.

The Committee’s first meeting took place in February 1975, and meetings were held regularly three or four times a year since. The BaselCommittee consists of senior representatives of bank supervisory authorities and central banks from Belgium,Canada, France,Germany, Italy, Japan,Luxembourg, Netherlands, Sweden, Switzerland,UnitedKingdomandtheUnitedStates.

Basel IThe1988BaselCapitalAccordwasamilestone.

For the first time, supervisors in the main banking markets agreed on a definition of capital and a minimum requirement (Caruana, 2008). The original Basel Accord, which was ultimatelyadopted by more than 120 countries around the world, attempted to subject all internationallyactive banks to a common set of minimum capital requirements by setting out risk-weights for assets and off-balance sheet positions, defining two kinds

of capital and establishing risk weighted asset ratios that all banks were required to meet. This is often summarized in two ratios: Tier 1 capital must be at least 4% of risk-weighted assets and Tier 1 + Tier 2 capital must be at least 8% of risk-weighted assets (Herring,2010).

Basel IIInresponsetothecriticismofBaselI,toaddress

the changes in the banking environment that the 1988 accord could not deal with effectively, and inresponsetotheviewthatBaselIwasbecomingoutdated, the BCBS decided to design andimplementanewcapitalaccord,BaselII.

In its introduction of the first set of proposals thatgavebirthtoBaselII, theBCBSproclaimeda critical need to redesign the 1988 Accord in the light of market innovations and a fundamental shift towards more complexity in the banking industry.

UnlikeBaselI,whichhadonepillar(minimumcapitalrequirementsorcapitaladequacy),BaselIIhas three pillars:

• Minimumregulatorycapitalrequirements;• Thesupervisoryreviewprocess;• Marketdisciplinethroughdisclosure.

The Basel Committee on BankingSupervision (BCBS) is the primary globalstandard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters.

important

Bank for International Settlement (BIS)was established on 17 May 1930, which is the world’s oldest international financial organization. From its inception to the presentday,theBIShasplayedanumberofkey roles in the global economy, from settling reparation payments imposed on Germany following the First World War, to serving central banks in their pursuit of monetary and financial stability.

Tier 1: A term used to describe the capital adequacy of a bank. Tier I capital is core capital; this includes equity capital anddisclosed reserves.

Tier 2: A term used to describe the capital adequacy of a bank. Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated debt of five years.

important

ThemainobjectivebehindtheintroductionoftheBaselIIAccordwastonarrowthegapbetween regulatory capital requirements and the economic capital produced by the banks’ own internal models.

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TheproclaimedfeaturesofBaselIIanditsdifferencesfromBaselIarethefollowing(Moosa,2015).:

• BaselIIincludesa“moresophisticated”measurementframeworkforevaluatingcapitaladequacy;

• Basel II is not only about capital adequacy, butalso about improving risk management in thefinanceindustrybyprovidingthecorrectincentivesfor better corporate governance and fosteringtransparency;

• In Basel II, an explicit weight is assigned tooperationalrisk;

• BaselIIismorerisk-sensitivethanBasel1;• BaselIIallowsagreateruseofinternalmodelsforriskassessmentandthecalculationofregulatory

capitalDespite allof theproclaimedbenefits andnoveltiesofBasel II, theaccordhasbeen subject toa

barrage of criticism from academics, practitioners and even some regulators (those who are not directly associatedwiththeBaselCommittee).Somebankersthinkthatitiscomplexanddangerous.BaselIIsharesmanyoftheshortcomingsofBasel1,butithasmoreofitsown(Moosa,2015).

Basel IIIThe global financial crisis of 2008 revealed very serious deficiencies not only in financial markets, but

alsothesupervisoryandregulatoryenvironmentatinternationallevel(GiovanaliandDevos,2015).Thatiswhy,despiteitscomprehensivestructureandsensitivitytorisks,theBaselIIAccordfailedtowithstandthe recent turmoil in the banking industry and maintain stability in financial markets.

Therewasatransitionalstepwiththeso-calledBasel2.5.Atthisstage,theglobalregulatoryinstitutionstrengthenedmarketriskcapitalforthetradingbook,introducedstresstestinginValueatRisk,andrevisedthetreatmentofsecuritizations.Followingthisstep,theBaselregulatorswentfurthertoachievethoroughamendments in order to supplement the existing global regulatory framework with new provisions. This ledtotheBaselIIIAccord,whichisconsideredasanextensiontoaddresstheweaknessesoftheBaselIIandprovide concrete and innovative solutions to the emerging challenges in the global banking industry and financialsystemaswell.BaselIIIAccordreleasedinDecember2010,thenewBaselAccordisexpectedtobeastringentreferenceinprudentialregulationintheglobalbankingsystem.Unlikethepreviousaccords,BaselIIIintroducedmacro-prudentialnormsinbankingregulationtohandlesystemicrisk(Vassiliadis,BaboukardosandKotsovolos,2012).

TheBaselIIregulatoryframeworkwasunableto maintain the adequate capital to absorb additional levels of risks in the banking system. These shortcomings triggered a wave of reforms in the aftermath of the crisis to introduce tighter capital adequacy and liquidity guidelines in the Basel regulatoryprovisions.

Whatwasthemainobjectivebehind the introduction of theBaselIIAccord?

Associate the 2008 global financial crises and the releaseofBaselIII.

What are the main objectives of financialregulations?

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


Learning Outcomes

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FINANCIAL SECTOR ASSESSMENT PROGRAM (FSAP)

The Financial Sector Assessment Program(FSAP),establishedin1999,isacomprehensiveand in-depth assessment of a country’s financial sector. FSAPs analyze the resilience of thefinancial sector, the quality of the regulatory and supervisory framework, and the capacity to manageandresolvefinancialcrises.Basedonitsfindings,FSAPsproducerecommendationsofamicro- and macro-prudential nature, tailored to country-specific circumstances.

The global financial crisis showed that the health and functioning of a country’s financial sector has far-reaching implications for its own and other economies. The Financial SectorAssessmentProgram(FSAP)isacomprehensiveand in-depth analysis of a country’s financial sector. FSAP assessments are the jointresponsibility of the IMF and World Bank indeveloping economies and emerging markets and of the IMF alone in advanced economies. The FSAPincludestwomajorcomponents:afinancialstability assessment, which is the responsibility of the IMF, and a financial development assessment, the responsibility of theWorld Bank.To date,more than three-quarters of the institutions’ member countries have undergone assessments.

TheFSAPisakeyinstrumentoftheFund’ssurveillance and provides input to the Article IV consultation. In jurisdiction with financialsectors deemed by the Fund to be systemically important, financial stability assessments under

the FSAP are a mandatory part of Article IVsurveillance, and are supposed to take place every fiveyears;forallotherjurisdiction,participationin the program is voluntary. In developing and emerging market countries, FSAPs areconducted jointly with the World Bank. Inthese countries, FSAP assessments include twocomponents: a financial stability assessment, which is the responsibility of the Fund, and a financial development assessment, which is the responsibilityoftheWorldBank.

AttheendofeachFSAPmission,teamsleavea detailed and comprehensive Aide Memoire with national authorities, which is confidential. FSAPs conclude with the preparation of aFinancial System Stability Assessment (FSSA),which focuses on issues of relevance to IMF surveillance and is discussed at the IMF Executive Board together with the country’s Article IVreport.PublicationofFSSAs isnotmandatory.In addition to the main document (listed below if published), individual country’s FSAPs maybring forward additional supporting documents (International Monetary Fund (IMF)).

* Aide-mémoire is a French loanword meaning “a memory-aid; a reminder or memorandum,especially a book or document serving this purpose”.

Kaynak: https://www.imf.org/external/np/fsap/fssa.aspx

In Practice

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Lehman Brothers Collapse: A Race to the Bottom

Before its demise, Lehman Brothers wasone of titans ofWall Street. It was the fourthbiggestinvestmentbankbehindGoldmanSachs,MorganStanleyandMerrillLynchleadingintothe global financial crisis.

It still holds the record for the largest bankruptcy inUShistory.At thetimeLehmanBrothers shut down on September 15, 2008 ithad$US639billioninassetsand$US619billionin debt.

It traced its history back to the 1850s when German brothers Henry, Emanuel and MayerLehman, transformed their small store in the deep south of Alabama into a bank.

From the late 1990s Lehman Brotherssought to capitalise on theUS housing boom,acquiring five big mortgage lenders, including BNCMortgageandAuroraLoanServices.

BNCandAurorawerepioneersinsub-primelending, selling high-risk mortgages with little documentation.

It was a punt that would ultimately destroy Lehman Brothers, leave Wall Street teeteringabove the abyss and help spark a global recession.

Real estate hedge fundThe shift into property financing catapulted

LehmanBrothersfrombeingjustanotherbond-trader to a massive, full service investment bank.

It specialised in highly risky and highly rewarding bridging finance in big real estate deals.

In 2006, the year before things started unravelling, the property unit was responsible for around20percentofbanks’$US4billionprofit.

Many argued it was not really a bank anymore, but a real estate hedge fund.

Cracks appearByFebruary2007LehmanBrothers’ shares

hit a record high of $86, giving it a market capitalisation of around $US60bn. It was alldownhill from there.

A month later the company conceded that defaultsinitsroughly$US150billionworthofsecuritised mortgages could impact the profits, a comment that turned out to be one of the larger understatementsinUScorporatehistory.

Nonetheless, it continued to write more mortgage-backed securities than any other bank.

The beginning of the endWhile an exact starting point of the global

financial crisis is hard to pinpoint, August 9, 2007 is as good a date as any.

ItwasthedaybigFrenchbankBNPParibasfroze a number of investment funds loaded with USmortgage-backedsecurities,andcollateralizeddebtobligations(CDOs)asdefaultsonsub-primeloans started mounting up at an alarming rate.

BNP simply could not work out whatthey were worth, or indeed if they were worth anything.

It was the same month Lehman BrothersclosedBNCMortgage,sacking1,200employees.At that stage the damage appeared limited to a $US50millionimpairmentcharge.

Bear Stearns collapsesThe second biggest underwriter of sub-prime

loans, and Lehman Brothers’ arch rival, BearStearnsfinallycapitulatedtoitstoxicloadofdebton March 14, 2008.

After the New York Federal Reserve back-tracked on a planned bail out, Bearn Stearnswas sold to JPMorganChase for$2a share, afraction of the value of its pre-crisis highs.

ThemarketbetLehmanBrotherswouldbethe next big bank to fall and its share price was cut in half almost overnight.

Too big to failLehmanBrothers’ demise prompted a full-

blownbank crisis in theUS,Europe and largeparts of Asia.

TheBushadministrationhurriedlycameupwiththeTroubledAssetsReliefProgram(TARP),a$US700billionslushfundtobuytoxicassetsfrom the banks that had engineered them.

Ithelpedstemtheoutrightpanic.Ultimatelythe banks chewed through more than $400 billionofTARPmoneystumpedupbytaxpayers,although the government ended up making a small profit on the salvage operation.

LehmanBrotherswastheonlybigbankthatwas allowed to collapse.

Its legacy for the survivors, or what are now known as systemically important banks, is taxpayers will have to stand behind them with the “too big to fail” guarantee.

Kaynak: https://www.abc.net.au/news/2018-09-14/lehman-brothers-timeline-a-race-to-the-bottom/10242912

Further Reading


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Sum

mary

LO 1 Discuss the reasons and effects of global financial crises.

Financial crises are usually caused by the following factors :• Mismanagementoffinancialliberalization• AssetPricebubblesorbooms,meaningmarketpricesofassetsrealizedaboveeconomicvalues• Highuncertainty,usuallyfollowingeconomicdownturnsorstockmarketcrashes• Currentaccountdeficits• Budgetdeficits• Excessiveborrowingofgovernment• Excessiveborrowingofbusinesses• Vulnerabilityorfragilityofbankingindustry

The effects of the financial crisis, in general, may include:• Economicdownturn• Deteriorationofcashflows• Declineoflending• Deteriorationinthebalancesheetsoffinancialinstitutions• Deteriorationinthebalancesheetsofbusinesses• Currencycrises• Risesindebtburdens• Bankfailures• Companyfailures• Increasedvolatilityinfinancialmarkets• Risesininflationandinterestrates• Risesinunemployment

LO 2 Identify financial crises in Turkey.

We can classify crises in Turkey as crises before 1990 and crises after 1990. Crises after 1990 are:• 1994and1997-1998Crises• November2000Crisis• February2001Crisis

LO 3 Explain the main objectives of regulations in the financial industry.

Themainobjectivesofimposingfinancialregulationsareasfollows(Llewellyn,1999):(1) to sustain systemic stability,(2) to maintain the safety and soundness of financial institutions,(3) to protect the consumers.


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Test

You

rsel

f

1 I. The money crisis II. The banking crisis III. The systemic financial crisis Which of the crises mentioned above are among the main types of financial and/or economic crises?A. Only IB. IandIIC. I and IIID.IIandIIIE. I, II and III

2 “…………………. crises are defined as financial distortions that have significant effects on the real economy by preventing the efficient functioning of financial markets.”Fill in the blank above correctly with one of the choices below.A. Money crisisB.BankingcrisisC.SystemicfinancialcrisisD.ExternaldebtcrisisE. Internal debt crisis

3 What is the first recorded speculative balloon in history?A. The Tulip Madness B.ThebankruptcyoftheSouthSeaCompanyC. The 1796-1797 panic D.TheLong(Great)DepressionE.TheGreatDepression

4 When did “the great depression” that originatedintheUSAbreakout?A. 1921B.1924C. 1929D.1931E. 1933

5 I. Baker’sPlan II. BradyPlan III. New York ClubWhich of the premises mentioned above are among thesolutionproposalsforthe1980GlobalDebtCrisis?A. Only IB. IandIIC. I and IIID.IIandIIIE. I, II and III

6 I. ThecollapseofUSrealestatemarket

II. Lack of transparency

III.Biased assessments of the credit ratingagencies

Which of the premises mentioned above are among the reasons for the 2008/2009 global financial and economic crisis?

A. Only IB. I and IIC. I and IIID. II and IIIE. I, II and III

7 In what year was there NO crisis in Turkey?

A. 1994B. 1998C. 2000D.2001E. 2005

8 Which of the following choices below are NOT among the main reasons for financial regulations?

A. Market failureB. FreebankingsystemC. Asymmetric informationD.SystemicriskandcontagionE. Fiscal rules

9 WhenwastheBaselCommitteeestablished?

A. in 1974B. in1979C. in 1981D.in1989E. in 1990

10 What is the world’s oldest international financial organization?

A.BankforInternationalSettlementB.BaselCapitalAccordC.TheFinancialSectorAssessmentProgramD.WorldTradeOrganizationE.WorldBank


167

Answ


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

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

6. E


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

8. E


2. C If your answer is wrong, please review the “Crises in Turkey” section.

7. E


4. C


5. B

If your answer is wrong, please review the “Regulations in the Financial Industry” section.

9. A

If your answer is wrong, please review the “Regulations in the Financial Industry” section.

10. A

How did the the 2008-2009 Global Financial and Economic Crisis influence the economies of the developed and developing countries?

self review 1TheUSfell intoeconomic stagnation inDecember2007.Growthrates inboth the developed world and developing countries also decreased. The global crisissignificantlyaffectedtheunemploymentrates.EspeciallyintheUSanddeveloped economies, the upward trend was striking.

What was the main reason behind the November 2000 crises?

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

What was the main objective behind the introduction of the Basel II Accord?

self review 3Themainobjectivebehind the introductionof theBasel IIAccordwas tonarrow the gap between regulatory capital requirements and the economic capital produced by the banks’ own internal models.

Suggested answ

ers for “Self R

eview”


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