University of Sunderland BA (Hons) in Banking and Finance

Financial Markets
Peter Howells
Professor of Monetary Economics Bristol Business School

Published by The University of Sunderland 2010 The University of Sunderland First published June 2010 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without permission of the copyright owner. While every effort has been made to ensure that references to websites are correct at time of going to press, the world wide web is a constantly changing environment and the University of Sunderland cannot accept any responsibility for any changes to addresses. The University of Sunderland acknowledges product, service and company names referred to in this publication, many of which are trade names, service marks, trademarks or registered trademarks. Technical reviewer: Hamid Seddighi, University of Sunderland Instructional design and publishing project management by Wordhouse Ltd, Reading, UK Index prepared by Indexing Specialists (UK) Ltd, Hove, UK

Contents
Introduction Unit 1 An introduction to financial systems Introduction 1.1 1.2 1.3 1.4 The key characteristics of a financial system The advantages of using a financial system in lending and borrowing Market efficiency and the real economy The financial system and economic development vi 1 1 2 9 13 17 20 20 22 23 23 24 25 33 34 38 39 40 41 41 42 44 46 52 58 62 63 64

Self-assessment questions Feedback on self-assessment questions Summary Unit 2 Money markets functions and operations Introduction 2.1 2.2 2.3 2.4 The characteristics and uses of money market instruments Pricing money market instruments Pricing instruments in a supply and demand framework The users of money markets

Self-assessment questions Feedback on self-assessment questions Summary Unit 3 Capital markets (I) Introduction 3.1 3.2 3.3 3.4 3.5 The characteristics and uses of fixed interest securities Understanding the data Pricing fixed interest securities Duration, price elasticity and the term structure of interest rates Users and markets

Self-assessment questions Feedback on self-assessment questions Summary

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Unit 4 Capital markets (II) Introduction 4.1 4.2 4.3 4.4 4.5 The characteristics and uses of company shares Understanding share price data The pricing of company shares The required rate of return The trading of company shares

66 66 67 68 72 81 45 91 92 94 94 96 96 97 108 114 121 121 123 124 124 125 128 137 142 142 144

Self-assessment questions Feedback on self-assessment questions Summary Appendix Unit 5 The efficient market hypothesis (EMH) Introduction 5.1 5.2 5.3 The basis and implications of the EMH Evidence on informational efficiency Behavioural finance

Self-assessment questions Feedback on self-assessment questions Summary Unit 6 The foreign exchange market (I) Introduction 6.1 6.2 6.3 Foreign exchange markets Forward rates and other forex derivatives Using foreign exchange derivatives

Self-assessment questions Feedback on self-assessment questions Summary

iv

Unit 7 The foreign exchange market (II) Introduction 7.1 Exchange rate determination 7.2 Interpreting the evidence 7.3 Arbitrage and speculation in forex markets 7.4 Foreign exchange risk and its implications Self-assessment questions Feedback on self-assessment questions Summary Unit 8 Exchange rate systems Introduction 8.1 8.2 8.3 8.4 The advantages and disadvantages of fixed and floating exchange rates The theory of currency union European Monetary Union (EMU) Other currency arrangements

145 145 146 154 157 161 164 164 168 169 169 170 180 182 185 191 192 193 194 194 195 205 215 220 221 222 223 228

Self-assessment questions Feedback on self-assessment questions Summary Unit 9 The regulation of financial markets Introduction 9.1 9.2 9.3 The need for regulation Financial regulation in the USA, UK and EU Globalisation and financial markets

Self-assessment questions Feedback on self-assessment questions Summary References Index

Introduction
Welcome to the Financial Markets learning pack! It has been designed to assist you in studying for the core module of the BA in Banking and Finance and covers all topics in the official module descriptor. As we prepared this learning pack, the world was breathing a sigh of relief at having (just) avoided a catastrophic collapse of its major financial systems. Much of the explanation for the near-disaster focused on banks. But it was investment banks, trading new types of securities linked to wildly over-valued assets that were at the centre of the problem. As we finished the pack Europe was looking at the prospect of a contagious default of major western governments on their debts, the so-called sovereign debt problem, as financial markets became increasingly reluctant to hold government debt and to refinance past borrowing. There was even speculation about the possible break up of the Eurozone. Whatever the outcome may be, you can be certain that the stability of financial systems, and the behaviour of financial markets, is an issue that will worry us all for many years to come. For this reason, it has never been more important to understand how financial systems work, both in theory where everything goes smoothly, and in practice where things can go seriously wrong. One of the saddest aspects of the recent crisis has been the way in which innocent people firms, households and individuals have been affected, losing their savings, facing pension reductions or repossession of their homes. As financial systems become more complex understanding why these things happen will become ever more important, especially since governments expect individuals to take more responsibility for their financial welfare and to rely less on the state. In this learning pack we shall learn how a financial system works and in particular at the role played by financial markets. To begin with, therefore, we shall take an overview of a financial system, what it consists of and what it does. We then move on to look at a series of markets. The first of these are the so-called money markets where large amounts of money are lent and borrowed for very short periods. Money markets are particularly interesting because these are the markets in which central banks conduct monetary policy by setting an official short-term interest rate. We then turn our attention to capital markets markets for long-term lending and borrowing. Weve divided this into two parts, treating bond markets first and then looking at the markets for company shares or equities. So far as the media are concerned, it is equity markets that generate the most excitement and attract most attention, but we shall see that bond markets are much larger and have the ability to pose major problems for governments. During the 2008 financial crisis it was widely agreed that financial markets had been substantially overvalued before the crash. (If you did not believe this, you had to believe that they were undervalued afterwards.) Either way, here was evidence that markets could get prices seriously wrong. This runs counter to economic orthodoxy which traditionally places much faith in the efficient markets hypothesis (EMH) and we look at this in Unit 5, immediately after our examination of bond and equity markets. vi

But the efficient markets hypothesis applies, in principle, to all financial markets. Indeed, many of the studies of the EMH use evidence on exchange rates. Foreign exchange (or forex) markets form the subject of units 6 and 7. Firstly we look at how exchange rates are expressed, how to read the data and the various types of forex contract that one can use. We then look at the theory of exchange rate determination. We shall discover that while there are numerous theories, each of which sounds entirely sensible, none is wellconfirmed by the facts and exchange rates are more volatile than one would expect in the light of the theories. Given the risk and disruption caused by forex fluctuations, it seems sensible to look at the possibility of adopting a system of fixed exchange rates. In unit 8, we look at the possible costs and benefits and at attempts to operate such systems, world-wide until 1972 and then in Europe after 1999. Finally we take a look at the controversial issue of regulation. There is widespread agreement that a financial system requires careful regulation, perhaps more than other sectors of the economy. But regulation was obviously unable to prevent the crisis that broke out in 2008. Maybe better regulation could have done so; but maybe booms and busts are always with us.

How to use this pack

The learning pack will take you step by step through the module in a series of carefully planned units and provides you with learning activities and selfassessment questions to help you master the subject matter. The pack should help you organise and carry out your studies in a methodical, logical and effective way, but if you have your own study preferences you will find it a flexible resource too. Before you begin using this learning pack, make sure you are familiar with any advice provided by the University of Sunderland on such things as study skills, revision techniques or support and how to handle formal assessments. If you are on a taught course, it will be up to your tutor to explain how to use the pack in conjunction with a programme of face-to-face workshops when to read the units, when to tackle the activities and questions and so on. If you are on a self-study course, or studying independently with remote tutor support, you can use the learning pack in the following way:

Scan the whole pack to get a feel for the nature and content of the subject matter. Plan your overall study schedule so that you allow enough time to complete all units well before your examinations in other words, leaving plenty of time for revision. For each unit, set aside enough time for reading the text, tackling all the learning activities and self-assessment questions and for the suggested further reading. Your tutor will advise on how they will plan activities around these materials and opportunities to network with other students.

Now lets take a look at the structure and content of the individual units.

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Overview of the units

The learning pack breaks the content down into nine units, which vary from approximately eight to ten hours duration each. However, we are not advising you to study for this sort of time without a break! The units are simply a convenient way of breaking the syllabus into manageable chunks. Most people would try to study one unit a week, taking several breaks within each unit. You will quickly find out what suits you best. You will see that each unit is divided into sections. It is assumed, for the most part, that you will study the units in the order presented. However, the sequence for some units is more important for others. This is indicated at the beginning of each unit. What is more important is that you try to study each section of each unit in the order presented. Each unit is written on the strict assumption that you will understand the material in each section before moving to the next. Each unit begins with a brief introduction which sets out the areas of the syllabus being covered and explains, if necessary, how the unit fits in with the topics that come before and after. After the introduction there is a statement of the unit learning objectives. The objectives are designed to help you understand exactly what you should be able to do after youve studied the unit. You might find it helpful to tick them off as you progress through the unit. You will also find them useful during revision. There is one unit learning objective for each numbered section of the unit. Following this, there are prior knowledge and resources sections. These will let you know if there are any topics you need to be familiar with before tackling each particular unit, or any special resources you might need, such as a calculator, graph paper or specific books. Then the main part of the unit begins, with the first of the numbered main sections. At regular intervals in each unit, we have provided you with learning activities, which are designed to get you actively involved in the learning process. You should always try to complete the activities usually on a separate sheet of your own paper before reading on. You will learn much more effectively if you are actively involved in doing something as you study, rather than just passively reading the text in front of you. The feedback or answers to the activities are provided immediately following the activity. Do not be tempted to skip the activity. Throughout the unit key terms are highlighted bold with the definition appearing in the margin. Each unit contains recommended reading which also appears in the margin and which refers you to relevant chapters of supporting textbooks including the core textbook. It is essential that you do this reading, since it is not possible to put everything you need to know in a single learning pack. At level 3 of a degree wider reading is key to developing deeper subject learning through a contemporary, contextual and critical perspective. This is important to consider when approaching the related assessment of the module. We provide a number of self-assessment questions in each unit. These are to help you to decide for yourself whether or not you have achieved the learning viii

objectives set out at the beginning of the unit. As with the activities, you should always tackle them. The feedback or answers follow immediately after at the end of the unit. If you still do not understand a topic having attempted the selfassessment question, always try to re-read the relevant passages in the textbook readings or unit, or follow the advice on further reading. Your allocated tutor will be available to deal with questions arising from the material and will assist your study through the unit. At the end of the unit is the summary. Use it to remind yourself or check off what you have just studied, or later on during revision. Finally, where possible, we have made reference to material on the internet since this is easy to access. You may find that addresses change. This can be annoying; but with a bit of effort you should be able to track the material down (nothing disappears completely from the web). And by searching you should learn even more! Good luck and enjoy it.

Core textbooks
The essential text that accompanies this learning pack is The Economics of Money, Banking and Finance by Peter Howells and Keith Bain. The 4th edition was published by FT-Prentice Hall in 2008. The main strength of this book is that it supports every unit in this learning pack. Furthermore, if you are studying the Money, Banking and Finance module, it also supports every unit in that learning pack. Like this learning pack, it makes the issues accessible to those with little previous experience of economics and/or finance and is written in a very accessible style. In particular, it encourages students to relate the theory they are learning to events as they are reported in the financial press. Most chapters have a section on how to read the financial press as well as exercises with solutions. There is also a companion website where students can do a number of self-assessment tasks and undertake more advanced work. A second text, Financial Markets and Institutions by the same authors was published in its 5th edition in 2007. This has many of the features of The Economics of Money, Banking and Finance, including a companion website, but is written at a rather simpler level and contains less detail.

Acknowledgements
We are grateful to the following for permission to reproduce copyright material: The London Stock Exchange for the data in Tables 1.1 and 4.3 and Figure 5.1; the Financial Times for the headline on page 145 and for the extract on page 162; the UK Office of Public Sector Information (OPSI) for the data in Figure 3.1 and Table 3.3 and the Bank for International Settlements for permission to reproduce the data in Tables 6.16.3. The Case Studies starting on pages 117 and 187 were made available by the generous permissions policy of VoxEU.org. In some instances we have been unable to trace the owners of what might be copyright material and we would appreciate any information that would enable us to do so.

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Copyright 2010 University of Sunderland

Unit

An introduction to financial systems

there is a firm consensus that a well-functioning financial sector is a precondition for the efficient allocation of resources and the exploitation of an economys growth potential
Thiel (July 2001)

Introduction
In this unit, you will learn what a financial system is and what it does. We shall explain what its advantages are, when it functions well and why people are willing to pay for the services offered by the financial system. In particular we shall see how a well-functioning financial system contributes to the rest of the economy. Unit learning objectives On completing this unit, you should be able to: 1.1 Describe the key characteristics of a financial system. 1.2 Demonstrate the advantages of a financial system in promoting lending and borrowing. 1.3 Show how efficient financial markets improve the functioning of the real economy. 1.4 Identify links between a well-functioning financial system and economic development. Prior knowledge The unit requires no prior knowledge but you will find sections 1.21.4 easier to understand if you have some prior knowledge of economics (both macro and micro) and/or finance. Resources The whole unit is supported by the core text (Howells and Bain, 2008: Role of a Financial System); Howells and Bain (2007) is a lower-level text but The Financial System and The Financial System and the Real Economy may also be useful to students coming to this material for the first time. Piesse et al (1995), although a bit dated, is helpful (especially Introduction to the Financial System and Financial Markets and Institutions). Mishkin (2007) Overview of the Financial System covers much of the material here. Ang (2008) is essential reading for section 1.4. In section 1.4, you will need access to the internet in order to pursue the debates about finance and development.
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Financial Markets

1.1 The key characteristics of a financial system

Recommended reading for this section includes: Howells and Bain (2008) Role of a Financial System; Howells and Bain (2007) The Financial System; Piesse et al (1995) Introduction to the Financial System; Mishkin (2007) Overview of the Financial System.

We frequently read and hear of references to the financial system especially when, as in the last two years, something goes seriously wrong. But what exactly does the phrase mean? At the most general level we can say that a financial system consists of:

a set of financial institutions a set of financial markets the end users of the markets and institutions a set of regulatory authorities.

Consider each of these key terms carefully.

Financial institutions
What do we mean by financial institutions? These are firms which provide various types of financial service. We shall see that many of them are engaged in lending and borrowing (or financial intermediation as it is called). In addition to intermediation, they may provide a range of financial services like financial advice and planning, insurance, a facility for making payments and opportunities to adjust the way in which one holds ones wealth. Not all institutions do everything or at least not to an equal degree. The reason that we identify different types of institution reflects the fact that they specialise to some degree. Figure 1.1 lists the main categories of financial institution.

banks building societies credit unions friendly societies

insurance companies pension funds unit trusts and OEICs investment trusts

Figure 1.1: Financial institutions

Lear

ga nin ct

If we summarise the main financial services as follows:

y ivit

1a

financial intermediation insurance and pensions a payments mechanism portfolio adjustment facilities

can you say which of the institutions listed in Figure 1.1 specialise in each of these services?

eedb ac

intermediation all insurance and pensions insurance companies and pension funds payments banks and building societies portfolio adjustment mainly unit trusts, open-ended investment companies (OEICs) and investment trusts.

1a

Copyright 2010 University of Sunderland

Unit 1

An introduction to financial systems

deposit

Notice that in Figure 1.1 we have listed the institutions in two columns. The reason for this is that the assets they offer to lenders (that is, the liabilities of the institutions) differ in an important respect. The principal liabilities of institutions in the left-hand column are deposits. Notice that these have a fixed nominal value. If you have 100 in the bank and you do not add to it or make cash withdrawals, you have a guaranteed 100. It does not fluctuate with the state of the stock market, for example. Furthermore, you can usually turn your deposit into cash (that is notes and coin) very quickly. For example, you can withdraw your deposit on demand through a cash machine. The liabilities of the other institutions are very different. Take the case of a pension fund. The pension fund has a liability to meet only when the saver retires. He or she cannot withdraw the pension whenever it suits. Furthermore, the value of the pension when it comes to be paid, may depend on what has happened to the value of stocks and shares in the recent past. Savings in a unit or investment trust can usually be withdrawn more quickly but withdrawal requires notice and again the value will be uncertain, depending on what has happened in financial markets. Why does this distinction matter? It matters to economists because the characteristics of deposits (fixed nominal value, instant access) means that they function as money. This is the fundamental reason why we distinguish between deposit-taking institutions (left-hand column) and non-deposit-taking institutions (right-hand column). For this reason, banks and building societies are sometimes singled out for more special treatment and are called monetary financial institutions (MFIs).

monetary financial institution

Financial markets
Let us turn now to financial markets. A market is any organisational device that brings buyers and sellers together for the purpose of trading. Traditionally, the device was a physical location a market square for example. With modern communications, however, there is no need for buyers and sellers to meet face to face. Provided that both sides know the identity of the other (often referred to as the counterparties) and they know how to contact them, trading can take place very easily, rapidly and at low cost. Figure 1.2 lists the better known financial markets in a modern, developed, economy.

The equity (company share) market The corporate bond market The government bond (gilts) market The market for asset backed securities

The options markets The swap markets Futures markets

The repo (repurchase agreement) market The discount market The interbank market The certificate of deposit market The commercial paper market The foreign exchange market

Figure 1.2: Some financial markets

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Financial Markets

capital market

money market

maturity

Notice that Figure 1.2 divides these markets into groups, similar to the way in which Figure 1.1 treated institutions. Firstly we have distinguished capital markets (above the dashed line) from money markets (below it). The distinction here refers to the maturity (or life) of the instrument that is being traded. We have put the company share market at the top of the list because a companys shares exist for so long as the company exists as an independent entity. They have no maturity or redemption date. By contrast, bonds usually do have a fixed maturity a date on which they will be bought back by the issuer though this may be a long way into the future. Bonds can have a maturity of 25 years or more when first issued. Below the dashed line we have a selection of money markets, markets in which short-dated instruments are traded. Many central banks are active in the repurchase market and they tend to do deals with a 14-day maturity. The discount market is dominated by treasury bills, which usually have an initial maturity of 91 days. Certificates of deposit (CDS) are commonly issued for one month, three months or six months. There is no precise maturity at which we can draw a hard and fast line between capital and money markets, but we can say as a rough guide that capital markets are trading instruments with a remaining life of five years or more, while money markets are trading instruments with a maturity of less than five years (and frequently very much shorter).

Lear

ga nin ct

1b

What factors will firms have in mind when choosing between money and capital markets as sources of funds?

eedb ac

y ivit

1b

The primary consideration will be the length of time for which they need the funds. If they are required to set up a new line of business with new equipment and maybe new buildings, then this will involve very substantial expenditure which may not show a profit for a number of years. The firm will prefer to borrow for a long period by issuing shares or bonds. By contrast, if the funds are required to expand the scale of some current activity, they may only be needed to buy additional raw materials which will soon be turned into finished goods and sold at a profit which will repay the loan. This might suggest the firm issues commercial bills or some other form of commercial paper. However, these decisions will also be affected by the levels of interest rates and expectations of future interest rates. For example, long-term rates are generally higher than short-term rates and firms borrowing long term will accept that. However, if this spread widens, long-term borrowers will try to borrow for the shortest possible period, while if it narrows they might borrow for longer than they originally planned. Also, if interest rates generally are expected to fall in future, long-term borrowers might be willing to borrow short term in order to take out a new loan in the future when interest rates have fallen. Equally if interest rates are expected to rise, short-term borrowers might decide to borrow for longer than usual in order to lock in the benefits of the low current rates.

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Unit 1

An introduction to financial systems

derivative

In the right-hand column, we have markets for derivatives. These are so-called because the value (or price) of the instrument depends to some extent on what is happening to the price of another (or underlying) asset. For example, you might buy the option to buy shares in Tesco plc at, say, 4 in six months time. You will do this if you think that there is a good chance that the Tesco price in six months is likely to be over 4. To have this option of course you will have to pay something, say 15p per share. And this option price (actually called a premium) is to some extent dependent on (or derived from) the underlying share price. If the Tesco share price shoots up, the option to buy at 4 becomes more valuable. These derivatives markets have grown very rapidly indeed in recent years. Before we leave our discussion of financial markets, let us just note that these markets are not separate from the institutions that we discussed in the last section. In fact the users of the markets are very often financial institutions of one form or another. This does not mean that households and individuals are excluded. Individuals can buy government bonds, company shares, equity options and so on. But even in the case of individuals, the trade will involve some financial institution or another. (In other words, the counterparty will be an institution.) This is because the market has to be made by someone. If we stay with Tesco plc, for example, in order for you to buy or sell Tesco shares you have to know who is willing to sell to or buy from you. This will be an investment bank that has chosen to make a market in company shares including Tesco plc.

End users of the financial system

The end users of a financial system are the firms, households and individuals that wish to make use of the services offered by the institutions and markets. But why do we talk about end users rather than just users or consumers or clients? In fact, we have just seen why, in the last paragraph. The term end user is important when we are looking at the intermediation role of the financial system. Remember that intermediation relates to the lending/borrowing function of the financial system. Suppose we consider the case of a firm which wishes to borrow for the long term by issuing, say, new shares or possibly corporate bonds. The new securities are initially sold to an investment bank that makes a market in the firms existing securities. At this point, we might say that the investment bank has made a loan to the firm, taking the securities in exchange. This is true, but the investment bank has no intention of lending long term to the firm. As soon as it has possession of the shares (or maybe even before it gets possession) it arranges to sell them on in smaller parcels to investors who wish to hold them as part of their portfolio. This may be a household that is looking for a home for its surplus income, in which case we have found the end user. In this case, the household is the ultimate lender while the firm is the ultimate borrower. These are the end users, while the investment bank is acting as an intermediary. Of course, the chain could be much longer. The shares might have gone from the investment bank to a pension fund which is looking for somewhere to invest its members savings. If this happens, then we introduce another intermediary into the chain. The pension fund is holding the new shares and is obviously, in a sense, lending to the firm by holding the shares. But the pension fund is not the ultimate lender. The ultimate lender is the employee whose pension contribution has been used by the pension fund. 5

ultimate lender

ultimate borrower

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Financial Markets

In many economies, the largest single borrower in the financial system is the Government. Governments frequently run budget deficits since their tax revenue is insufficient to cover expenditure, especially expenditure on capital projects. This government borrowing takes the form of the issue of government bonds fixed interest securities that we study in Unit 6. Over the years, this stock of bonds grows, adding to what is called (roughly) the national debt. These bonds, once issued, become part of someones savings usually through a pension fund or some other long-term savings plan. Provided that the stock of debt grows at a rate which is similar to the growth of a countrys economy, there is no problem with this expanding debt and certainly no plan to repay it. However, during the financial crisis of 2008 and the associated recession, many governments found themselves having to provide a lot of financial assistance, especially to their banking systems, while suffering from falling tax revenues and increased unemployment benefits. This has led to a rapid increase in debt/GDP ratios in several countries to the point where there is some concern about whether future governments will be able to meet the interest payments. Greece, Portugal and Iceland saw their government bonds downgraded by risk-rating agencies in 2009 and the UK came close. The situation has been eased to some degree by dramatically expansionary monetary policies carried out by central banks. These have been buying up government bonds in the open market in a process known as quantitative easing. When the central bank buys these bonds, the sellers receive bank deposits (ie money) in exchange. And so quantitative easing is a way of pushing money into the economic system in the hope that people will spend it (rather than hoard it). A simpler example, which we shall need in the next section (1.2), arises when a household increases its deposit in a bank. The household is lending to the bank and the bank is thus a borrower from the household. At the same time, the bank lends to borrowers who may be a household buying a house or a firm hoping to expand. So the bank is itself a borrower and a lender. But it is not the ultimate borrower or lender; this is the firm or household. What we have said so far could be summed up in a simple diagram, like Figure 1.3. At each end of the system we have the ultimate lenders and ultimate borrowers. Funds from lenders to borrowers via intermediaries or via markets and the dotted arrows show that some intermediaries (especially investment banks and mutual funds) are very active participants in the markets.

Intermediaries

Lenders

Borrowers

Markets

Figure 1.3: A simple model of a financial system

Copyright 2010 University of Sunderland

Unit 1

An introduction to financial systems

Lear

ga nin ct

1c

Why will some ultimate lenders (and borrowers) prefer to use financial markets while others prefer intermediaries?

eedb ac

y ivit

1c

It is mainly a question of cost and information. Thinking of lenders first, many savers prefer to use intermediaries like banks and building societies because they are familiar with the way in which they work. Furthermore, intermediaries will accept small savings because they can pool them into larger loans. There is a cost to the lender in the sense that the return paid on these small savings will be lower than might be available elsewhere, but lending on a small scale through financial markets also has substantial costs since there are often minimum commissions and fees and these can be substantial as a fraction of a small transaction. Large lenders will certainly find lending by buying securities and other traded assets much cheaper than small savers. From a borrowers point of view, borrowing by issuing securities has a high fixed cost (paid to the investment bank managing the deal) but this may be a very small fraction of the funds raised if the deal is large enough. But the borrower has to meet other requirements regarding disclosure of information and needs to have an established history and reputation if the securities are going to be willingly bought and held. Smaller borrowers cannot make the necessary information about themselves available to the markets and the costs of issuing securities would be prohibitive.

The regulatory authorities

Recommended reading for this section includes: Howells and Bain (2008) Regulation of Financial Markets; Howells and Bain (2007) Regulation of Financial Markets; Piesse et al Role of Government.

We end this brief discussion of what constitutes a financial system with a quick look at the role of the regulatory authorities. It is a characteristic of financial activity that it is always and everywhere subject to much higher levels of regulation than other types of economic activity. Furthermore, deposit-taking institutions are subject to the toughest regulation of all. In the UK, most financial regulation is the responsibility of the Financial Services Authority (FSA). In the USA it is divided between the Federal Reserve Board and the Securities and Exchange Commission. In the Eurozone, responsibilities are divided between the European Central Bank (ECB) and national regulators. Above all this, we have the Basel Committee, which lays down regulations for the conduct of international banks which are then meant to be applied by each national regulator. Why is financial activity subject to so much regulation? Ultimately, the explanation lies with a concept known as asymmetric information. This refers to a situation in which one party to a transaction has different information from the other. Different usually means that one has more information than the other and this is where the problem lies. Consider, for a moment, how this asymmetry may affect market participants and how some degree of regulation may be required.

asymmetric information

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Financial Markets

Lear

ga nin ct

1d

Suppose you are thinking of buying shares in Microsoft. What information would you want in order to make a confident decision and how might you be sure of getting it?

eedb ac

y ivit

1d

You would certainly want information about Microsofts recent profit record. You might want to know how these profits are generated by different parts of the business. You would want to know something about Microsofts capital structure: how many shareholders have a claim on these profits? How much debt does the company have (since debt holders have a prior claim on the companys earnings)? You would want to know about Microsofts immediate investment plans in order to make a judgement about likely future profits. You would also want to know that the key decision-makers in Microsoft were not using their inside information to trade in the shares before you had a chance to use the information. Requirements to make information publicly available and to prevent its abuse by insiders are enforced by regulation. The details will vary between countries. In some cases the conditions have to be met in order for the firm to have its shares listed on a stock exchange; in some cases the requirements will be imposed by companies legislation.

However the regulation is performed, it is unlikely that a market for company shares could function without some guarantee as to the availability and use of information. As a general rule, it is assumed that the borrower is better informed than the lender, since the relevant information refers to the likely return on the funds and the risk to which they will be put. Since the borrower knows more about the details of the projects being funded, the borrower has an information advantage. Regulation goes some way to maintaining a fairer balance. Another argument for some degree of regulation (much heard since the 2008 financial crisis) concerns the stability of the financial system. For example, once a bank has received funds from its depositors, the bank can increase its profits by using the deposits to fund loans or investments with a higher level of risk than depositors expected (since they do not have the information). If the loans or the projects go bad, the bank becomes insolvent and depositors lose their wealth (and their means of payment). Worse than this, once depositors lose confidence in banks (which they do as soon as one fails) then there is likely to be a run on all banks as depositors all try to withdraw their savings at once. You may have heard of the famous case of the Lehman Brothers investment bank in the USA which was declared insolvent in September 2008. This caused a colossal loss of confidence which shook the whole financial system because banks lost confidence in each other and would not lend to anyone (except the central bank). In the worst case, banks could refuse to transmit funds of any kind to each other and then the whole payments system collapses. It is this risk

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Unit 1

An introduction to financial systems

contagion

of contagion the high probability that one bank failure will spread like wildfire that makes regulators very reluctant to allow a major bank to fail. To prevent this the regulators may offer deposit insurance which discourages depositors from making panic withdrawals. Or they encourage a weak bank to merge with a strong bank, or the Government puts additional capital into the bank as weve seen with the Lloyds Banking Group and the Royal Bank of Scotland. Ironically, this reluctance to allow bank failures creates a further case for regulation. This is because the implicit guarantee offered by the regulators against bank failure may encourage riskier behaviour by banks and other institutions. To prevent this, tighter supervision of intermediaries is required.

1.2 The advantages of using a financial system in lending and borrowing

Recommended reading for this section includes: Howells and Bain (2008) Financial Markets and Financial Institutions; Howells and Bain (2007) The Financial System and the Real Economy; Piesse et al (1995) Introduction to the Financial System; Mishkin (2007) An Overview of the Financial System.

In Learning activity 1a we identified four types of services that a financial system provides. The first thing that we can say about a well-functioning financial system is that it provides a whole range of services that consumers find useful. Provided the cost of using the service is less than the value that the consumer places on it, the services will be bought. So, we can see quite a number of advantages of consuming financial services in the same way that we see people benefiting from lots of other services travel, restaurants, entertainment, legal advice and so on. However, in this section we are mainly concerned with the benefits of using markets and these lie primarily with the financial systems role in channelling funds from deficit to surplus units (lenders to borrowers) and also in providing an opportunity for portfolio adjustment. We shall focus on lending/ borrowing first. The easiest way to understand why lenders and borrowers are so keen to use organised markets (or financial intermediaries) is by thinking what it would be like without them. We could, for example, lend directly to each other, cutting out the middleman and avoiding the costs of the market or the intermediary. However, the fact that we dont do that, and that we are prepared to pay a variety of fees and commissions in order to have access to organised markets, suggests that there must be some real advantages over direct lending. Look at the situation from a lenders point of view first. The lender will be concerned about:

Search costs we need to find a borrower who wants to borrow the same amount that we have to lend and for the same period. Contract costs unless the loan is very small we shall need to draw up a legally enforceable contract. We may need the services of a lawyer. Enforcement costs if the borrower falls behind with payments of interest (or defaults completely) we shall need to exert pressure to encourage payment or recover what we can.

transaction cost

We could put the three costs together and call them transaction costs. But cost is not the only problem. There is also the major issue of:

risk 9

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which we know is partly the result of asymmetric information. And another one that is sometimes related to it is:

illiquidity.

primary market

secondary market

The borrower will also face problems if forced to consider raising a loan privately from an individual lender. There will be formidable search costs, since it is more than likely that the loan required will be much larger than any individual lender would wish to finance. There could also be a degree of risk. This would take the form of risk of early repayment and would arise because of the lenders desire to avoid illiquidity. This would mean that the borrower had to accept a contract that allowed the lender to demand early repayment in certain circumstances. This could be disastrous for a firm that was only half-way through commissioning a new project. As a rule, a borrower wants to borrow for the longest possible period while the lender wants to lend for the shortest. Leaving aside the issue of costs, which of course both sides wish to minimise, we could say that there is some degree of conflict between lenders and borrowers. At the very least there is a mismatch of preferences primarily over loan size and duration. Organised markets go a long way to resolving these conflicts as we shall see now. We shall deal firstly with transaction costs and then questions of risk and liquidity. However, before we do this we need to be aware of the distinction between a primary market and a secondary market. The primary market is the market for newly-issued shares. In this case, a firm requiring additional long-term funds engages an investment bank to advertise a certain quantity of shares for sale on terms that the investment bank thinks will strike an appropriate balance between raising the maximum capital and being attractive to shareholders. If the new issue is successful, then the firm receives the proceeds of the share sale, minus the fees that it must pay to the investment bank for managing the sale. Notice that the firm gets additional funds because it has issued new shares. However, most trading in financial markets involves the buying and selling of existing securities. This is the secondary market. Clearly in this case the buying and selling involves no new lending. Both primary and secondary markets contribute to the reduction of costs and the reconciliation of conflicting preferences.

Markets and cost reduction

The first thing we need to recognise about any organised market is that it trades standardised products. This is related again to information. A market cannot function satisfactorily unless the participants know exactly what they are trading. Hence a market for company shares expects those shares to have some common characteristics. These relate to voting rights, frequency of dividend payments, arrangements for registration of ownership. Fixed interest securities traded in bond markets will also have fundamentally similar characteristics. This standardisation of features is one of the first elements in the reduction of costs. A company share is a company share and there is no need for individual contracts to be drawn up specifying the rights and obligations of the seller (the borrower) and the buyer (the lender). There is a substantial reduction in search costs (for borrowers) in so far as firms know that there is a national stock market in which they can raise additional funds by making new issues. It is quite possible that certain investment banks specialise in handling new issues for certain sectors of the economy but these areas of specialisation are well-known or can be obtained from the managers of the exchange. 10
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An introduction to financial systems

market maker

bid-ask spread

The search costs are also reduced for lenders by means of the publication of share listings by the exchange, together with up to the minute information about prices and other key variables. Market makers and brokers advertise their services to potential shareholders. The saving of transaction costs for lenders is dramatically illustrated by the very low commissions paid to brokers and market makers for the sale/purchase of shares. In the UK, traditional brokers charge around 0.25 per cent of the value of the transaction once the contract size exceeds about 15,000. But there are online brokers prepared to charge a flat-rate commission of 25 for smaller deals. In addition, there is the bid-ask spread. The spread is the difference between the prices at which market makers are prepared to buy and sell securities. The market makers are firms, usually investment banks, who make up the membership of the exchange in question and in return for their membership they agree to obey certain rules, the principle one of which is to offer always to buy and sell a range of specified assets. In an equity market, the market maker will offer to maintain a market in a specified list of shares. This means holding a stock or inventory of the relevant shares and adding to or selling from that stock in response to requests from investors, adjusting the price as sell or buy orders dominate the order book. Most market makers will list the alpha shares. Less popular shares will have fewer market makers and this reduced competition is usually reflected in larger bid-ask spreads. For alpha stocks, the difference between the bid price (the price at which the market maker offers to buy) and the ask price (at which the market maker sells) is likely to be around one per cent of the central price. Remember that these are the charges for (effectively) arranging a loan. In most countries, these commissions and bid-ask spreads fell throughout the 2000s partly as a result of increased use of electronic technology. We shall learn more about detailed trading arrangements in later units when we look at different types of market.

Markets, liquidity and risk

So far we have concentrated on the role of primary markets in helping investors to buy newly issued stocks. This does not mean that the secondary market is unimportant. Firstly we should note that when the equity market is working in this secondary capacity it is providing the portfolio adjustment facilities, described in learning activity 1a. Secondly, it is performing an important role in support of the primary market because it is telling the investment bank, handling a new issue, how existing investors see the company and this should be a strong guide as to the terms on which they are likely to subscribe new capital. For example, if the market price is high, the firm will be highly valued and, other things being equal, it will be cheaper to raise new capital than if the market price of the shares were low. The terms of the new issue will normally be close to, but better than, the terms on which the existing shares are trading, when seen from an investors point of view. This is why new issues are usually sold at a discount to the price of existing shares. Finally, the existence of a secondary market makes the relevant securities much more attractive than they would be in its absence because it means that they can be sold quickly, and for a reasonably certain price, if the holder needs to raise funds quickly. This is an illustration of how organised markets create liquidity. Making assets liquid makes them more attractive to investors and, other things being equal, should make it cheaper and easier for firms to raise new capital 11

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through new issues. Since liquidity means that assets can be sold quickly and for a reasonably certain price, the creation of liquidity helps to reduce risk. However, markets do a lot to reduce risk further by helping to discover or provide information (see section 1.1 under The regulatory authorities). The starting point is that participation in the market requires a high level of disclosure and the rules that cover disclosure are very strict. In order for a companys shares to be listed on a stock exchange, for example, they have to publish a set of annual accounts which must be prepared in accordance with a set of rules that should mean that the accounts give a true and accurate picture of the state of the business. These accounts must be updated half yearly and, in addition, firms must disclose immediately any information that is likely to affect their financial position. This information is then analysed by market makers as well as investment banks, mutual funds and other financial firms who are usually the major holders of shares (see section 2.4). The results of this analysis then also become publicly available quite quickly, since once one major participant is known to have made a buy/sell decision, this becomes public knowledge and other investors, including private buyers and sellers can follow suit. Inevitably, the amount of information that is available about a firm is likely to increase with the firms size and with its age. A large firm is likely to have a large number of shares in issue. (Its shares will be alpha shares, and so many people will be buying and selling and therefore analysing the firms performance.) Additionally, a firm whose shares have been quoted for a long time will have built up a reputation. Investors will be familiar with it and with its management. Its behaviour will be predictable.

Lear

ga nin ct

1e

Most trading in the stock market is secondary trading which involves no new lending or borrowing and is therefore of little economic value. Comment critically on this statement.

eedb ac

y ivit

1e

Firstly, as a factual statement it is correct. Total turnover in stock markets vastly exceeds the amount of money raised by new issues as you will see in Unit 4. Therefore most of this trading is simply redistributing the ownership of existing assets. However. three possible benefits should be considered: 1. The ability to buy and sell shares cheaply and easily makes a very longterm instrument into a relatively liquid one. As such, company shares are much more attractive as an asset than they would otherwise and this attractiveness makes it possible for firms to pay much lower dividends than would otherwise be necessary. This reduces firms cost of capital. 2. The ability to buy and sell shares cheaply and easily enables investors to make quick and cheap adjustments to their portfolio. This enables them to adjust their exposure to risk and return to their needs which will change over time. 3. The markets attitude to existing shares may be a useful disciplinary device for the managers of firms. If investors do not like the way in which a firm is being run, they will sell the shares, reducing the value of the firm and raising its cost of capital. If the value falls enough, the firm may become a target for takeover.

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An introduction to financial systems

1.3 Market efficiency and the real economy

Recommended reading for this section includes: Howells and Bain (2008) Financial Market Efficiency; Howells and Bain (2007) Financial Market Efficiency; Mishkin (2007) The Stock Market and the Efficient Market Hypothesis.

It seems an obvious thing to say that an economy will be better served by a financial system (and financial markets) which are efficient, rather than inefficient. This is of course true, but we need to define efficiency carefully and to understand that there is one special meaning of efficiency that applies to financial markets and is controversial, above all since the financial crisis of 2008. We look at each of these briefly and when we do that we shall link each type of efficiency to certain benefits for the real economy. We shall link the first type of efficiency to the encouragement of saving, investment and economic growth (what we might call macro benefits) and we shall link the second type of efficiency to resource allocation (what we might call micro benefits). This is a bit of a simplification since both types of efficiency are relevant in some degree to both sets of outcomes. But it helps us to distinguish the different types of efficiency and it forces us to think about several ways in which the financial system may interact with the real economy.

Operational efficiency, investment and growth

operational efficiency

The first sense in which most people will think of the term efficiency refers to technical or operational efficiency. This refers to a markets ability to carry out transactions quickly, cheaply and reliably. For example, a buyer of shares needs to know that the broker or market maker will buy/sell the shares at (or very close to) the price that has just been displayed on the internet. It will not be satisfactory to find that the trade was not done for, say, thirty minutes after the instruction when the price had changed significantly. We have already mentioned the need to minimise costs. Market participants also want to know that the paperwork settlement of the trade and the transfer of funds will occur quickly and securely. These are all aspects of operational efficiency, which is generally regarded as satisfactory in most major markets and is generally improving (as regards speed and accuracy) as a result of improving communications technology. In section 1.2 we looked at a number of advantages that follow from using financial markets. We summarised the benefits by saying that markets make it easier and cheaper to lend and to borrow. If this is true, then it amounts to saying that without organised markets lending and borrowing would be very difficult and expensive. Hence, we can be sure that a well-functioning financial system will encourage more lending and borrowing than would otherwise be the case. Why does this matter for the economy as a whole? First of all, we all of us know borrowing helps consumers to buy goods and services beyond what is possible from their current income. Current income becomes less of a constraint and lending and borrowing enables us to shift our consumption in time: postponing it or bringing it forward. However, we are more interested here in another benefit: the financing of real investment projects. Notice that we say real. This is to distinguish the kind of investment that we are interested in here which is the purchase of machinery, buildings, equipment and so on that facilitates the production of other goods and services from the purchase of financial assets (or financial investment). From this definition we can see that real investment is something that is normally done by firms (or public authorities) rather than by households.

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Financial Markets

The purchase of real capital goods typically involves a large expenditure which has to be made before the equipment begins to work and earn a profit. It is usually impossible for the firm to make this expenditure out of current income. Consequently, it must either draw on existing savings (out of previous profits) or it must borrow. This means that the cost of borrowing (sometimes called the cost of capital) plays a major role in the decision to invest. The lower is the cost of borrowing, the more likely is it that a particular investment will recover its cost and make a profit. At low costs of borrowing, there will be more profitable-looking projects than there will be when borrowing costs are high. In Figure 1.4, we show this relationship between investment spending and the cost of borrowing.
cost of capital %

C1

l 0

l real investment

Figure 1.4: Lending, borrowing and investment Figure 1.4 can be used to show how the amount of investment depends, amongst other things, on the quality of the financial system. Start with the figure as drawn. The cost of capital is set at C which is partly dependent on investors willingness to buy and hold, say, company shares. Now imagine that the system develops certain improvements. Maybe the costs of trading fall, or the markets becomes more liquid or brokers start to target new investors. This will encourage more people into the market and, other things being equal, we would expect share prices to rise. In the next section we explain why a rise in security prices is equivalent to a fall in the cost of capital. So, these improvements in the share market that have made shares more attractive, have made it cheaper for firms to raise new funds. Why does this matter? The answer is that there is a widespread belief amongst economists that one of the principal determinants of an economys rate of growth is the rate at which the capital stock expands and is replaced. Expanding the capital stock gives workers more equipment to work with; replacing capital equipment at frequent intervals gives a firm access to the latest technology. Both of these should make workers more productive and an increase in output per head is just another way of referring to an increase in real income. In so far as we are concerned with material standards of living, a high level of investment should help bring rapid improvements.

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Informational efficiency and resource allocation

informational efficiency

The second, and more controversial, meaning of efficiency refers to informational efficiency. The issue here is the extent to which all information that is relevant to the valuation of an asset is incorporated in the price and this must also introduce the question of time or speed of incorporation. Broadly speaking, a financial market which manages to absorb all relevant information into the price of assets being traded so quickly as to prevent anyone profiting from the information is regarded as efficient. Let us assume for the moment that such efficiency is typical. There are some very strong implications. We postpone the full list until Unit 5, but just consider these for now:

If information is incorporated so fully and so quickly, it will be impossible for anyone to earn consistently abnormal rates of return. To beat the market they will have to guess and occasionally they will guess lucky but at other times they will guess wrong. If markets are informationally efficient, anything that can be learned from past price behaviour will have been learned and will be already incorporated in the price. Therefore, the only thing than can change prices is news and news, by definition, is random sometimes good and sometimes bad with absolutely no pattern. If prices incorporate all the relevant information, those prices will be correct prices and this ensures that funds will flow to where they are most productive.

If we are thinking about the financial system making the best contribution that it can to the real economy, then it is this third implication that concerns us most. We must postpone a full discussion until Unit 5 but briefly, the argument goes like this. The price of a security in any market depends upon three things which are referred to as fundamentals. These are: 1. The future stream of earnings, which may be in the form of interest or a variable dividend linked to the profitability of the firm both of these are linked to the underlying productivity of the project that the funds are financing. 2. The level of risk that comes with those earnings. 3. The rate of interest, since the rate of interest is combined with a risk premium (from 2) in order to discount the earnings (in 1). Take now the case of a firm with a high share price, relative to the dividend that the firm is paying. According to our three conditions, the share price will be high because investors are optimistic about the future stream of earnings, relative to the risk involved. Why should the future stream of earning be so impressive? It can only mean that the firm is likely to make large future profits and this means that its projects are highly-valued by society (represented by consumers willingness to pay a good price for the outputs) and efficiently operated. These are the sorts of activities that society appears to value and the firm should be encouraged to produce more. Now consider the significance of the share price being high relative to the dividend being paid. This means that the firms cost of capital (at least, equity capital) is low since it could if it wished issue new shares (and raise corresponding funds) for only a small payment in dividend. Imagine instead

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Financial Markets

that the share price were half what it is (and the dividend were unchanged). A new issue would now bring in much less capital, each unit of which would now be twice as costly as before. Of course, the opposite will be true. A low valued firm will find it expensive to raise new funds and expand. And if our reasoning is correct, then this is as it should be since the firm cannot be delivering highly-rated benefits to society. Indeed, it might be a good idea if the shares were to fall a bit lower in price because another firm may then take it over and turn it into something more useful. So if all goes according to the efficient markets theory, capital is attracted to good firms (who find it relatively cheap), but is in short supply to poor firms (who find it expensive). Good firms will expand while poor firms will stagnate, maybe shrink and/or maybe taken over. The idea that financial markets make very efficient use of information is the basis of the efficient market hypothesis (EMH). This is a controversial issue which we discuss more fully in section 5.2.

efficient market hypothesis

Lear

ga nin ct

1f

Which of the following statements is consistent with the hypothesis that markets are informationally efficient? 1. Some unit trust funds consistently produce higher rates of return than others. 2. When it comes to takeovers there are no bargains. 3. Buying shares whenever their price falls by ten per cent in a month will produce superior returns in the long run.

eedb ac

y ivit

1f

1. This is consistent. The EMH only says that it is impossible to earn abnormal rates of return consistently. Abnormal means rates of return that are higher than the market rate for a given level of risk. If some unit trust managers set out to specialise in high-risk portfolios while others specialise in low-risk, we should expect to see the former earn higher returns consistently. 2. This is consistent. Firms may have a low share price and so the value of the company is low. It may look cheap. But if the share price incorporates all relevant information it will be cheap because it is a poorly performing firm. This is not a bargain. 3. This is inconsistent. It suggests that there is a rule which leads to abnormal returns. But the EMH says that if such a rule were to exist, then everyone would know it. And if they know it, they will use it and this immediately makes the rule useless because any shares that might have yielded abnormal returns identified in this way, would have the information in their price and would not fall by ten per cent.

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1.4 The financial system and economic development

Recommended reading for this section includes: Ang (2008); Mishkin (2007) Economic Analysis of Financial Structure.

We have just discussed two ways in which the functioning of a financial system, including financial markets, may affect the real economy. As the financial system expands and improves we would expect to see less consumption but more saving, investment and economic growth; if the financial system is informationally efficient this will go some way to ensuring that funds flow to their most productive uses. In this section, we take these same ideas, which are usually applied to developed economies with sophisticated financial systems, and show how they can be applied to the process of economic development in poorer countries. The idea that finance plays an important role in economic development goes back a long way, at least to Schumpeter (1911). Other writers in a similar tradition include Gurley and Shaw (1955) and Hicks (1969). Their arguments were broadly similar to what we said under Operational efficiency, investment and growth above, namely, that the financial system helps to mobilise saving and investment and therefore, for many less developed countries, policy should be directed towards encouraging the growth of a financial system. More recently, McKinnon (1973) and Shaw (1973) took this argument a stage further by introducing elements of our discussion under Informational efficiency and resource allocation in so far as they were concerned with the financial systems ability to direct resources to their most efficient use. They laid less stress on simply expanding the financial system and placed more emphasis on ensuring that it worked well. The target of their criticism was the practice in many less developed countries of what came to be known as financial repression. Financial repression was characterised by high levels of government regulation of the financial system. This took many forms, including high reserve requirements on banks, obligations on banks to hold high levels of government debt and ceilings on interest rates. As we shall see in Unit 9, regulation may sometimes be essential but it inevitably acts like a tax and in so doing it raises the price and reduces the quantity of the activity concerned. More interesting was their attack on interest rate ceilings. Taking a charitable view of interest rate ceilings, one might say that they were a well-intentioned device to encourage investment by holding the cost of borrowing below the market-clearing level. However, this overlooks two things. The first is that if saving is not adequately rewarded, it will not be forthcoming. Hence while low interest rates may encourage the demand for loans, it will discourage the supply. There will be excess demand, but the amount of borrowing will be limited to the amount of saving. Borrowing will be supply-constrained. So this wellintentioned measure has the opposite effect of what was intended. The second issue is at least as interesting. In the normal appraisal of investment projects, the key question is whether the project will earn a return which covers the cost of capital. Consequently, the higher the cost of capital the better or at least more productive the project has to be. By holding down the cost of capital, many poor quality projects will now pass this test. Recall that there is excess demand for the limited funds available. How are the limited funds to find their way to the best projects? The McKinnon and Shaw argument is that they will not. At best, some sort of human agency bank managers, public officials will do their best to identify the most deserving cases. At worst, the limited funds will be allocated by corrupt methods. The result will be a very poor

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quality of rather limited investment. The contribution to growth and development will be much smaller than it should be. The policy implication is clear. What is required is financial liberalisation. Over the years there has been much further discussion of the financial repression hypothesis and a good deal of empirical testing, initiated by famous paper by King and Levine (1993). One problem for empirical researchers is that long time series of data for individual countries is not available, because, although the theoretical argents began in the 1970s, developing countries often did not record the necessary data until later. Many of the studies are therefore crosssectional comparing countries with different degrees of liberalisation rather than the same country before and after. A good survey of the results (and of the theoretical debates is in Ang (2008). What most of the studies show is that there is a widespread association between finance and economic growth where finance refers both to the size of the financial sector (the traditional view) and the more recent liberalisation hypothesis. The problem, as so often in economics, is distinguishing cause and effect. The original King and Levine (1993) study focused mainly on banking variables as indicators of finance. From our point of view it is interesting that more recent work has gone on to look at the effect of stock markets on economic growth. Studies by Demirguc-Kunt and Maksimovic (1998) and Levine and Zervos (1998) confirm a positive link between markets and economic growth. Finally, we should note that there are dissenting voices. In particular, Joseph Stiglitz (2000) has argued that financial liberalisation has led to increased instability within financial systems and is responsible for the increased frequency of financial crises. This is a point of view that has attracted increased attention since 2008.

Lear

ga nin ct

y ivit

1g

Business sector Basic materials Industrials Consumer goods Healthcare Consumer services Telecoms Utilities Financial Technology Total

October 2008 0 0 0 0 3.40 0 0 10.75 75.00 89.15

March 2009 4222.35 33.12 457.48 0 0 0 0 28.86 0 4741.81

October 2009 197.20 622.54 876.54 0 287.39 0 0 533.57 0 2517.24

Table 1.1: Funds raised by the issue of new ordinary company shares on the London Stock Exchange ( million)
Source: London Stock Exchange, Market Statistics, October 2008, March 2009, October 2009

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Lear

ga nin ct

y ivit

1g

1. Write a brief commentary on what is shown. 2. What sort of factors might play a part in firms decisions regarding the timing of new issues? Figure 1.5 may suggest some ideas. It shows the behaviour of the FTSE-100 index covering the period June 2008 to December 2009.
FTSE100 (adjusted close) 6000 5500 5000 level 4500 4000 3500 3000

09/09/08

17/05/09

14/10/09

Figure 1.5: FTSE-100 index

01/06/08

21/07/08

29/10/08

18/12/08

06/02/09 date

28/03/09

06/07/09

25/08/09

03/12/09

eedb ac

1g

1. The figures show very large variations in new issue activity. In October 2008 firms raised only 89 million while in March they raised almost 4742 million, an increase of 50 fold. The figures also show considerable variation across sectors. Some sectors like healthcare, telecoms and utilities raised nothing over the period while basic materials, industrial and consumer goods raised much more. However, it is worth noting that this is just a small sample and the figures are monthly. We might expect to see large fluctuations from month to month since one large new issue in one month and no large issues in another would make a large difference. We should always be careful not to read too much into a small sample. 2. The major effect upon the timing of new issues will be the timing of firms requirements for additional capital. However, there may be some flexibility in this. It may be possible to advance or postpone some expenditures or to finance them in some other, temporary, way if it seems beneficial to delay the new issue. If there is any flexibility, the firms and the underwriters of new issues will generally want to make the new issue when market conditions are favourable. The underwriters will be an investment bank and they will have agreed with the firm beforehand that they will take up any new shares that are not sold, in order that the firm can be certain of getting the funds that it

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eedb ac

1g

needs. But the bank will not want to hold these unsold shares for longer than necessary. They will therefore favour a situation where there is likely to be strong demand. They will certainly not want to launch the issue when investors are selling their shares and share prices are falling. It is noticeable that the FTSE index was falling steeply in October 2008 which was also more or less the height of the financial crisis when high levels of uncertainty encouraged investors to hold safe assets like money. The big sales in our table (in March 2009) coincided with the very lowest turning point and the revival of enthusiasm for company shares, as shown by the chart.

Self-assessment questions
1.1 1.2 1.3 1.4 1.5 1.6 Distinguish between long-term and short-term financial markets. How might the regulation of financial activity increase the level of risk? How do financial markets help to solve the problem of asymmetric information? How do conditions in secondary markets affect the ability of firms to raise new capital by the issue of new shares? Why might we expect financial markets to be reasonably efficient at reacting to relevant information? Outline two ways in which the performance of a financial system may affect economic growth.

Feedback on self-assessment questions

1.1 There is no strict definition, but in practice, long-term or capital markets are markets for instruments with a maturity in excess of five years. Shortterm or money markets are markets for instruments with less than one year to maturity. This leaves a grey or indeterminate area of one to five years. Instruments in this maturity are usually treated as belonging to the market in which most instruments of that type fall. So, government bonds of. say three years to maturity, would be regarded as capital market instruments because the bulk of government bonds most certainly belong in that category; by contrast, a two year CD would still be a money market instrument since the vast majority of CDs are money market instruments. Where regulation offers protection after something goes wrong, it reduces the costs of the malfunction. So, for example, if the authorities guarantee the safety of bank deposits when a bank gets into trouble, the guarantee lessens the costs of the banks insolvency. But by reducing the costs of certain actions, this may serve to encourage them. If depositors know that their deposits are safe, they do not need to be too concerned about what a bank is doing with those deposits; if shareholders know that their bank is too big to fail then they do not have the usual incentive to monitor the banks management. Both situations may encourage riskier behaviour by the bank. Hence more regulation will be needed to prevent this.

1.2

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An introduction to financial systems

1.3

Financial markets require users to disclose a large amount of information about themselves as a condition of access to the market. This is particularly true for borrowers (typically large firms). Remember that in the text we said that it was usually the borrower that had the information advantage and so this forced disclosure goes some way to restoring a balance. Furthermore, the organisers of the market will themselves publish a lot of information. They will show the price of the assets (company shares, for example) in real time as well as the volume of trading in each stock. Thus, if someone makes a large sale which causes a shares price to drop this is notified instantly to all participants in the market and will act as a signal to everyone that there may be something wrong with the firm. The main advantage of the secondary market is that it adds to the liquidity of the asset being traded. The degree of liquidity in a market is sometimes described as its depth and it is measured by reference to how large a sale or purchase can be, without causing a change in market price. The advantage of this liquidity to the issuer is that it makes shares much more attractive than they would otherwise be and this reduces the level of dividends that the issuer has to pay subsequently. There is a further advantage which is that an active secondary market in a firms shares gives a clear signal as to the cost of raising new capital. New shares will have to be issued on terms which are close to what shareholders are currently requiring to hold the shares. Part of the answer lies in Q1.3. Organised financial markets are structured with the intention of making information available. Amongst the information that firms must provide is all the financial information that an investor needs to make an informed decision. Furthermore, if something happens to the firms trading situation that might have a material impact on its financial position, that information must be disclosed at once. But in addition to this, the strongest reason for expecting markets to make efficient use of information is that it is irrational not to do so. Traders who are persistently badly-informed will be driven out of business by those who know better. Hence there is intense competition to find the latest news. This is the job of so-called analysts. And as soon as someone trades on the basis of this news the trade is instantly visible to everyone. There are numerous ways in which the performance of an economic system may be linked with economic growth. The two that we have mentioned here focus on increasing the amount of saving and investment in an economy in the belief that the rate of economic growth is linked to the expansion of the economys capital stock. On the assumption that the financial system is operationally and informationally efficient, this is really an argument for having a financial system which expands with the rest of the economy. But the system may not always be efficient, especially in less developed countries. where this is the case, savings may be discouraged (by interest rate caps) and the resulting funds may not flow to their most productive use if the limited saving is rationed by non-price methods. Where these restraints exist, this is an argument for liberalisation of the financial system.

1.4

1.5

1.6

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Financial Markets

Summary
As a result of studying this unit you should now understand what a financial system is and how financial markets work within that system. Specifically, you should now be able to:

describe the key features of a financial system distinguish financial markets from intermediaries and understand how both help to mobilise savings for the purpose of investment appreciate the importance of information in financial activity and way imbalances of information may give rise to a need for regulation understand the meanings of efficiency as applied to financial markets and appreciate how that efficiency improves the functioning of the real economy.

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Unit

Money markets functions and operations

Historic lows for Libor raise lending hopes.

Financial Times (14 July 2009)

Introduction
In this unit you will learn what is meant by the expression money markets, what is traded in these markets and by whom. You will also see that these markets are critical in the process whereby the policymaker sets the general level of interest rates in the economy. Unit learning objectives On completing this unit, you should be able to: 2.1 Describe the characteristics and uses of money market instruments. 2.2 Price a selection of these instruments. 2.3 Show how the pricing of money market instruments can be linked to a supply and demand framework. 2.4 Identify the key users of the money markets, including central banks. Prior knowledge The unit requires no prior knowledge but you will find section 2.1 and 2.2 easier if you have some basic mathematical skills. Section 2.3 will be easier if you are familiar with some microeconomics and the use of a supply/demand framework. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: Money Markets). In addition, Piesse, Peasnell and Ward (1995) has a chapter on the money markets but is a bit dated. Howells and Bain (2007) also covers much of the material but at a rather lower level. There are many other books about financial markets and institutions, but few of them refer specifically to shortterm money markets. You will need a calculator and access to the internet.

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Financial Markets

2.1 The characteristics and uses of money market instruments

Recommended reading: Money Markets in Howells and Bain (2008 and 2007) and Piesse, Peasnell and Ward (1995). .

initial maturity

residual maturity

In Unit 1 we saw that financial markets existed for two main purposes: to help in channelling funds from surplus to deficit units and to facilitate portfolio adjustment. Money markets, and the instruments traded in those markets, are markets which channel short-term funds. There is no strict definition of shortterm, but generally speaking money market instruments have an initial maturity of less than one year. Notice that we say initial maturity. As time goes by, the residual maturity of an instrument shortens. Hence a government bond with an initial maturity of ten years will have a residual maturity of six months after a period of nine and a half years. However, we would not normally regard a government bond with a residual maturity of six months as a money market instrument since its initial maturity was much longer (and puts it firmly in the capital markets category). We shall see later that there is a short-term money market that features government bonds. This is the repo or repurchase market. But we treat this as a money market because the repurchase deals themselves have an initial maturity of less than a year, regardless of the maturity of the bonds that are being used as collateral. If the initial maturity of a money market interest has an upper limit of one year, it follows (a) that many will have an initial maturity of much less (three months or 91 days is quite common) and (b) that the average residual maturity will be very short indeed. Most instruments trading in money markets will have a residual maturity of less than three months. As a general rule (but there are exceptions) when it comes to pricing money market assets it is residual maturity the remaining life that matters. Figure 2.1 lists some money markets instruments. Notice that we have two groups.

Treasury bills Commercial bills Euro commercial paper US commercial paper

Bank deposits Certificates of deposit Repurchase agreements (REPO)

Figure 2.1: Money markets instruments

discount instrument

yield instrument

This is because the two groups of instruments differ in the way in which their rates of return are calculated and expressed. Those on the left have their return expressed as a rate of discount. (They are discount instruments.) Those on the right have their rates of return expressed as a conventional rate of interest. (They are yield instruments.) We shall see what this means in the next section. Because they are short-term instruments, we can say that a further characteristics of money market instruments will be high liquidity. This is because we define liquidity as:

The speed with which an asset can be converted to money for a known value.

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Money markets functions and operations

Because these instruments are never far from maturity, their price can never be far from the maturity value whatever shocks may hit the market. Furthermore, as we shall see in section 2.4, the issuers of money market instruments tend to be governments, banks and large corporations. This gives the instruments a very low default risk. Finally, because they all have similar maturities and a similar low level of risk, money market instruments tend to have rates of return that are very similar. For this reason, differences in money market returns are often expressed in basis points.

basis point

Lear

ga nin ct

(a) Describe the key characteristics of money market instruments. (b) How do you think these characteristics affect their rate of return relative to other financial assets?

y ivit

2a

eedb ac

2a

(a) The key characteristic of money market instruments is that they are very short-term instruments, even when newly issued. Other characteristics flow from this. They are highly liquid since any holder has only to wait a short time to maturity. Furthermore, if they had to be sold prior to maturity the price will always be known with a reasonable degree of certainty. This is because a change in market interest rates cannot have much effect on very short-dated assets. This stability of value then makes them low-risk and the low-risk is reinforced by the fact that the borrowers in money markets are governments, banks and other large corporations. (b) The low-risk, high-liquidity nature of money market instruments means that their rates of return are generally lower than can be earned in other financial markets.

Recommended reading: Money Markets in Howells and Bain (2008 and 2007) and Piesse, Peasnell and Ward (1995).

Copyright 2010 University of Sunderland

2.2 Pricing money market instruments

In this section we shall look at the pricing procedure for a discount instrument and then for three yield instruments. Throughout this discussion, and in future units, we must remember that the present value of all assets is given by: the present value of their future income stream, suitably discounted. By suitably discounted we mean adjusted by a discount factor which incorporates the return that could be earned on similar, alternative assets and this amounts to saying that we use a risk-adjusted rate of interest. The discount factor is 1/(1 + i), where i is the risk-adjusted rate of interest. In all the calculations relating to money market instruments we shall find that we need to refer to a fraction of a year since money market instruments have maturities of less than one year. For this reason the discount factor becomes:

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Financial Markets

1 (1 + i.nm)

[2.1]

where nm is the residual maturity of the asset expressed as a fraction of a year. This introduces a complication since money markets in different countries have different definitions of a year strange as it may seem! Of the major trading centres UK, the Eurozone and Japan assume that a year is always 365 days long; in the US, however, it is assumed always to be 360 days. To see why this matters, consider this example. Suppose that the rate of interest on an 100,000 instrument for three months is quoted as six per cent. What does the holder actually receive? The answer is: interest paid = 0.06

( )

91 100,000 = 1496 365

Clearly if we change the length of the year from 365 to 360 this will make a difference to the sum received and this in turn will make it difficult to make comparisons of money market rates across different countries. Learning activity 2b gives you an illustration.

Lear

ga nin ct

2b

Suppose that the return on UK treasury bills is quoted at 7 per cent while on US treasury bills the return is quoted as 6.9 per cent. Which of these gives you the best return?

eedb ac

y ivit

2b

Look at the illustration in the text. If we change 365 to 360 we shall get a larger fraction of the annual interest rate quoted. This means that 6.9 per cent on a 360 basis will gives us more than 6.9 per cent on a 365 basis. But will it be enough to compensate for the quoted rate of 6.9 per cent being below 7 per cent? Let us see: interest paid = 0.069 interest paid = 0.07

( ) ( )

91 100,000 = 1744.17 360

91 100,000 = 1745.21 365

It turns out that when we quote returns on money market instruments 7 per cent in the UK is still slightly better than 6.9 per cent in the USA but the results are very close.

We can convert returns calculated on different year bases by using the following formulae; i360 = i365

( )
360 365

[2.2]

i365 = i360

( )
365 360

[2.3]

[2.2] converts a 365 rate into its equivalent 360-day version; [2.3] enables us to see what a US 360 rate would be worth when compared with a UK 365rate. For example, using [2.2] we find that the 6.9 per cent rate in the US is equivalent to 6.995 per cent in the UK not quite 7 per cent. 26
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Money markets functions and operations

Pricing a discount instrument

We look at the pricing of a discount instrument by looking at a treasury bill. A UK treasury bill is an instrument issued by the UK government to fund shortterm borrowing. The initial maturity is most commonly 91 days, but occasionally bills are issued with longer and shorter maturities. What makes them discount instruments is the fact that they are issued at a discount to their maturity value. In other words, the gain to the holder comes in the form of capital appreciation the difference between what it cost and what it is worth at maturity. The price is found as: P = M d(M.nm) [2.4]

where P is the market price, M is the maturity value, d is the rate of discount and nm is the residual maturity expressed as a fraction of a year. For example, a UK 91-day treasury bill (TB) for 1 million offering a rate of discount of five per cent will be offered for sale at: P = 1m 0.05 (1m 0.25) = 987,500 It is a simple task to rearrange [2.4] so that we can find the rate of discount given the other terms. d=MP M.nm [2.5]

For example, a Japanese TB for 5 million is trading at 4,900,000, with 80 days to maturity. Find the rate of discount. d= 5 4.9 0.1 = = 0.0912 = 9.12% 80 1.096 5 365

Lear

ga nin ct

2c

(a) Take the UK treasury bill described above and calculate its price when there are 50 days remaining to maturity, assuming all else is unchanged. (b) Does your answer suggest anything significant?

eedb ac

y ivit

(a) P = 1m 0.05 (1m 0.137) = 993,150 (b) We said earlier that money market instruments have high liquidity partly because, being short-term instruments, their price can never be far from maturity. What your calculation should show is that, all else being equal, the market price must converge on the maturity value as the period to maturity gets shorter.

2c

Notice that we have been talking about a rate of discount (rather than a rate of interest). [2.4] explains why. It is because it is the rate that is used to find the discounted price at which the bill is issued or trading. In the case of the UK TB, the discount of 12,500 was calculated by taking five per cent of 1 million. This is not the same as a five per cent rate of interest. Learning activity 2d shows why.

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Lear

ga nin ct

(a) What is the difference between a rate of discount and a rate of interest? (b) What rate of interest would be equivalent to the five per cent rate of discount above?

y ivit

2d

eedb ac

2d

(a) A rate of discount is expressed as a fraction of the sum received. A rate of interest is calculated on the outlay, or sum invested. (b) [2.4] is the formula for the rate of discount. If we were to use [2.5] to calculate a rate of interest, then we should have to put P rather than M in the denominator. Notice that, since P < M the equivalent rate of rate interest will be higher than the rate of discount.

Given the discount rate we can find the equivalent interest rate as follows: i= d 1 d.nm [2.6]

and, given the interest rate we can find the rate of discount. d= d 1 i.nm [2.7]

Finally, before leaving this discussion we need to confirm that the prices of the treasury bills we have just looked at conform to the rule that they are equivalent to their discounted future income streams. At the beginning of this section we saw that the appropriate discount factor is: M

1 (1 + i.nm)

[2.8]

Notice that the discount factor (1/(1+i)) uses a rate of interest and that we have to adjust for the fraction of the year that is left to maturity. Remember this rate of interest is not the same as a rate of discount (confusing as the terminology is). So, if we take our UK treasury bill we have first to convert the five per cent discount rate to its equivalent rate of interest using [2.6]: i= 0.05 = 0.05063291 1 0.05(0.25)

Using this rate of interest in [2.7] we have: lm

1 1 = 1m 0.987500 = 987,500 = 1m 1 + 05063291(0.25) 1.012658

which is the same result that we achieved using [2.4].

Pricing yield instruments

Interbank deposits Notice that we included bank deposits in Figure 2.1. This is because they are certainly short-term instruments (indeed, sight deposits have zero residual maturity) and because we do talk about a market for bank deposits but this is not a market in the conventional sense of lots of buyers and sellers trading 28

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Unit 2

Money markets functions and operations

over the counter transaction

LIBOR

assets between themselves. A bank deposit is an over the counter transaction you can only sell the deposit back to the bank. You cannot trade it (and your bank can not sell it to a third party). One particular category of bank deposits is of interest when it comes to studying the behaviour of money markets. These are the interbank deposits the counterparts to interbank loans. This is because the return on these deposits (called London Interbank Offer Rate or LIBOR) is used as a benchmark for setting the return on a variety of other instruments. This in turn is important for four reasons: (a) The range of interbank-linked products is very large it includes most retail deposits and loans, for example. (b) Where an instrument is a market-traded instrument, setting the return effectively sets the price (as we saw under Pricing a discount instrument above). (c) Because of the link from LIBOR to other market rates, it is LIBOR rates that are the first target of a central banks monetary policy (as we shall see in section 2.4) and this explains why the conduct of monetary policy begins with central bank money market operations. (d) During the 2008 financial crisis the link between monetary policy rates and LIBOR rates broke down to some degree which made the operation of monetary policy quite difficult. Although the deposits are not traded in a conventional sense, they do have a price and it is determined in exactly the same way as any other financial asset: it is the present value of the future income stream. This income stream from a deposit depends on the rate of interest and the term to maturity. In the case of interbank deposits we are dealing with fixed-term deposits with an initial maturity of up to one year. Suppose we are looking at a three-month interbank deposit of 10 million which is about to be made at an agreed LIBOR rate of 3.5 per cent. The future income stream will be: 10 million (1 + 0.035(0.25)) = 10.0875 million To find the present value of 10.0875 in three months time we simply discount by the usual expression [2.1]. The question is what rate of interest do we use in [2.1]? Remember that this must be the rate of interest on similar assets, so this reasoning is going to bring us back to the 3.5 per cent offered on the deposit. And you have probably guessed the rest. (If not, guess now. What will the present value be?) If we discount 10.0875 million by 3.5 per cent for three months we have: 1 10.0875m 1 + 0.035(0.25) = 10m! What this shows is that the price of a deposit is the initial payment to the borrower. And this makes perfect sense when we think about it. The price of the loan to the UK treasury was the price that we paid for the treasury bill. Here, the price of the deposit is the initial outlay. The problem we have with thinking about deposits like this arises partly from the fact that they are not tradable. It is also due to the fact that we tend to think of the outlay (what we hand over to the borrowing bank) and the deposit itself as one and the same thing. But this is not strictly correct. When we place funds with a bank we are definitely buying something. We are buying a deposit contract. And this

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Financial Markets

specifies what we shall get back at the end. Because we are buying something, there is a price the initial outlay and the link between this price and its reward follows all the standard rules of finance. Certificates of deposit Our second yield instrument will be a certificate of deposit. This is a certificate of ownership of a time deposit. You will remember that we said at the beginning of this unit that bank deposits themselves are not tradable and so we were not going to discuss them further. But some time deposits come with a certificate of ownership and the certificate is tradable.

Lear

ga nin ct

2e

(a) What do you think is the advantage of a certificate of deposit to: (i) the depositor (ii) the bank? (b) How would you expect these advantages to be reflected in the rate of return on a CD compared with a simple time deposit?

eedb ac

y ivit

2e

(a) (i) the advantage to the depositor is that she can enjoy the higher rate of interest that goes with a fixed-term time deposit while knowing that she can gain instant liquidity by selling the certificate if the need arises. (ii) the bank knows that it will retain the deposit for the full term because the depositor can meet a liquidity shortage by selling the certificate. (b) In effect the CD is more liquid that the simple time deposit, since it can be sold in the market we are discussing. One would expect depositors to pay for this advantage and therefore the rate of interest on CDs is usually slightly lower than the interest rate on the simple time deposit of the corresponding maturity. This means that the bank also benefits by getting a fixed-term deposit for a slightly lower rate of interest than it would have had to offer for a simple time deposit.

When it come to pricing a CD, we shall apply the universal principle in [2.1]. But we need to know some of the characteristics of the instrument first. The underlying asset is a bank time deposit of given maturity. We shall assume 182days (six month) initial maturity. This will pay a rate of interest (known as the coupon rate) which is usually (but not always) fixed at the outset. Thus, compared with a TB, the first thing we must do here is to calculate what the maturity value will be. We can find this by: M = D (1 + c.nim) [2.9]

where M is the value of the deposit at maturity, c is the coupon or interest rate and nim is the initial maturity expressed as a fraction of a year. Notice that this is one of the few cases where we use initial maturity in a calculation. Once we have found M we can price it by using [2.1], as in learning activity 2f.

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Money markets functions and operations

Lear

ga nin ct

2f

(a) Find the value of a newly-issued six month CD for 100,000 where the agreed interest rate on the deposit is four per cent and the yield on other CDs in the market is 3.9 per cent. (b) How do you interpret the price of the CD when compared with the value of the underling time deposit?

eedb ac

y ivit

2f

(a) Step 1: find M using [2.9]. M = 100,000 (1+ (0.04 0.5)) = 100,000 1.02 = 102,000 Step 2: find the PV of 102,000 in six months discounted at 3.9 per cent using [2.1] 102,000

Lear

ga nin ct

1 102,000 = = 100.049 (1 + (0.039 0.5) 1.0195

) (

(b) The difference in value between the CD and the underlying deposit is 49. This slightly higher value has been caused by discounting at 3.9 per cent when the time deposit was earning four per cent. The difference in the two interest rates is saying that, other things being equal, investors would rather have the CD because of its greater flexibility. The 49 represents the price that they are prepared to pay for this.

In the case of our treasury bill we saw that its value increased as the residual maturity shortened, other things remaining unchanged, and we established this as a general principle. We can show this for our CD as well by, say, looking at its price after three months have passed. We do this in learning activity 2g. But we also want to show another general principle in the pricing of assets, namely that their price will move inversely with interest rates. This should be obvious from [2.1] since the term i incorporates an appropriate rate of interest and a risk premium and it appears in the denominator. Even so, it is worth seeing the effect. (a) Recalculate the price of the CD in learning activity 2f when there are three months left to maturity. (b) Suppose that market interest rates fall by 50 basis points on the day after your calculation. What is the value of the CD now? (c) What is your interpretation of these two changes in price?

y ivit

2g

eedb ac

k
(a) P = 102,000

2g

1 102,000 = (1 + (0.039 0.25) 1.00975

)(

= 101,015.10

The price has risen by 966.10.

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eedb ac

2g
continued

(b) For simplicity, we shall leave the residual maturity at 0.25 (strictly, it should be 0.247). Then we have: P = 102,000

1 102,000 = = 101,140.30 (1 + (0.034 0.25) 1.0085

)(

The price has risen by 125.20 (c) The price of the CD rises as time passes because the investor has to wait less time for the benefit paid on the time deposit. (Instead of earning 2000 in six months, he or she will gain the 2000 in three months.) The shorter time horizon is worth paying for. The further rise in the value of the CD when market interest rates fall is explained by the fact that this CD buys the right to 2000 in three months (the result of a four per cent coupon rate) while 2000 in three months is no longer available when market interest rates fall since new time deposits will be paying only 3.5 per cent.

Repurchase agreements A repurchase (or repo) deal is a short-term securitised (or collateralised) loan. The collateral takes the form of some readily tradable asset (usually government bonds, known as gilts in the UK) which the borrower sells to the lender for a specified period with the promise to repurchase on a set future date at a set price. The repurchase price is higher than the initial sale price and this difference is the interest paid from borrower to lender. This can be seen clearly in [2.10]: i= PR PS PS.nm [2.10]

gilt

where i is the rate of interest, PS is the sale price, PR is the repurchase price and nm is the term to maturity as a fraction of a year. In practice the sale price, PS, is usually rather less than the market value of the bonds or other collateral. This difference, known as a haircut, provides additional protection to the lender. By way of illustration, suppose that Citibank sells 5 million-worth of US government bonds to the Federal Reserve with a promise to repurchase in 30 days for $5.03 million then the interest rate is: d= 5 .03 5 0.03 = = 0.0719 7.2% 30 0.4167 5 360

(Notice that a year is 360 days.) It is a fairly simple task to re-arrange [2.10] in order to find the repurchase price, corresponding to a particular rate of interest, given the sale price. PR = PS + i.PS.nm [2.11]

And we can re-arrange [2.10] to find the sale price, given the repurchase price and other terms: PS = PR 1 1 + i.nm [2.12]

The expression [2.12] is useful since it allows us to show that repo deals follow the rules that we have laid down for other assets. The price, PS, converges on 32
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Unit 2

Money markets functions and operations

PR as nm tends to zero while the price varies inversely with interest rates. Furthermore, expression [2.12] shows us that we are discounting the repurchase price by [2.1]: PS = PR

1 1 + i.nm

[2.12]

2.3 Pricing instruments in a supply and demand framework

Recommended reading: Money Markets in Howells and Bain (2008 and 2007) and Piesse, Peasnell and Ward (1995).

secondary market

primary market

Let us see now if we can convert this discussion of pricing into the familiar demand supply framework. In Figure 2.2 we show the market for treasury bills, though it could as easily be the market for commercial paper, or CDs or any other money market instrument. This is the market for existing TBs, or what is sometimes called the secondary market. However, the price (and return) fixed in the secondary market similarly fixes the price and return in the primary or new issue market, since new issues will only be held if they match the terms offered by existing TBs. Since we are looking at the existing stock of TBs, the supply is fixed and this is shown by the vertical supply curve, S. (This curve will shift to the right whenever the flow of new issues exceeds the number of maturing bills and vice versa.) The demand curve, D, is shown downward-sloping since, as we have just seen, a lower price means a higher return and we assume, other things being equal, that the demand for any asset increases with its rate of return.
market price, m S 0 rate of discount, %

0.9900 0.9875 D D

0.04 0.05

0 stock of bills

Figure 2.2: The bill market In order to draw a market diagram we have to decide exactly what TBs we are looking at. Strictly speaking, each size of treasury bill and each maturity is a separate market, though obviously bills of different size and maturity will be close substitutes for one another and a change in one market will be felt instantly in markets of adjacent maturity and size. In this illustration we shall assume that we are looking at three-month TBs for 1 million like the example at the beginning of section 2.2. The diagram shows that, initially, the equilibrium price is 987,500 and this is because the return (expressed here as a rate of discount) is five per cent. Now suppose that interest rates fall by 100 basis points and that
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Financial Markets

this includes all money market rates. This means that existing TBs become suddenly more attractive. Demand switches from other money market assets offering four per cent. The demand for TBs increases, shown by the shift of D to D. The increase in demand will cease when the price (and return) have adjusted to the new conditions. If the new conditions mean a TB discount rate of four per cent, then we can calculate the new equilibrium price: P = 1m 0.04 (1m 0.25) = 990,000 What this discussion tells us is that the formulae and pricing techniques that we have looked at in section 2.2 all operate on the demand side of the market. They explain the equilibrium or fair price that investors are willing to pay. The supply side of the market is given. It is the stock of assets that is already in existence. Thus, when we talk about a change in interest rates leading to a change in asset prices in the opposite direction, this is shorthand for saying the change in interest rates has an effect on the demand for assets such that the demand curve shifts until a new equilibrium price emerges.

2.4 The users of money markets

Recommended reading: Money Markets in Howells and Bain (2008 and 2007) and Piesse, Peasnell and Ward (1995).

Remember that money markets are a source of short-term finance. Where money market instruments are being traded between third parties all the items in Figure 2.1 except bank deposits must be of reputable quality. This means that the issuers of the bills must be known entities that are trusted by participants in the market. This means that the instruments will be issued by government, banks and other financial firms and large corporations. They will not be issued by households or the personal sector. This means that money market instruments are not only highly-liquid (as we saw in section 2.1). They are also of large denomination, upwards of 100,000 in the UK. This means that money market instruments are not widely held by the personal sector either they are too large. There are some money market mutual funds which take savings from households and invest them in the money markets so that the personal sector has an indirect holding through holding units in these mutual funds. But this still means that money markets are dominated by large organisations, including mutual funds. We made the point in section 2.1 that money market instruments of any given maturity have very similar rates of return. This is because the issuers of the instruments (the borrowers) are all of lowish risk ranging from virtually riskfree in the case of government to low risk in the case of major banks (until 2008 at least) and large corporations. Given the participants in these markets we can add that rates will move quite closely together because the traders will be well-informed professional dealers. This means that a shock to rates in one of the markets will be quickly transferred to all others. This is immensely important since it means that any central bank with sufficient presence in the money markets should be able to influence the general level of low-risk shortterm interest rates by virtue of its own transactions. This exactly what happens in most developed economies. In spite of the fact that economics textbooks are still fond of showing central banks controlling the quantity of money (usually through changes in the size of the monetary base), in practice central banks allow the quantity of money to be demand-

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Money markets functions and operations

endogenous

determined. The money supply is endogenous. What central banks do instead is to set the rate of interest at which they refinance past loans (and make new loans) of reserves to the commercial banking system. Briefly, it works like this. Commercial banks operate on the basis of a fractional reserve ratio. This means that they hold reserves (note and coin and deposits with the central bank) that are only a very small proportion of their customer deposits. However, these reserves are absolutely essential to protect banks from the possibility of unforeseen net withdrawals of cash by customers. Hence this ratio must be maintained very carefully and as banks expand they will need additional reserves. The quantity of reserves can always be topped up by borrowing from the central bank. It can add to commercial bank deposits just as your bank can add to your deposits if you ask for a loan. These reserves are supplied on demand. There is no quantity constraint. But there is a price and this is set by the central bank as its policy rate. In the UK it is set by the Bank of Englands Monetary Policy Committee (MPC) (Bank, 2009); in the USA it is done by the Federal Reserves Open Market Committee (Fed, 2009) and at the ECB it is done by the Governing Council (ECB, 2004 chapter 1). The argument is that banks with accounts at the central bank have the option when searching for reserves of bidding in the interbank market or borrowing from the Bank of England (BoE). Provided that commercial banks presence in the interbank market is large enough, then the rate charged on reserves by the central bank must affect interbank rates and then (see section 2.1) all other short-term rates. The way in which this is commonly done is to establish what is called a corridor system. We shall describe the system as it has worked in the UK since May 2006 but other systems are very similar. Banks are required to maintain a target level of reserves (including deposits at the Bank of England). Provided that this target is met (a small margin of error is allowed and the target is an average over a month) then the deposits at the BoE earn interest at the rate set each month by the MPC. Reserves can be held in excess of the target but these earn interest at MPC rate one per cent; a shortage of reserves can be overcome by borrowing from the BoE at MPC rate + one per cent (and these borrowed reserves do not earn the MPC rate). The BoE then conducts repo deals, at the rate of interest set by the MPC, in order to help the banks maintain the central target. As this rate changes, the whole structure of rates at the BoE shifts since the other rates are calculated from the MPC rate. Suppose, for example, that the MPC announces an increase in the policy rate from three to 3.5 per cent at its May meeting. We shall see in a moment how it changes its repo deals to make this effective but first let us see what this does to interest rates more generally. Figure 2.3 may help. Before the increase, commercial banks can deposit excess reserves at the BoE at two per cent and borrow from the BoE at four per cent. After the increase, the deposit rate is 2.5 per cent while the borrowing rate is 4.5 per cent. Imagine now a commercial bank that wants to supplement its reserves. Before the increase it could have gone to the BoE and paid four per cent or it could have paid the going rate in the interbank market if that were less. Since they are close substitutes, we would expect the rates to be very close indeed. Now the official rate has increased, borrowing from the interbank market will almost certainly

fractional reserve ratio

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Financial Markets

Bank of England repo rate %

MPC + 1 3.5 3.0 MPC rate MPC 1

April

May

Figure 2.3: The Bank of Englands corridor system be cheaper. But the additional demand for interbank funds will tend to push interbank rates up towards the new BoE lending rate. At the same time, there will be changes at the lower band. Banks with a surplus might have deposited with the BoE at two per cent or in the interbank market (at a very similar rate). Now that the official deposit rate is 2.5 per cent, banks with a surplus will switch from the interbank market to the BoE, draining funds from the interbank market and again tending to raise interbank rates. Hence interbank rates are pushed up by increasing demand for loans and a reduction in deposits. This is a process known as arbitrage and it shows how the BoEs action on its official or policy rate, is communicated to LIBOR rates and from there to other short-term rates. Amongst the other short-term rates will be the rate charged on commercial bank loans. Credit becomes more expensive, fewer people borrow, others increase their savings. These and other reactions lead to a reduction in aggregate demand. This is the form that a restrictive monetary policy takes in the twenty-first century. In order to see how this change in the central (or policy or MPC) rate is imposed we need to go back to our discussion of repo deals. If we go back to [2.10] we can see how the rate of interest is related to the other features of the deal. i= PR PS PS.nm [2.10]

arbitrage

In Figure 2.3, the Bank of England initially sets a policy rate of three per cent. It does this by virtue of repo deals of various maturities, all priced to give an interest rate of three per cent. Since 14 days is one common maturity for these deals we shall use that and we shall suppose that the sum lent by the BoE is 100 million per deal. This is the sale price or PS. Using [2.11] we can find the repurchase price that the BoE needs to set to make three per cent effective: PR = 100 million + 0.03(100 million)0.0384 = 100.1152 million or 100,115,200 Then, in May the MPC decides to raise the policy rate to 3.5 per cent. Learning activity 2h invites you to find the new repurchase price that the Bank will have to insist on in order to raise the rate.

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Unit 2

Money markets functions and operations

Lear

ga nin ct

2h

Find the repurchase price that a UK policymaker must set if it wishes to use 14-day repo deals for 100 million to make a policy rate of 3.5 per cent effective.

eedb ac

y ivit

2h

Using the data from the three per cent example in the text and substituting 0.035 for the interest rate we have: PR = 100 million + 0.035(100 million) 0.0384 = 100.1344 million or 100,134,400

Lear

ga nin ct

2i

Table 2.1 shows a number of money market interest rates for three recent dates. End-June 2007 Three-month LIBOR Three-month gilt repo Three-month CDs Three-month treasury bills Policy rate Table 2.1: Money market rates
Source: Bank of England Interactive Interest and Exchange Rates at: <http://www.bankofengland.co.uk/statistics/index.htm>

eedb ac

y ivit

End-June 2008 5.91 5.2 5.91 5.1 5.0

End-Sept 2009 0.58 0.43 0.48 0.4 0.5

5.96 5.82 6.08 5.77 5.5

1. What happened to money market interest rates, in general, over the period? 2. How would you explain this? 3. Calculate the difference between the highest and lowest rates at each date. Do you notice anything? 4. Look at the spread (the difference) between policy rate and LIBOR at each date and comment on what you see. 5. Arrange the rates in descending order (highest rate first) at each date. Do you see any pattern? If so, how would you explain it?

2i

1. Over the period money market rates fell quite sharply, from around six per cent at end-June 2007 to about 0.5 per cent in September 2009. 2. The policy rate was reduced from 5.5 per cent to 0.5 per cent. This reflects the Bank of Englands loosening of monetary policy to try to stimulate aggregate demand to limit the depth of the recession that began at the beginning of 2008. Section 2.4 shows how the

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Financial Markets

eedb ac

k
2.1 2.2 2.3

2i
continued

policymaker can do this by trading in very short-term gilt repos. Section 2.1 also explains that money market rates move closely together and so we see the policy rate coming down to 0.5 and other rates following very closely. 3. The difference between highest and lowest rates was 0.58 (= 6.08 5.5) in June 2007; 0.91 (= 5.91 5.0) in June 2008 and 0.18 (= 0.58 0.4) in September 2009. Firstly, it is clear that the range is always quite small (less than 100 basis points). This is what we would expect when we look at a range of very similar instruments. But it is also clear that the range is very small in 2009. This is also what we would expect. With the average rate around about 0.5 per cent, the range must also be small. What is also noticeable is that the range is largest in June 2007. Looking carefully at the figures we can see that this is because the policy rate has come down (from 5.5 to 5.0) and this is largely reflected in the interest rates on government debt (gilt repo and treasury bills) but the rates on commercial or private sector debt (CDs and LIBOR) are little changed. 4. In June 2007 the spread is 0.46 (5.96 5.5), in June 2008 it is 0.91 (5.91 5.0), in September 2009 it is 0.08. If we had a longer run of data we would see that the LIBOR-policy spread is normally about 0.1 or 10 basis points. So, the spread in September 2009 is more or less normal. What is truly remarkable is the gap of 0.91 (5.91 5.0) in June 2008. As we said in (3) above, this arose because the Bank of England began cutting the official rate in late 2007 but to begin with LIBOR scarcely changed. We commented in section 2.4 that this undermined the effectiveness of monetary policy since market rates in general were linked to LIBOR and so long as LIBOR was reluctant to change, then other market rates remained stubbornly high. 5. CD rates and LIBOR rates tend to come at the top of the rankings; treasury bills and gilt repo at the bottom. Remember that LIBOR and CD rates are rates on bank deposits. Banks are private firms and consequently they are exposed to a degree of risk. This risk was seen as especially great in the financial crisis of 2008 (which is why LIBOR and CD rates stay high). But treasury bills are government liabilities and gilt repo are loans which are secured on government liabilities. These are regarded as virtually risk-free and this difference in risk is reflected in rates of return.

Self-assessment questions
How do money markets differ from capital markets? Who are the main users of capital markets? What is the difference between money market instruments quoted on a discount basis and on a yield basis? Suppose that one month CDs and one month treasury bills are both quoted as having a rate of return of four per cent. Which gives the higher return to an investor. Suppose that short-term interest rates are currently five per cent and that you deposit 200,000 with a bank in exchange for a three-month CD paying five per cent. Suppose now that after one month, a liquidity crisis forces you to sell the CD and that interest rates at that point have risen to 5.25 per cent.
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Unit 2

Money markets functions and operations

(a) (b) 2.4

What price would you get for the CD? What effect has the rise in interest rates had on its value (hint: compare with its value if interest rates had been unchanged)?

Looking at Figure 2.2, assume that three-month UK treasury bills for 1 million are trading at five per cent and a price of 987,500 (the original equilibrium). Imagine now that the UK Government issues a very large number of new treasury bills. How would you show this in the diagram and what might the results be? Suppose that the Bank of Japan becomes worried about a build up in inflationary pressure in the economy. (a) Explain what it might do with respect to the policy rate of interest and why. (b) Work an example to show how the Bank of Japan might change the repurchase price of one-month repos for 500 million in order to raise the policy rate from three to 3.25 per cent.

2.5

Feedback on self-assessment questions

2.1 Money markets are markets for instruments, which permit short-term lending and borrowing. There is no strict definition of short-term but one year is a widely accepted upper limit. Capital markets are markets for instruments, which permit lending and borrowing for longer periods. The ultimate borrowers in money markets are governments and large corporations and the main ultimate lenders are large corporations. In addition to helping ultimate lenders and borrowers, a lot of money market activity involves financial institutions lending to and borrowing from each other. The clientele of these markets is thus rather restricted and this is reflected in the instruments traded, which usually have a large minimum denomination. The personal sector has virtually no direct involvement in the money markets. When instruments are quoted on a discount basis, the gain is expressed in relation to the total sum received at maturity. When instruments are quoted on a yield basis the gain is expressed in relation to the sum originally invested. Hence a four per cent discount is ((100 96)/100); the corresponding yield calculation would be ((100 96)/96), which will be slightly more than four per cent. Four per cent as a conventional yield would be (104 100/100). So if both are quoted as giving a return of four per cent then the TBs are giving a slightly better return. You need to calculate the market price of a three-month CD for 200,000 with a five per cent coupon, with two months left to maturity with interest rates unchanged (at five per cent) (for (b)) and with interest rates at 5.25 per cent (for (a)). (a) the answer is 200,743. We calculate this in two stages. Firstly we calculate the maturity value which is: M = 200,000 (1 + 0.05(0.25)) = 202,500 Then we discount this in the normal way: P= 202,500 202,500 = = 200,743 (1 + 0.0525(0.1666) 1.00875 39

2.2

2.3

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Financial Markets

(b)

Without the interest rate increase the price would have been P= 202,500 202,500 = = 200,833 (1 + 0.05(0.1666) 1.0083

a difference of 90. 2.4 If the Government issues new treasury bills (in excess of the bills that are maturing) the stock will increase. This is shown by a rightward shift of the supply curve, S, in Figure 2.2. The diagram suggests that this rightward shift will mean that prices will fall and the return increases. This seems reasonable since we would expect that in equilibrium investors are holding the current stock on just those terms that they find attractive. If they are to hold more, then these must be more attractive. They must offer a bigger discount to their maturity value and therefore offer a higher return. (a) If the Bank of Japan is concerned about the build up of inflationary pressure it will tighten monetary policy. In most countries the policy instrument is a short-term rate of interest and so a tightening of monetary policy means increasing this rate of interest in order to reduce the level of aggregate demand. If the current rate of interest is three per cent, then one month 500 million repos must have a current repurchase price of PR = 500 million + 0.03 (500 million) 0.0833 = 501.2495 million or 501,249,500 If the Bank of Japan wishes to raise the rate to 3.25 per cent, then the repurchase price will need to be: PR = 500 million + 0.0325(500 million)0.0833 = 501.353625 million or 501,353,625

2.5

(b)

Summary
In this unit we have looked at the characteristics of money market instruments and how to calculate prices and yields for a selection of them. We have seen who the participants in money markets are and how the trading of money market instruments can be fitted into a supply and demand framework. Having studied this unit, you should now be able to:

explain the characteristics of money market instruments as a group price instruments which are reported on both a discount and a yield basis and show the connection between price and rate of return show how the pricing of money market instruments can be interpreted as the outcome of the forces of supply and demand identify the main participants in money markets and, in particular, to show how central banks conduct money market operations in their conduct of monetary policy.

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Unit

Capital markets (I)

Downgrading of Greek bonds to junk raises fear of sovereign risk.

Introduction
In this unit you will learn what is meant by the expression capital markets. In particular, we shall look at the trading of bonds. Unit 4 looks at the market for company shares. Unit learning objectives On completing this unit, you should be able to: 3.1 Describe the characteristics and uses of fixed interest securities. 3.2 Retrieve and understand data relating to fixed interest securities. 3.3 Price a selection of these instruments. 3.4 Link the concept of duration to the price elasticity of bonds. 3.5 Identify the key users of bond markets and the trading arrangements.

Prior knowledge The unit assumes that you have studied Units 1 and 2. Otherwise, it requires no prior knowledge, but you will find sections 3.2, 3.3 and 3.4 easier if you have some basic mathematical skills, and familiarity with basic economics is useful for section 3.5. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: Bond Markets). In Piesse et al (1995) The Valuation of Financial Instruments deals with some of the financial calculations that we shall be doing, while Bond Market covers institutional features of bond markets. Howells and Bain (2007) chapter 6 also covers much of the material but at a rather lower level. Mishkin 2007 Financial Markets covers the theory. You will need a calculator and access to the internet.

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Financial Markets

3.1 The characteristics and uses of fixed interest securities

Recommended reading: Howells and Bain (2008) The Bond Market; Howells and Bain (2007) The Capital Markets; The Bond Market (1995) chapters 5 and 11; Mishkin (2007) Financial Markets.

Capital markets, and the instruments traded in those markets, are markets which channel long-term funds. The instruments have an initial maturity of more than five years. Fixed interest markets are markets where the instruments are bonds. Using fixed interest to describe bonds is a bit misleading since some money market instruments also pay a fixed rate of interest (see Unit 2) and some bonds actually pay a variable rate. Nonetheless the majority of bonds pay a fixed rate and fixed interest is widely used to refer to bond markets. If we begin with simple, or plain vanilla bonds, we see that these have a fixed maturity value and maturity date and they pay a regular coupon which forms the basis of the rate of return. A bond will usually be described in such a way that these terms are clear. For example, Treasury 5% 2012 is a bond that pays 5 per year until it matures in 2012. 5 is the coupon and this is converted to a coupon rate by dividing by the par or maturity value which is always 100 in the UK. Bonds are often classified by residual maturity as follows:

coupon

coupon rate

<5 years residual maturity: shorts 515 years residual maturity: mediums >15 years residual maturity: longs

Variations on the simple vanilla bond include:

Convertible bonds: carry the option to convert at some point in the future either to other types of bond issued by the firm, or more usually to its equity. Floating rate notes (FRNs): pay a coupon which is adjusted in line with some other, usually short-term, interest rate, such as LIBOR. Index-linked bonds: have their par value uprated periodically in line with a price index and the coupon payment increased by the amount of the recent change in the index. Zero coupon (deep discount) bonds: pay no coupon but are issued at a substantial discount to their maturity value (rather like very long-dated bills see Unit 2). Strips: are entitlements to each individual cash flow from a bond (each coupon payment and the maturity value) sold at a discount.

Bonds will normally be issued in the domestic currency by firms based in that country. However, bonds can also be issued in the domestic currency by nonresident firms (foreign bonds) and the last twenty years has seen the very rapid growth of eurobonds. These are bonds denominated in a currency which is different from that of the country of issue US$ bonds issued in Hong Kong, for example. While most foreign and eurobonds will be plain vanilla bonds, they can take any of the various forms that we noted above. Note that the coupon rate does not tell you the rate of return that you will earn from holding the bond. The rate of return will depend upon this (fixed) coupon and the price of the bond. The higher the bond price, for a given coupon, the lower the rate of return and vice versa.

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Unit 3

Capital markets (I)

In recent years, it has become quite common for banks to securitise some of their loans (and other assets). This involves creating a portfolio of similar assets and selling this portfolio to another institution that finances the purchase by the sale of bonds. The bank collects the interest from the borrowers and then (after deducting a fraction for its own costs and profit) passes on the remainder to the buyer of the loans, who uses some of it to pay the interest on the bonds. These bonds have become knows as asset-backed securities (ABS) or collateralised debt obligations (CDOs). As a rule, bondholders have a prior claim over a firms assets in the event of the firm becoming insolvent, In this sense, all bonds are ABS/CDOs. But the terms are used to refer to bonds linked to a securitisation process where the underlying assets are loans rather than, say, physical plant and equipment. Where a firm has issued a range of bonds, their priority in the claim to interest payments and in the event of liquidation is sometimes indicated by terms like senior, mezzanine or junior debt. Although bonds are relatively secure financial instruments, they nonetheless vary in their degree of risk. For large bond issues, the degree of risk is often indicated by a rating from a credit ratings agency like Standard and Poors or Fitch or Moodys. These use rating scales starting with grades like AAA to indicate the very best quality, down to D to indicate bonds that are already in default or have failed to make interest payments on time. Naturally enough, the riskier the bond, the higher the rate of interest it will pay. In normal circumstances, the difference between one risk level and the next would result in a yield difference of about 30 basis points (= 30/100 of one per cent). But this can vary. Obviously, if people become more risk-averse (as during the 2008 financial crisis) these risk premia will be larger. In more optimistic times they will be smaller. Finally, the ownership of most bonds is kept on a central register by the issuer of the bonds (or an agent appointed for the purpose). This means that bondholders can be paid the coupon without their having to claim for it. In fact, the term coupon come from the days when ownership was not registered. Possession of the bond itself was the only proof of ownership and this required the owner to claim interest by detaching a dated coupon attached to the bond and sending it to the issuer for payment. Such bonds are known as bearer bonds and many eurobonds are still of this form.

risk premium

Lear

ga nin ct

3a

Why are investors willing to hold bonds paying a four per cent coupon rate, when there are other bonds with five per cent, six per cent, seven per cent and higher coupon rates?

eedb ac

y ivit

3a

The coupon rate tells us nothing about the rate of return on a bond. It tells us the absolute size of the periodic payment but the rate of return depends on the price that you pay for the stream of coupon payments. If you pay 100 for an eight per cent bond, your rate of return (ignoring tax and some other details) will be the same as you would get from a four per cent bond for which you paid 50. The coupon rate on a bond may indicate something about the general level of interest rates when the bond was first issued (the coupon rate was probably close to the market rate of interest) but this is not guaranteed, and so the coupon rate (as opposed to the coupon amount) is of limited concern. (We see one example of where it matters in section 3.4.) 43

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Financial Markets

3.2 Understanding the data

Recommended reading: Howells and Bain (2008) The Bond Market; Mishkin (2007) Understanding Interest Rates.

Data showing bond prices and yields (rates of return) can be obtained from many sources. Professional traders receive the data in real-time from wire services provided by Thomson/Reuters and Bloomberg. The financial press (the Financial Times and the Wall Street Journal are examples) publish a selection of bond price information each day and their own websites often carry more detail and they are updated during the day. For government bonds (which in many countries are the largest category of fixed interest securities), information is often available from the central bank or the ministry of finance or some other government agency. The important data is the same in all cases. Table 3.1 shows typical bond data for five major corporations whose bonds are listed on the US($) bond market.

1 Citigroup Morgan Stanley Household Fin HBOS Treas UK Verizon Global

2 01/11 04/12 05/12 06/12 09/12

3 6.50 6.60 7.00 5.50 7.38 A A A A+ A

4 A3 A2 A3 Aa3 A3 A+ A

5 103.62 109.10

6 3.16 2.53 2.91 3.57 2.00

7 0.07 0.03 0.15 0.05 0.03

8 0.29 1.19 0.47 0.54 0.45

9 2.92 1.81 2.19 2.37 0.83

AA 109.55 AA 104.56 A 114.22

Table 3.1: Corporate bond data

Source: Compiled from Datastream

The information that we need (and its location in the table) is as follows:

name of the bond issuer (1) maturity or redemption date month/year (2) coupon (3) credit ratings from three major agencies (4) current buy price (5) redemption yield calculated on the buy price (6) change in yield since previous day (7) change in yield over one month (8) yield spread over yield on government bonds (9).

The significance of the first six items should be obvious. The purpose of (7) and (8) is to give us some idea of the bonds trend or momentum (yield rising or falling). (9) tells us how the market views the risk of the bond when compared with US government bonds of comparable maturity. A high spread indicates high risk. The markets perception of risk is not necessarily the same as that taken by the ratings agencies in (4). Some reports include recent price changes and figures showing the amount of trading in the bond.

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Unit 3

Capital markets (I)

Lear

ga nin ct

3b

Read the following extract from The Independent 12.12.09 and answer the questions below. (Hint: the discussion surrounding Table 3.1 may help you.) After a week that saw the Greek sovereign debt downgraded below the prized A-rating for the first time in a decade, and the worst bond market collapse in the history of the Eurozone, Athens was scrabbling to restore confidence yesterday. At a two-day EU summit in Brussels, the Prime Minister, George Papandreou, promised far-reaching cuts in his countrys bloated bureaucracy and an assault on its rampant corruption. Like Britain, Greeces problem is its debt currently running at 300 billion (270 billion), the highest since democracy was restored in 1974, and expected to hit 113 per cent of GDP this year and more than 120 per cent next. The latest crisis started on Monday when Fitch Ratings downgraded Greece by one notch to BBB+, and Standard & Poors put it on a negative outlook. Fears that it might become the first Eurozone government to default on its debts sent yield spreads on 10-year bonds shooting up to an eight-month high above German equivalents, and by Wednesday the Athens stock market was down by nearly 12 per cent. 1. What does the report mean when it says that Greek sovereign debt [was] downgraded...? 2. What does the report mean when it says that these events caused yield spreads on 10 year bonds to shoot up to an eight-month high above German equivalents and what is the link with the downgrade? 3. Why might cutting the countrys bloated bureaucracy help to solve the problem?

eedb ac

y ivit

3b

1. This is a reference to actions of the ratings agencies in column (4) of Table 3.1. We are told later that the Fitch agency moved the rating down to BBB+. Many western governments have top AAA ratings (or equivalent) and it would be very unusual for a government in the Eurozone to have a rating which was not somewhere in the A category. 2. We expect return and risk to move together. Hence if a ratings agency gives a bond a lower rating (meaning higher risk) we would expect the yield in column (6) of Table 3.1 to rise. This occurs because the bonds market price (5) falls. In Table 3.1 column (9) tells us the difference between the yields on these corporate bonds and the yield on (perfectly safe) US government bonds. The report does the same except that it uses the safest bonds in the Eurozone as the basis of comparison and these are German government bonds. The report does not give us the spread but says that it jumped to an eight-month high. 3. Here we must be careful to distinguish between debt (the outstanding stock of bonds which has accumulated as the result of past borrowing) and the current deficit (the difference between this years government spending and income which will have to be financed by new bond issues which add to the existing stock). As regards the stock, the report says that it is currently equivalent to 113 per cent of GDP and will be more than 120 per cent next year. This growth is the result of the current

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Financial Markets

eedb ac

3b
continued

deficit, so if the growth rate of the debt is to be brought down, then current deficits must be smaller. This can only be done by some combination of reducing government spending and generating more income. The report suggests that Greece should start by reducing employment in the public sector.

Price ()

Figure 3.1: Treasury 6.25% 2010, 19982009

Source: Office for National Statistics, Interactive Database, IDKX

Figure 3.1 is typical of any chart showing bond prices. In this case it shows the price of a government bond called Treasury 6.25 2010 from 1998 to 2009. The term Treasury indicates that it a government bond, 6.25% tells us that the annual coupon is 6.25 and it matures in 2010. In the next section we shall see that the cause of price fluctuations is changes in interest rates and that interest rates and bond prices move in opposite directions. However, if we look carefully at the chart, we see that the price of this bond was falling during 2009 when interest rates were unchanged (but very low). This reminds us that the price of any asset must eventually converge on its redemption value since the only value that it has at the end is its redemption or maturity value. For a UK government bond, that is 100.

3.3 Pricing fixed interest securities

Recommended reading: Howells and Bain (2008) The Bond Market Mishkin (2007) Understanding Interest Rates; Howells and Bain (2007) Capital Markets; Piesse (1995) The Valuation of Financial Institutions.

In this section we look at the pricing of bonds and how prices and yield (or rate of return) are connected.

Prices
As with any other asset, the price of a bond should correspond to the present value of the future income stream and this is found by discounting the stream of payments in a suitable way. As always, suitable means using a discount rate which recognises the rate of return on assets of similar risk (the market rate) and takes account of the time at which the payment is due. Remember that for some bonds the final payments could lie a long way in the future. The general expression for finding the price is:
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98 19 Nov 99 20 JU 00 L 20 Ma 00 r N 20 ov 01 20 Ju 02 l 20 Ma 02 r N 20 ov 03 20 Ju 04 l 20 Ma 04 r N 20 ov 05 20 Ju 06 l 20 Ma 06 r N 20 ov 07 20 Ju 08 l 20 Ma 08 r N 20 ov 09 Ju l
Date

19

120 115 110 105 100 95 90

Unit 3

Capital markets (I)

t=1

= (1 C i) +
t

M (1 + i)n

[3.1]

This tells us that we find the price by discounting each of the coupon payments and the maturity value. We then sum these discounted values. Notice that each payment is discounted by: 1 (1 + i)t where t represents the time at which the payment is due. But the final payment, the maturity value, is discounted by: 1 (1 + i)n where n is the total number of periods in the sequence the number of periods from the time of purchase until the bond matures. Suppose therefore that we were looking at the price of a five per cent bond maturing on 31 October 2012 and that we were looking at this on 1 November 2009 (so that we can ignore accrued interest). If the going rate of return on similar assets is four per cent, then we have: P= 5 5 5 100 + + + (1 + 0.04) (1 + 0.04)2 (1 + 0.04)3 (1 + 0.04)3 [3.2]

4.81 + 4.62 + 4.44 + 88.88 102.75 Notice that the effect of discounting the future cash flows is that what we call the present value of those cash flows is less than their face value. The face value in [3.2] is 5 + 5 + 5 + 100 = 115 while the present value after discounting is 102.75. Why do we make this adjustment? We do it because of what is sometimes called the time value of money. This is just a formal way of saying that any payment received now is worth more than the same payment received at some time in the future; in other words, waiting for the payment reduces its value. First thoughts might suggest that the value is reduced as a result of inflation. Inflation certainly does reduce the real value of future payments but even with zero inflation, future payments are worth less than if they were received immediately. Inflation merely increases the effect. The key to the explanation is that if we had the payment now (instead of in the future) then we could invest the payment immediately and earn interest on it for the period that we would otherwise have been waiting. And the rate of discount represents the rate of return that we forego by waiting. That is why it is important to choose a rate of discount which incorporates the basic or risk-free rate of interest as well as a risk premium that reflects the riskiness of the asset in question. It is not appropriate to discount payments from a low risk investment by a rate which assumes that we could have earned a much higher return by investing the payments in a much riskier asset. If inflation is positive, then the discount rate must also include an inflation premium. (In fact, this will normally be already incorporated in market interest rates.) The calculation in [3.2] is not difficult to do (and a spreadsheet like Excel has built-in functions that make it very fast and easy). But if we are using a hand calculator, and if we are pricing a long-dated bond and if we remember that there should be two coupon payments per year then finding the price by [3.1] could be very slow and difficult. Fortunately, we can simplify by using:

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P=

C 1 M 1 + i (1 + i)n (1 + i)n

[3.3]

which has the advantage that we have to do only one calculation in which we raise (1 + i) by some power (though n could be large). If we then wish to modify this to take account of coupon payments in half-yearly instalments, we have: P= C 1 1 i 1+i 2

)] (
2n

M 1+i 2

2n

[3.4]

By way of illustration, we can take our five per cent, three-year bond from a moment ago, assume that it pays half-yearly coupons and assume again that we price it immediately after the payment of a coupon. Then, n = 3 and 2n = 6. P= 5 1 M 1 100 1 + = 125 1 + 0.04 0.04 6 0.04 6 (1 + 0.02)6 (1 + 0.02)6 1+ 1+ 2 2

) (

= 125 1

1 100 + = 125 [1 0.888] + 88.81 = 14 + 88.81 = 102.81 1.126 1.126 [3.5]

Compared with our earlier result, this is very close (102.75 against 102.81). The reason for the difference is that by paying the coupon in half-yearly instalments we bring forward the cash flow very slightly and thus make it subject to a very slightly reduced discounting effect.
clean price

dirty price

The next thing we need to understand about bonds is that they have a clean price and a dirty price. So far, we have calculated the clean price. The difference arises because of the way in which bonds pay interest. As we know, they pay a fixed coupon and they do this most commonly by paying one half of the coupon twice a year. One of those coupon payments will occur on the day/month scheduled for its maturity. This means that one could buy a bond and wait 180 days for payment, or one day, or anything in between. Clearly, waiting 180 days for a payment of 4 (say) is much less attractive than waiting one day for it. Consequently, the seller of a bond which is close to the coupon payment day will expect to receive a higher price than the seller of the same bond in identical circumstances who sells with 180 days to the next coupon. This higher price compensates sellers for the fact that they may have done most of the waiting for a coupon which will eventually be paid entirely to the buyer. The dirty price of a bond includes this accrued interest; the clean price ignores it.

Lear

ga nin ct

3c

Imagine a bond that pays half the coupon at six-monthly intervals. Can you think of a way in which the price of the bond might be adjusted between coupon payment days in order to provide a fair price to the buyer and seller?

y ivit

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eedb ac

3c

One way might be to divide the coupon by 182 days and add 1/182 of the coupon to the bond price for every day of the coupon payment cycle. This means that the seller of a bond with one day left to go would receive a price which included 181/182 of the next coupon payment.

accrued interest

Lear

ga nin ct

The adjustment of a bonds price to reflect the sale date within the coupon payment cycle is known as the adding of accrued interest as shown in learning activity 3c. Adding accrued interest to the clean price gives us the dirty price. Hence: Pd = Pc + AI = Pc + AI = C nlc 2 182

( )

[3.6]

where nlc is the number of days since the last coupon payment. Notice that in the UK we use 182 days as the measure of a half-year (= 365 2). As with the money markets we discussed in Unit 2, so with bond markets different countries use different definitions of a year. Imagine a six per cent bond which pays its coupon in two equal parts at six monthly intervals. It will mature on 12 September 2017. Suppose that this bond is sold on 30th September 2010. Find the difference between the clean and dirty prices.

y ivit

3d

eedb ac

3d

The difference between the clean and dirty prices will be the accrued interest and this will be found as: AI = 6 17 = 3(0.093) = 0.28 or 28p. 2 182

( )

Since accrued interest is a matter of simple arithmetic, when we talk about the pricing of bonds we are usually thinking of the clean price. It is this price that is going to be affected by economic or financial events such as a change in interest rates or the degree of investors risk aversion or their perception of risk in the economy at large or simply in the bond issuer and so on. When we observe lists of bond prices, more often than not they will show clean prices even though we would actually have to pay the dirty price if we chose to buy. Fortunately it is a simple task to add accrued interest. Suppose that, instead of buying the bond on 1 November 2009 we delayed it until 2 January 2010, then all else would be unchanged but the seller would be entitled to a higher price to compensate for the interest earned (accrued) between 1 November and 2 January. Firstly the formula: P= C 1 1 i 1+i 2

) ](
2n

M 1+i 2

2n

C nlc 2 182

( )

[3.7]

followed by the calculation which is 102.81 + 2.05(62/182) 102.81 + 0.70 = 103.51.

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Lear

ga nin ct

3e

Using [3.5] find the clean price of our five per cent three-year bond if the rate of interest had been three per cent (instead of four per cent), all else unchanged. What do you notice?

eedb ac

y ivit

3e

P=

5 1 M 1 100 1 + = 125 1 + 0.03 0.03 6 0.03 6 (1 + 0.015)6 (1 + 0.015)6 1+ 1+ 2 2

) (

= 166.7 1 = 105.66

1 100 + = 166.7 [1 0.915] + 91.46 = 14.17 + 91.49 1.093 1.093 [3.8]

As a result of the fall in interest rates from 4 to 3 per cent, the price of the bond has risen from 102.81 to 105.66, a change of 2.85

So far we have seen that bonds are relatively low risk instruments since their payments are fixed and they have a fixed maturity value. Indeed we shall see in the next section that if you buy a bond and hold it to maturity, you have a guaranteed income stream. Apart from the possibility, the only risk the investor faces is that of needing to sell the bond prior to redemption at a time when interest rates are high. In these circumstances, there is a good chance that the bond will be worth less than the purchase price and the seller will incur a capital loss. What we have not seen yet is that the size of the effect on bond prices of a change in interest rates varies with the characteristic of the bond. The key characteristic is the period to maturity. Roughly speaking, the longer the period to maturity, the more sensitive are bond prices to interest rate changes. We come back to this in section 3.4. If you want a proof and an illustration of this effect, you will find it in an appendix at the end of this unit.

Yields
interest yield

As most textbooks will show the yield on a bond can take a number of forms. The simplest is called interest or running yield. This is calculated by taking the coupon payment and dividing by the clean price of the bond: interest yield = C Pc [3.9]

Of all the forms that yield can take, simple yield shows most clearly that price and yield must be inversely related.

Lear

ga nin ct

3f

Look at our calculation of bond prices in [3.5] and [3.8]. Calculate the simple yield in each case and compare the results.

y ivit

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eedb ac

k
For 3.9 the calculation is

3f

5 = 0.0486 or 4.86 per cent 102.81 5 = 0.0473 or 4.73 per cent 105.66

For 3.10 the calculation is

Notice that the simple yield varies inversely with the price of the bond and is lower than the coupon rate because the market price in each case is above the par value of 100.

simple yield to maturity redemption yield

The problem with interest yield is that it is a very poor guide to the rate of return that a bondholder will receive if the bond is held to maturity. For example, if you bought the bond at, say, 102.81, and held it to redemption (100) you would earn 4.86 per cent only by ignoring the fact of an eventual capital loss of 2.81. You could, of course, hope to sell the bond again before maturity for the same price that you paid. In this case, simple yield would be an accurate measure of your return, but if you plan to hold to redemption then, strictly speaking, you should find a way of spreading this 2.81 loss over the six-year period. The effect will obviously be to give a yield which lies below the simple yield. The easiest way to take some account of the loss is to calculate the simple yield to maturity. The method is shown in [3.10]: simple yield to maturity = C + 100 P P nm P [3.10]

where C is the coupon, P the clean price and nm is the period to maturity (in years). A quick glance at the formula shows us that what we do is to take the simple yield and then calculate the capital gain/loss (= 100 P) which we spread over the remaining years and turn into an annual percentage. We then add this percentage gain/loss to the simple yield. However, the normal way of expressing the yield on a bond is to quote the redemption yield. In principle, this is similar to the simple yield to maturity in the sense that it assumes that the investor holds the bond to redemption and must therefore take account of the capital gain/loss. The redemption yield is the internal rate of return that makes the discounted values of the bonds cash flows equal to the dirty price, Pd . If we let ry stand for redemption yield then finding the redemption yield requires us to solve for it in the following expression. C Q1 1 2 M [3.11] Pd = + (1 + 1 ry) ntc (1 + 1 ry)t (1 + 1 ry)Q1 2 2 2 t=0 182

][

where ntc is the length of time (in days) to the next coupon payment and Q is the number of coupon payments to be made before redemption. Unfortunately, this is not a simple calculation without a programmable calculator, or a spreadsheet (Mishkin 2007, chapter 4). Without this equipment, it can really only be done by trial and error (or iteration) combined with a process known as interpolation. The procedure involves choosing two values for redemption yield that we feel confident will fall either side of (or bracket) the true rate. We then solve [3.11] for each trial value of ry and if we have chosen wisely, we shall have one price above and one price below Pd . This completes the trial and error. We then look at the three prices: the two trial prices and Pd which lies somewhere between the two. By measuring the position of Pd between the two trial prices we can work out where
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to find the correct value of ry between the two trial redemption yields. It is not particularly difficult but it is time consuming. Care must be taken to ensure that the two trial rates really do bracket the true one, first time round. This means not trying too hard to get the trial rates and prices too close to the true rate/price since this carries the danger that both trial rates/prices fall on the same side of the true values. In that case we have to start again. Howells and Bain (2008) work some examples.

Lear

ga nin ct

3g

Bonds issued by the governments of major western economies are often described as virtually risk free. How can that be when the bonds are traded and can fluctuate in price?

y ivit

eedb ac

3g

Such bonds are certainly low risk since it is extremely unlikely that the issuer will default. As a last resort, governments can always raise taxes to find the means of paying interest and repaying the principle, though this may be unpopular. But the bonds can be made virtually risk free by holding to redemption. This means firstly that the buyer knows for sure what the value will be at maturity. The fact that the price may fluctuate in the meantime is irrelevant if the buyer has no plan to sell. Secondly, the yield is also known with certainty since the coupon is fixed and any capital gain/loss that arises from the difference between purchase price and maturity value is known at the time the purchase is made. Thereafter, there is nothing that can happen to change the cash flow. The only possible risk is that the rate of inflation may differ from what was expected. This will cause a change in expected real return (unless the bonds are index-linked).

Recommended reading: Howells and Bain (2008) The Bond Market; Mishkin (2007) Understanding Interest Rates; Howells and Bain (2007) Capital Markets; Piesse, Peasnell and Ward (1995) The Bond Market.

3.4 Duration, price elasticity and the term structure of interest rates
In the previous section we calculated the price of a three-year bond when interest rates were four per cent and three per cent. The price rose from 102.81 to 105.66, an increase of 2.85. In the appendix of this unit we show that if we do the same for a six-year bond with the same coupon we should find that the price changes from 105.24 to 110.95, an increase of 5.71. In the language of economics, the interest elasticity of bond prices increases with the bonds residual maturity. This elasticity is defined (and can be measured) as the percentage change in price divided by the percentage change in interest rate. Table 3.2 summarises our results. Maturity 3yrs 6yrs P(i=4%) 102.81 105.24 P(i=3%) 105.66 110.95 P + 2.85 + 5.71 %i 25 25 %P + 2.77 + 5.43 Elasticity 0.11 0.217

Table 3.2: Interest elasticity of bond prices

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This characteristic of bonds is important when it comes to assessing their risk. It tells us that bonds which may be identical in all other respects will be subject to a level of interest rate risk which varies positively with their term to maturity. Hence long-dated government bonds are riskier than short-dated government bonds, notwithstanding that both are issued by the same borrower (which has virtually no risk of default). Interest rate risk is one element in the term structure of interest rates which we come to in a moment. Notice that we have been careful to say that the interest elasticity varies positively with maturity, other things being equal. This is because there is another factor which plays a part and also gives us an important clue as to why interest elasticity varies. The other factor is the size of coupon. If we did some more pricing exercises, we could show that if we priced two bonds with the same residual maturity but different coupons, the bond with the larger coupon would have the lower interest elasticity.
duration

The key to all this is the concept of duration. Formally speaking, duration is defined as: the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period. This sounds more complex than it really is and Howells and Bain (2008) show how duration can be calculated and how the result can then be used to calculate interest elasticity. The intuition is certainly simple enough. The average maturity of a bond simply means the average length of time that it takes to receive all the cash flows. Recall that the cash flows are a series of payments some of which arrive very soon while some (including the maturity value) are received in the distant future. This immediately explains why maturity plays a part since (other things equal) the longer the residual maturity the longer we have to wait in order to receive the average of the cash flows. It also explains the role of coupon. Other things being equal, a high coupon bond delivers the average of its cash flows sooner than a low coupon bond, since a low coupon bond pays its largest cash flow (the maturity value) right at the end. So too does a high coupon bond but it also makes significant payments in the early stages and so this reduces the average time for the cash flows to arrive. Notice that although term to maturity is a major component of duration, they are different things. Provided that a bond pays coupons during its life, then the duration must be less than the maturity of a bond. However, by the same reasoning, a zero coupon bond of the kind we mentioned in 3.1 will have a duration which is equal to maturity. We now turn our attention to the yield on bonds with different terms to maturity and we shall see that duration (and interest rate risk) play an important role. The range of yields yield on assets (here bonds) differentiated solely by their term to maturity is called the term structure of interest rates. The yields in question are the redemption yields we discussed in section 3.3. A very easy way of seeing the term structure is to plot the rate of interest available on bonds with different terms to maturity. Look at Figure 3.2 which shows the yield increasing with term to maturity.

term structure of interest rate

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yield %

term to maturity

Figure 3.2: A time-yield curve

yield curve

The curve in Figure 3.2 is often described as a normal yield curve. It is a yield curve because it shows the yield or rate of return on a range of assets and it is described as normal for the simple reason that we do, as a matter of fact, quite often see an upward-sloping curve when we plot the yield curve over assets with different terms to maturity. We might think it natural that (other things being equal) the rate of interest should be higher on assets with longer periods to maturity but the way in which term affects interest rates is not so obvious as it seems at first sight. We look at four possible explanations for the shape of the yield curve.

Liquidity premia
liquidity premium

Our first thought might be that holders of longer-dated bonds require a liquidity premium because they are giving up access to their funds for a longer period. (Recall that we saw in Unit 1 that lenders prefer liquidity.) But we shall see in 3.5 that there is a very active market for bonds. They are bought and sold in large quantities on a continuous basis and therefore holders, even of the longestdated bonds, can sell them at a moments notice. It is difficult, therefore, to argue that any premium can be explained by illiquidity.

The expectations hypothesis

There are other possible explanations of the term structure but in almost all cases there is a problem in explaining the dominance of an, upward-sloping yield curve. For example, the most commonly advanced explanation for a systematic relationship between yields and term, where bonds are concerned is expectations of future interest rates or the expectations hypothesis. The argument is that if people expect short-term interest rates to be higher (lower) than they are now, current long-term rates will be above (below) current short rates; that is, expectations about future changes affect the current structure. Why the present should be influenced by events which have not yet occurred seems rather strange, but learning activity 3h might give you a clue.

expectations hypothesis

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Lear

ga nin ct

3h

Suppose that two year bonds yield four per cent while four year bonds yield 5 per cent. Assuming that you are able to invest for a four year period, can you think of any reason why you would prefer to hold the two year bonds?

eedb ac

y ivit

3h

If you buy the four year bonds now, you will receive five per cent for each of four years. If you buy two year bonds you get four per cent for each of two years and then you can reinvest at whatever the two year rate is in two years time. Suppose that you think that two year rates are going to rise significantly in about two years time. You might, for example, think that they could be around seven per cent. You would be better off by taking the low two year rate now and being able to take advantage of seven per cent for two years in future.

That clue is that short-term assets will be attractive (and their yields will be low) if we think that future short-term interest rates will be higher (and viceversa). The next paragraph takes you through the argument in more detail. We assume that most lenders have a choice about the period for which they can lend or the term to maturity of the asset that they invest in. Suppose that their preference is for a five year investment. They can either buy a one year bond and then buy another when that matures and then buy another and so on for five years. Alternatively, they can buy one five year bond now. Assume that the yield curve is stable. This must mean that bondholders are broadly happy with the current pattern of interest rates and therefore we have an equilibrium position. (If they were not happy, then there would be a general shift towards buying long-dated bonds, or towards buying short, and the yield curve would be changing its shape.) If we have equilibrium, then it follows that investors are currently indifferent about whether they invest for a series of short periods or one longer period. If we ask ourselves, in what circumstances would investors be indifferent between a series of short-dated assets loans and one long one?, the answer ought to strike us quickly that they will be indifferent when there is no difference in the return expected from adopting either strategy. In other words, the reward for the long strategy must be equal to what investors think they will get from a series of short-dated assets. The reward for the long strategy must equal the average of the series of short-dated deals. This is where expected future interest rates enter the picture. Since investors can only know the current short rate, they have to make an educated guess at likely future short rates. It is this guess that must be responsible for any observed difference between current short and long rates. That is, expected future short rates are implicit in any difference between current long and short rates. Suppose for simplicity that a short loan is for one year and a long loan is for two years. Suppose, furthermore, that the current short rate (is) is five per cent while the current long rate (iL) is ten per cent. If this differential is stable then lenders are happy with the prospect of what they will earn by lending for one year and then renewing at the expected one-year rate compared with what they would get by lending now for two years. Formally, it must be the case that they expect:
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(1 + is) (1 + s) = (1 + iL)2 where s is the expected future short-term (one-year) rate. Rearranging gives us: (1 + is) = (1 + L)2 / = (1 + is) Substituting actual values gives: (1 + s) = (1.1)2 / (1.05) = 1.21/1.05 = 1.152 If (1 + s) = 1.152, then s = 1.152 1 = 0.152 or 15.2% In this example, therefore, we can see that if current short rates are five per cent and long rates are ten per cent then this suggests that people expect short rates to rise to 15.2 per cent before the second period begins. In this example, therefore, the yield curve slopes upward and long-dated bonds have a higher yield than short-dated ones. Notice once again that this is not because they involve a greater sacrifice of liquidity than short-dated bonds. It is because their current yield persuades those willing to invest for a longer period that they will do just as well from holding long-dated bonds as they will from holding a succession of short-dated ones, bearing in mind what is expected to happen to interest rates on short-dated bonds in future. Conversely, if the market expected short rates to fall in future, the yield curve would be downward-sloping. The argument then would be that investors would still be willing to hold (lower yielding) long-dated bonds because this would give them the same return as a succession of short-dated bonds, bearing in mind that short rates in future would be lower than they are now, and indeed lower than current long rates. The problems with the expectations hypothesis are twofold. Firstly, when interest rates are examined retrospectively, the subsequent movement in shortterm rates often differs from what one would have expected given the level of long-term rates. Secondly, the expectations hypothesis cannot explain a dominant shape for the yield curve since this dominant shape would suggest that there was one expectation of future interest rates that dominated all others. But it is not possible for interest rates to keep moving in one direction, so such an explanation would require people to have persistently wrong expectations of interest rate movements. This seems unlikely.

Market segmentation
market segmentation

Another factor which might play a part in shaping the yield curve is market segmentation. We know that, in practice, some investors prefer to concentrate on certain parts of the maturity spectrum and are reluctant to move outside the territory they are familiar with. Life insurance companies and pension funds, for example, have liabilities which are very long-term. They need to know with reasonable certainty now what they will be able to pay out at dates which lie a long way into the future. For this reason they prefer to hold longdated bonds. Short-dated bonds are just not suitable. At the opposite end of the spectrum, banks and building societies hold only short-dated bonds. If there are strong maturity preferences, then interest rates at any part of the maturity

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spectrum will depend upon the strength of supply and demand in that particular part of the spectrum. In other words we are saying that, instead of their being one big market for government bonds (for example) of all maturities, the market is segmented or divided into a series of sub-markets. Let us take an example. Suppose that a government decides for the next few years to fund its annual budget deficit by the issue of bonds exclusively in the seven to ten year maturity range (medium-dated). This will create a steady increase in the supply of medium-dated bonds. Let us assume that investors have strong preferences regarding term to maturity. In this case, the limited number of investors favouring medium-dated bonds will eventually find that they are holding sufficient bonds. If the Government continues with its funding policy it will only succeed if it offers higher interest rates on these medium-dated bonds. (Or, what amounts to the same thing, sells them at a lower price.) This will produce a hump in the yield curve in the seven to ten year range. There may well be some truth in the notion that some investors have preferences for particular parts of the maturity spectrum and therefore that the supply and demand for bonds with particular maturities will have some effect on prices and yields but again we have the problem of explaining why longer maturities have generally higher yields. It does not seem plausible that there should be a chronic oversupply of long-dated bonds.

Duration and interest rate risk

Finally, we are forced back to our discussion at the beginning of this section. Longer-dated bonds have a higher exposure to interest rate risk. This is inevitably the case and it comes from the mathematics of duration. It will always be so. This makes duration a strong candidate when it come to the question of why the yield curve should normally slope upwards. However, we still need some words of caution. Firstly, for duration and interest rate risk to provide the answer we have to assume that the bond market is dominated by investors who are capital risk averse. In other words, the mathematics of duration are insufficient on their own. It has to be the case that investors dislike the consequences of duration sufficiently to demand a premium by way of compensation. This may seem a safe assumption but it is not guaranteed. Remember learning activity 3g. We saw there that many government bonds are effectively risk-free if held to redemption. This is because the governments have a triple A rating (so we can ignore default risk), we know in advance the terminal value of our investment (the maturity value of the bond) and we know the yield if we hold to redemption. There will be investors like life insurance companies and pension funds who value these long-term certainties. So, if the market were dominated by investors who were income-risk averse, the issue of duration and interest rate risk would be less important. Secondly, we must keep in mind that these various explanations are not mutually exclusive. For example, it may be that capital risk aversion is strong and so gives the yield curve an upward-slope most of the time. But there may be occasions when a decline in future short-term rates is so strongly expected that the yield curve becomes flat or even downward-sloping for a period. And then, on top if this, there may be some degree of market segmentation such 57

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that if there is a major issue (or redemption) of bonds in a particular part of the maturity spectrum this causes a small hump (or dip). The important conclusion is that we cannot tell, simply by looking at the shape of the yield curve, what single explanation may be responsible.

3.5 Users and markets

Recommended reading: Howells and Bain (2008) The Bond Market; Mishkin (2007) Understanding Interest Rares; Howells and Bain (2007) Capital Markets; Piesse et al (1995) }The Bond Market.

The users of bond markets are the ultimate lenders and borrowers that we identified in Unit 1. In this particular case, the borrowers are Government and large corporations. The ultimate lenders are households, who can buy government bonds directly from the UK Debt Management Office and corporate bonds from market makers by using a broker. However, most bonds are held on behalf of households by intermediaries who pool the bonds with other assets in pension funds and other long-term savings plans. Many of these intermediaries also trade bonds on their own account as a source of profit. In most countries, the Government is the biggest issuer of bonds and trading in bonds is consequently dominated by trading in government bonds. In economics a market is any device that allows people to trade together. Today, most financial markets consist of traders linked together only by high speed broadband, sharing the same software which displays the bid/ask prices of the market makers for all the stocks they deal in and for various sizes of transactions. The traders, usually employees of large financial institutions, place buy and sell orders sometimes on behalf of their clients and sometimes for the profitability of their own firm. The few exceptions to this are the much smaller online retail brokers who are buying and selling almost wholly on behalf of clients. In order to have access to the software and the network, all the parties must be members of the exchange. This means meeting a set of financial and other tests and paying a regular membership fee. The exchange (often a publicly quoted company) provides the software and undertakes tasks likes the recording and registering of transactions and publicly reporting the prices of stocks and the volumes being traded. Everything that we have said so far applies to the trading of most financial instruments whether it be equities, bonds, derivatives, foreign exchange or whatever. However, in the case of bond markets it is sometimes the case that only a subset of market makers deal in government bonds. This usually places them under some extra obligations for which they receive certain advantages, not available to others, in return. The reason for this is that governments feel that they must know for certain that they can sell whatever quantity of bonds they require at a particular time. In the UK, these firms are known as Gilt Edge Market Makers (GEMMS) after the popular term gilts for government bonds. They are authorised by the Bank of England and have borrowing rights at the Bank of England. Corporate bonds are traded in the normal way, by market makers who will usually be dealing in the ordinary shares of the same companies.

market maker

secondary market

primary market

The arrangements that we have just described set out the trading arrangements in what is called the secondary market for bonds. This is the market in which existing bonds are traded. But it is possible also to talk about a primary market the market which deals with new issues. In most cases, the organisations involved are the same as those that are making the secondary market though
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in the case of bonds, the issuing of new bonds involves extra players. Firstly, new issues of UK government bonds are handled by the Debt Management Office (DMO) which is an agency of the Treasury. Its website (<http://www. DMO.gov.uk>) is a useful source of information about the government bond market. In the case of corporate bonds, new issues are handled by investment banks but by a different part of the bank from that which is making markets in existing bonds. Arrangements in other countries are broadly similar. In some countries it is the central bank that is responsible for new issues of government bonds (as it was in the UK until 1998). According to the London Stock Exchange (2009a) the value of new bond issues in 2009 (to end-November) was 518 billion. By comparison the total trading in fixed interest securities (corporate and gilts) was 8599 billion (London Stock Exchange, 2009b). Since there were 625,661 trades, we can calculate that the average size of each transaction was 13.7 million. The following figures relate to government bonds only. Two things are striking (and are similar to the figures for the bond market as a whole). This is that the total amount of trading in government bonds (turnover) is very much larger than the amount of money being raised by the issue of new government bonds. This gives us a rough indication of the size of the secondary market in relation to the primary market. Turnover is also very much larger than the outstanding stock of debt. The DMO provides its own calculation of this relationship which shows that turnover amounts to nearly eight times the value of the total stock. Turnover 4077.42 Market value of outstanding stock 525.94 Turnover ratio 7.75 Net new issues 208.5

Table 3.3: UK government bond market data, 200809 (bn)

Source: UK Debt Management Office (2009a, b)

In economics, it is customary to analyse the functioning of a market within a supply and demand framework. We do this in Figure 3.3 where we show the market for the three year bond that we priced in [3.5] and [3.8]. Firstly, we are looking at the price (and yield) of existing bonds, so we are looking at the secondary market where the quantity is fixed. Hence the supply of bonds is show by the vertical supply curve, S. Initially, demand is shown by D. The demand curve is downward-sloping because, other things equal, bonds are more attractive at a lower price since (we know) their yield is higher. Initially, then we have an equilibrium price of 102.81 (calculated in [3.5]) on the lefthand axis. However, we know that for any price there is a corresponding rate of return. We can put this on the right-hand axis in order to emphasis that it varies inversely with the price. For this purpose we could put any measure of yield, even simple yield, though normally we would use redemption yield. Recall that the bond in [3.5] and [3.8] has no accrued interest and so the dirty price and the clean price are the same. This means (if we look at our explanation of redemption yield again) that the rate of interest in [3.5] and [3.8] is the internal rate of return or redemption yield. So we can show this on the righthand axis as four per cent. In our pricing discussion we then introduced a fall in market interest rates to three per cent. This means that many other assets now yield only three per cent
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but with a coupon of 5 and a price of 102.81 our bond has a redemption yield of four per cent and is thus suddenly made more attractive by the fall in market rates. Inevitably, buyers will want to hold our bond in preference to other assets, so long as the price/yield combination remains superior to what is available. But inevitably, the increased demand for our bond pushes up the price (and lowers the yield). Where does the process stop? Demand for our bond will cease to rise when the return that it offers is no longer superior to that available elsewhere on similar assets. in other words when the yield falls to three per cent. And we know from [3.8] that this will be when the price rises to 105.66.
Yield, % 3 4 D D 0 Quantity of bonds
Copyright 2010 University of Sunderland

105.66 102.81

Price,

Figure 3.3: Bond prices in a supply and demand framework The lesson to be learned from Figure 3.3 is that the pricing discussions in section 3.3 should be interpreted as operating on the demand side of the market. When we calculate the present value of a futures income stream we are calculating what price holders should be prepared to pay. Any change in that present value, corresponds to a shift in demand.

Lear

ga nin ct

3i

During 2009, there were rumours that the ratings agencies were about to reduce their rating of government bonds in a number of countries (including the UK). Suppose that a downgrading were to occur. What do you think would happen to the price of the bonds concerned and why? (Hint: In your explanation, make reference to a pricing equation (any of [3.1], [3.2], [3.3], [3.5] or [3.8] will do) and to Figure 3.3.

eedb ac

y ivit

3i

If bonds receive a downgrading, we would expect the price to fall (and the yield to rise) because the ratings agencies are telling us that they think the bonds have become more risky. Formally, we can show why this happens by looking at any pricing formula for a fixed interest bond. In any of these formulae we find the present value of the bond by discounting the future cash flow by a discount rate that is the rate available on other assets of similar risk. (Alternatively we could say that this rate incorporates the risk-

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eedb ac

3i
continued

free rate of interest plus a risk premium.) However we express it after the downgrading the risk premium is bigger (so if we compare with other assets, these should be riskier assets than before). The critical point is that the rate of discount rises. Since the discount rate appears in the denominator, an increase must result in a fall in the price. In Figure 3.3, we would show this by a downward shift of the demand curve.

Lear

ga nin ct

3j

Imagine that you are managing a UK high income fund that is invested wholly in bonds. The average risk of your bonds according to the Standard and Poors rating agency is AA-. The simple yield to maturity on the portfolio is five per cent: 1. You are thinking of investing 1 million in the following bond (which also has an AA- rating):

eedb ac

y ivit

issuer: ABC plc coupon rate: five per cent coupon payable: Six-monthly, in two equal instalments maturity date: 28 August 2014 date of purchase: 28 January 2011 market interest rate: seven per cent.

Calculate the dirty price and then the simple yield to maturity and explain your decision about whether to invest in the bond. 2. The national statistics office announces that inflation rose unexpectedly to 3.5% last month. How might your understanding of duration guide you in designing an investment strategy in these circumstances?

3j

1. Using [3.7] to find the dirty price (including accrued interest) we have Pd = 7 1 100 7 154 1 + + 0.04 (1.02)8 (1.02)8 2 182

Pd = 175 1

[ [

1 100 + + 3.5(0.846) (1.172) (1.172)

] ]

( )

175 [1 0.853] + 85.32 + 2.115 = 25.69 + 85.32 + 2.961 = 113.97 We then use [3.10] to find the simple yield to redemption: = (Remember that P is the clean price). Then sym = C + 100 P 7 100 111.01 11.01 = + = 0.0631 + 4 111.01 444.04 P nm P 111.01 C 100 P + p nm P

)
61

= 0.0631 0.0247 = 0.0384 or 3.84%

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Financial Markets

eedb ac

3j
continued

On the face of it, the ABC bond looks to be overpriced and we would not buy it for the portfolio. We draw this conclusion because it has the same risk as the portfolio as a whole (AA ) but its return is substantially below what we can earn on AA- bonds. If the price were to fall to the point where the simple yield to maturity rose to five per cent, then we could reconsider our decision. 2. Duration could be relevant here because it tells us how bond prices change in response to a change in interest rates. Our first step is to decide whether there might be any useful information regarding interest rates in the announcement from the national statistics office. We know that inflation has risen unexpectedly. We know (from Unit 2) that the level of interest rates is set by the central bank in the light of its monetary policy objectives. Let us suppose, for example, that the central bank has a policy of inflation targeting. The news that inflation has risen unexpectedly would then suggest the probability of a future rise in interest rates. We know from our pricing exercises that bond prices change with interest rates and so we must expect that a rise in interest rates will cause the value of our bond portfolio to fall. However, duration tells us that some bonds will be more seriously affected than others. These will be long-maturity bonds with low coupons. A sensible strategy therefore would be to sell these bonds before interest rates change and prices fall. Since we are committed to running a bond fund (and there is probably a trust deed which prevents us from holding other assets instead of bonds) we have to continue to hold bonds of some sort. Again, duration helps by suggesting that we should hold short-dated, high coupon bonds. Their price will still fall, but the fall will be minimised. Apart from the duration issue, there are two other lessons to be learned here. The first is that since changes in interest rates are critical to the behaviour of bond prices and interest rates are set by central banks, bond investment strategies inevitably involve making judgements about monetary policy and the likely next movements of the central bank. The second is less obvious. This is that the response of bond prices to news (for example about inflation) depends upon whether the information was expected or came as a surprise. If the information were already expected it is likely that it was already incorporated in the bond price. In these circumstances the arrival of the information has no effect on price. The ability of assets to incorporate information before it actually arrives is part of the efficient market hypothesis that we examine in Unit 5.

k
3.1 3.2

Self-assessment questions
Suppose that Treasury 8.75% 2019 pays half-coupons on 1 May and 1 November and that it is 1 November 2010 now. Find the price if interest rates are 9.54 per cent. (Hint: use [3.5].) Looking at [3.5], how could you simplify the formula if n=? What sort of bond would you have created by making n=?

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3.3

How would you expect bond prices to respond to the following (unexpected) events? (a) an increase in the balance of payments deficit in a fixed exchange rate regime (b) a fall in the rate of inflation combined with fears of recession (c) the announcement of a large budget deficit. Would your answers be different if these events were expected and if so why? If the current (redemption) yield on bonds with one year to maturity is six per cent, while the yield on bonds maturing in three years is eight per cent, what does this imply about one-year yields in three years time? If the coupon on a bond is increased, what effect does this have on its duration and why? In what circumstances might the shape of the yield curve tell you something about (a) the future level of interest rates and (b) the future rate of inflation?

3.4 3.5

3.6 3.7

Feedback on self-assessment questions

3.1 P= 8.75 1 0.0954

1 1 + 0.0954 2

) (
8

100 = 52.07 + 43.24 = 95.30 8 1 + 0.0954 2

3.2

Looking at the formula in the previous answer we can see that if we make n (=8) infinitely large, then two things happen. The first is that the denominator in the fraction within the square brackets becomes infinitely large, so that the fraction becomes 1/, or infinitely small. Consequently, the expression in square brackets becomes [1 0] or [1]. By the same reasoning, the denominator in the final part of the expression also becomes infinitely large. This gives us 100/ which = 0. So we are left with P = 8.75/i [1] + 0. This, of course, reduces to P = 8.75/i or more generally P = C/i. This is the expression for the valuation of a perpetual or irredeemable bond a bond with no maturity date. (a) An increase in the balance of payments deficit would tend to cause the external value of the currency to fall. Since this is not allowed in a fixed exchange rate regime the central bank would have to raise interest rates in order to attract an inflow of funds to support the currency. The rise in interest rates, all else unchanged, would lead to a fall in bond prices. Expectations of recession should cause the central bank to cut interest rates. If inflation is also falling, then the major obstacle to a cut in interest rates disappears and makes it even more likely. Bond prices will rise. The announcement of a large budget deficit will cause investors to expect a large issue of government bonds. In Figure 3.3 the supply curve will shift to the right and this will cause a fall in bond prices and a rise in their yields.

(b)

(c)

3.4

If these developments were widely expected then it is quite likely that their effects would be incorporated in the price/yield of bonds at the time of the expectation so that when the events actually took place there would be no change in prices/yields. 63

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3.5

These conditions describe an upward-sloping yield curve. We know that longer dated bonds have larger duration and increased exposure to interest rate risk. It is possible therefore that this difference is a risk premium to compensate capital risk investors. However, the difference in rates is quite large for bonds whose maturity differs only by two years. Another possibility is that it reflects expectations about future short-term rates. If there are investors willing to hold one year bonds at 6 per cent while three year rates are 8 per cent, this suggests that there are many investors who think that by selling their one year bonds in a years time they will be able to reinvest for the next two years at interest rates that will give them an average of eight per cent pa overall. This implies that interest rates by year three will be higher than in year one, but not just higher than six per cent but higher also than eight per cent if the average over years one, two and three is to match holding a single three year bond. If the coupon on a bond were raised at some point in its life (there are some bonds like this) then its duration would be reduced at the point of changeover. This is because a higher coupon causes a higher proportion of the bonds total cash flow to be paid early. Alternatively, we can say that it reduces the average waiting time. Firstly, with regard to interest rates the shape of the yield curve might tell us something about the future level of short-term rates if (a) the shape of the curve is determined by expectations and (b) if those expectations are generally correct. It is also possible that the curve could tell us something about future inflation rates if we know that the real rate of interest is stable, that is that nominal rates represent a stable real rate plus an inflation premium. In these circumstances, we find the expected future nominal rate, using the expectations hypothesis, then subtract the real rate often estimated at around two per cent and what is left is the markets estimate of inflation.

3.6

3.7

Summary
In this unit we have looked at one of the major capital markets. We have seen what bonds are, how they are priced, used and traded. Having finished this unit you should now be able:

to describe the key characteristics of bonds and their uses and to retrieve and understand bond market data to price bonds of varying maturities and to show how the price varies with market interest rates to distinguish different meanings of yield and be able to show how yields vary inversely with price to recognise the concept of duration and show how this affects the price sensitivity of bonds and how it may also play a part in the term structure of interest rates to understand something of the institutional arrangements for the trading of bonds.

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Appendix: Bond price sensitivity and period to maturity

We mentioned in the text that the sensitivity of bond prices is influenced by the period to maturity. We illustrate this here by looking at a bond with six years to maturity. This is directly comparable to our pricing of a three year bond in the text. We shall ignore accrued interest in order to keep the calculations as brief as possible. Firstly, then, we find the price on 1 November 2009 of a five per cent bond maturing on 31 October 2015 when interest rates are four per cent. P= 5 1 M 1 100 1 + = 125 1 + 0.04 0.04 12 0.04 12 (1 + 0.02)12 (1 + 0.02)12 1+ 1+ 2 2

) (

= 125 1 = 105.24

1 100 + = 125 [1 0.789] + 78.86 = 26.38 + 78.86 1.268 1.268

[3.12] Compared with our three year bond, we see that the price of an identical six year bond is rather higher (105.24 against 102.81) because the six year bond pays six more coupon-instalments of 2.50 each. Even when discounted, these extra payments have some small value and the market price of the bond reflects this. What is going to be more remarkable is what happens when we re-price for the fall in interest rates from four to three per cent. P= 5 1 M 1 + = 125 1 1 0.03 12 (1 + 0.015)12 0.03 0.03 12 1+ 1+ 2 2 100 + (1 + 0.015)12

) (

= 166.7 1 = 110.95

1 100 + = 166.7 [1 0.836] + 83.61 = 27.34 + 83.61 1.196 1.196

[3.13]

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Bank shares hit by Dubai World fears.

Financial Times (14 July 2009)

Introduction
This unit continues our discussion of capital markets by looking at the market for company shares. Unit learning objectives On completing this unit, you should be able to: 4.1 Describe the characteristics of company shares. 4.2 Retrieve and understand data relating to share prices. 4.3 Price company shares by reference to a range of models. 4.4 Derive the required rate of return from the capital asset pricing model. 4.5 Compare the trading arrangements in a range of different countries and compare the scale of activity in primary and secondary markets.

Prior knowledge The unit assumes that you have studied Units 1, 2 and 3. Otherwise, it requires no prior knowledge, but you will find sections 4.3 and 4.4 easier if you have some basic mathematical skills, and familiarity with basic economics is useful for section 4.5. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: on Portfolio Theory, Valuation of Assets and Equity Markets). In Piesse et al (1995) Structure of Securities Markets and The Equity Market are most relevant. Howells and Bain (2007) Capital Markets also covers much of the material but at a rather lower level. The first part of Mishkin 2007 The Stock market explains the Gordon growth model. You will need a calculator and access to the internet.

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4.1 The characteristics and uses of company shares

Recommended reading: Howells and Bain (2008) The Equity Market; Howells and Bain (2007) Capital Markets; Piesse, et al (1995) The Equity Market; Mishkin (2007) The Stockmarket.

Firms can raise money in a number of ways. Short-term borrowing is usually done via banks or through issuing bills and other securities in money markets (see Unit 2). Long-term borrowing usually involves selling bonds (see Unit 3) or shares in the firms ownership. Notice that while shareholders are effectively lending to firms, they are doing so by taking a share in the ownership. This has important implications for the rights and obligations of shareholders. Firms which are financed by the issue of shares are known as joint stock companies or limited liability companies. Many of these firms are small or medium-sized and their shares may be held by very few people (sometimes the family of the founder) and very infrequently traded. However, larger firms require substantial capital more than can be raised through family networks. The shares have to be made attractive to the largest number of holders and this means that they must be listed on a recognised exchange where they can also be traded. Firms in this position are sometimes referred to as corporations. The simplest shares are ordinary company shares or equities or what US markets refer to as common stock. From the point of view of their holders these shares give a number of advantages. Firstly, the holders have certain rights regarding the management of the company usually exercised through a board of directors who are strictly speaking appointed through the votes of shareholders. Secondly, the shareholders are entitled to share in the profits (or earnings) generated by the firm. This comes in the form of a dividend, which may be paid annually or in more frequent instalments. Notice that if the firm adopts a fixed payout ratio (or retention ratio) it will distribute a fixed proportion of its profits as dividends (retaining the rest to reinvest in the firm) and therefore the dividends received by shareholders will vary with the profitability of the firm. However, many firms prefer to smooth the dividend payments, preferring to see them grow steadily over time, even if this means varying the proportion of profit distributed each year. Thirdly, if the firm flourishes and grows, shareholders can expect to see the value of their shares increase since each share confers ownership of a fixed proportion of the firm. On the other hand, there are drawbacks to share ownership. We have just seen that the dividend payments can vary and if the firm runs into long-term difficulties the dividends may cease altogether. Furthermore, if the firm fails, the shareholders rank last behind the firms creditors and bondholders. Since insolvency is defined as an excess of liabilities over assets, this usually means that shareholders get nothing. The principle is that the owners of a firm should take the risk of the firms operation and that means the shareholders. As with bonds, there are variations on this basic type of share. For example, there are:

Preferred shares which pay a fixed dividend (and in that sense are like a bond). Preferred shareholders rank behind bondholders, however. Thus, in periods of low earnings bondholders may be paid when preferred shareholders (and ordinary shareholders also of course) get nothing. Predictably, there are many variations on the preference theme.

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Cumulative preferred shares, unpaid dividends are cumulated and become payable when earnings permit. Convertible preferred shares carry rights to convert to ordinary shares on specified terms and at specified times. And there are other variations.

The fact that the income stream from ordinary shares is uncertain naturally makes share valuation more difficult (than, say, bond valuation). The difficulties are further increased because it is difficult to establish precisely the degree of risk for any individual share and thus it is difficult to calculate an appropriate rate of discount. We shall see one way of finding a discount rate in 4.4.

Lear

ga nin ct

4a

When firms make new issues of shares (in order to expand their capital) existing shareholders must be given the right to buy the new shares in proportion to their existing share of the firm. What can you see in the nature of shares that explains this?

eedb ac

y ivit

4a

It is explained by the fact that shareholders are the legal owners of the firm and the possibility that the fraction they own may be important to them. Therefore, the firm must not do anything to alter this fraction without the shareholders consent. For example, suppose a shareholder owns 10 million shares out of a total of 500 million. This is equivalent to two per cent of the firm. If the firm then issues another 500 million (a one for one issue) this would reduce the shareholders stake to one per cent, unless he decides to buy another one million. He has the right to that opportunity.

Recommended reading: Howells and Bain (2008) The Equity Market; Howells and Bain (2007) Capital Markets; Piesse, et al (1995) The Equity Market; Mishkin (2007) The Stockmarket.

4.2 Understanding share price data

Share price data can be found in numerous places. For most people, the convenient sources are the newspapers with a major business section. The Financial Times and Wall Street Journal carry full listings of shares traded in London and New York. Other newspapers will have details for major firms only (for example, those in the FTSE-100 or Dow Jones indexes). When it comes to electronic sources, the stock exchanges own websites will provide data which is updated throughout the trading day, though it may be available for free only with a short time-delay. The websites of the financial newspapers also provide a similar facility and some individual firms have an investor relations section on their own websites which may give the current price of the firms shares. Hardcopy share price data will look something like that in Table 4.1. The first column shows the name of the company. Notice that firms are grouped by the economic sector in which they specialise. This makes it easier to compare the data for firms in a similar line of business. The second column shows the latest price, normally in pence. (In a newspaper this will be the price at the close

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price/earnings ratio

of trading on the previous day.) The third column shows the price change from the previous days close. High and Low refer to the maximum and minimum price so far during the year. Yield is the dividend yield, the latest dividend divided by the current price. P/E is the price/earnings ratio. This shows the cost of buying a share in the companys profits. In the case of Carphone Warehouse, for example, buying a share for 188p gives the holder a claim to the firms profits of 1/73.5 of 188 or 2.56p. The final column shows the number of shares bought and sold in the previous days trading. 2009

Telecommunications Carphone Warehouse Cable & Wireless Colt Tel

Price 188 142 125

Change +2.10 0.50 0.60

High 216.10 170 138

Low 88.25 125.10 65

Yield 2.4 6.2

P/E 73.5 22 12.8

Vol.000s 3,350 21,246 1,194

Table 4.1: Share price data

Lear

ga nin ct

In Table 4.1, 188p buys 2.56p of Carphone Warehouses earnings. 1. What is the cost of buying a share of the Cable and Wireless earnings? 2. Why should shareholders be willing to pay such widely differing amounts?

y ivit

4b

eedb ac

4b

1. The data says that one share costs 22 times the earnings purchased. If the share costs 142p then the earnings must be 1/22 142p = 6.45. For the same price as a Carphone Warehouse share (188p) an investor in Cable and Wireless could buy 188/142 6.54p = 8.65p. 2. One possible explanation for this difference could be the level of risk. If investors thought that Cable and Wireless earnings were very uncertain, then they would be willing to pay only a low price while investors might be willing to pay more for a reliable stream of earnings from Carphone Warehouse. It could also be that the earnings in Carphone Warehouse are expected to grow very rapidly, while Cable and Wireless may be in a slow-growing part of the market.

Copyright 2010 University of Sunderland

Similar data, in tabular form. is sometimes available electronically as a pdf file. More usually, however, the electronic sources allow you to search for the data one share at a time. In this case, there may be an option to display the share price movement in graphical form over various periods and even to show this against the movement in some index or against movements in rival shares. By subscribing to some websites, it is often possible to get access not just to the data but also to a range of analytical tools.

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For example, Figure 4.1 shows the recent behaviour of the price of shares in BP, the oil producer, as it appears in the markets data section of the Financial Times (FT) website (<http://markets.ft.com/markets/overview.asp>).

620

600

580

560

Jan 15 17.34.00 October 2009 GMT

+2.30 +0.40% November 2009

+25.40 +4.42% December 2009

January 2010

Figure 4.1: The BP share price The price (in pence) is shown on the vertical axis and the horizontal axis shows that the data relates to the last three months. Along the bottom of the chart, the vertical bars shows the volume of trading in the shares, day by day and there is a summary of the price change in each month. Notice that the price change is given as an absolute amount and as a percentage. This is important since a given absolute amount may look large but be insignificant when we look at the level of the share price. In the case of BP, a 50p rise in price in mid-January 2010 would be equivalent to a jump of about eight per cent. The same rise in the price of Anglo-American mining shares would be equivalent to about 1.8 per cent since the market price was 27. When it comes to taking action, however, just looking at the price of a single share in isolation is not very helpful. We need some way of interpreting the information. Has BP done well or poorly by comparison with relevant benchmarks? In order to answer this, the FT database also provides a facility known as interactive charting whereby the researcher can compare the individual share price against a number of indexes or against similar firms. (One can compare BP against Shell, for example.) Figure 4.2 show the BP price against the FTSE-100 index of share prices. Notice that in order to make the comparison, both series have to start at a common point and that they have to be judged using a common standard which is the percentage change from the starting point. Thus we see that the FTSE index fell to begin with while the BP price rose. By the end of November 2009, they were close together again, though the BP share price was showing a slightly larger gain (of around 2.5 per cent). Neither series showed much change during December 2009, but both moved upwards through January 2010, with the BP price pulling further ahead. By using this facility we can now say that investors in BP have done rather better over the period than those who invested in a portfolio of FTSE-100 companies. If we did a bit more research, on similar lines, we could discover that the Shell share price also did better than the FTSE70
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Capital markets (II)

100 index, suggesting that part of BPs performance is explained by a strong performance across the oil sector as a whole. If we then plotted the BP price against Shell, however, we would find that the BP performance was slightly better than Shell during this period suggesting that there must have been some firm-specific factors at work in the BP company. The period of the comparison is just one of many parameters that can be varied from one day to five years. Finally, notice that at the bottom of the chart, the daily trading volumes are given in absolute figures and it appears that the daily turnover in BP shares (the vertical bars) is normally between 20 million and 30 million. This may sound like a very large number until we discover (from elsewhere) that BP has nearly 19 billion shares in issue.
+10.00% +7.50% +5.00% +2.50% 0.00% 2.50% Jan 15 17.34.00 +13.30 +2.36% +2.30 +0.40% October 2009 November 2009 GMT
80M 60M 40M 20M

+25.40 +4.42% December 2009

+29.00 +4.83% January 2010

Figure 4.2: BP and FTSE-100 compared

Lear

ga nin ct

4c

Go to the FT homepage (<http://www.ft.com>), drop down the menu headed markets and click on markets data. Then select companies research. Put Barclays in the search box and then select the first Barclays on the list. Display the share price in a graph that enables you to describe what happened to the share price during 2008. Then look at the data below the graph and answer the following questions. 1. What happened to the Barclays share price during 2008. Can you think of any explanation? 2. How many shares does Barclays have in issue and what is the dividend pay date?

eedb ac

y ivit

4c

1. The share price fell from about 600p to 200p in the course of the year. 2008 was the year of the financial crisis. At the beginning of the year there were serious fears that some banks might become insolvent and

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eedb ac

4c
continued

governments across the world introduced a number of emergency measures in order to bail out their banks. 2. In November 2009, Barclays had 11.41 billion shares in issue. The dividend pay date is shown as 11 December.

Statistics relating to whole markets for example turnover or new issue activity on the New York NASDAQ, or the London Stock Exchange and so on can usually be downloaded from the website (see for example, <http:// www.londonstockexchange.com/statistics/home/statistics.htm>).

4.3 The pricing of company shares

Recommended reading: Howells and Bain (2008) Portfolio Theory, Valuation of Assets and Equity Markets; Howells and Bain (2007) Capital Markets; Piesse, et al (1995) The Equity Market; Mishkin (2007) The Stockmarket.
fundamental analysis

technical analysis

chartism

There are, broadly speaking, two ways of approaching the valuation of company shares. The first follows directly from our discussion of money market instruments and bonds and says the present value of a share is determined by its future cash flow and the risk associated with it. Hence, as before, we set out to calculate the present value of that cash flow when discounted by a term which incorporates the current level of interest rates plus a risk premium. We call this approach fundamental analysis since it focuses on what are regarded as the fundamental characteristics of a share, namely its ability to earn so much income for a given level of risk. An alternative approach is to look for patterns in past price movements in the belief that similar patterns emerging now tell us something about how the price of the share is likely to move in future. This is called technical analysis or sometimes chartism. Notice that it does not generate a definitive value for the share. It simply tells us whether the current price is sustainable or likely to rise or fall. Technical analysis is controversial since it offers no reason for the change in share prices, other than the alleged patterns in the data. Neither does it provide any justification for the present price: it is mainly concerned with spotting the next movement.

Fundamental analysis
In fundamental analysis, we focus upon a shares ability to earn a stream of income (its cash flow) in return for a certain level of risk. As with any other asset we discount the income stream in order to find its present value and the discount rate that we use incorporates the general level of interest rates and then any allowance that we think we should make for the risk of the share. The cash flow comes in the form of a dividend, D, and so fundamental analysis often involves the use of dividend discount models. If we wish to discount a stream of dividends we can write:
t=

dividend discount model

PV =

(1 + K)
t=1

Dt

[4.1]

where K is the discount rate. Except for the use of the terms D and K and the absence of any maturity value, [4.1] is the same as the expression that we used for the valuation of bonds in Unit 3. However, we must not take this equivalence too far. In Unit 3, D was replaced by C which was the bonds coupon and was fixed. But dividends are definitely not fixed. They fluctuate, though over time they may be expected to grow and (we saw in section 4.1) firms often smooth their growth. Suppose that we assume a constant growth rate, g, then: 72
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PV =

D1 (1 + g)D1 + (1 + g)2D1 (1 + g)3D1 + + (1 + K) (1 + K)2 (1 + K)3 (1 + K)4

[4.2]

We can then simplify [4.2] by using the formula for the sum of a geometric progression: PV =
constant growth model

D1 (K g)

[4.3]

Assuming that the market prices shares at their present value so that PV = P0, where is the current price then [4.3] is known as the constant growth model, or Gordon growth model after Gordon (1962).

Lear

ga nin ct

4d

1. Thornbury plc has been making chocolate and other high quality confectionary for a number of years. Its last dividend was 6p per share and earnings have been growing steadily at 10 per cent pa. The rate of return on shares in the luxury food sector is generally about 12 per cent pa. What is the fair price of Thornburys shares? 2. Suppose that Thornbury then announces that it has decided to branch out into the riskier high class catering business. What do you think _ would happen to the value of K and to Thornburys share price (all else unchanged)?

eedb ac

y ivit

k
1. P=

4d

6(1.01) 6.6 = = 330p or 3.30 (0.12 0.1) 0.02

2. The immediate effect will be to raise the required return. Using [4.4] we can see that this can only happen if the dividend yield rises and this requires a fall in price. In future, the higher risk activity should produce higher earnings (and dividends) and maybe a higher dividend growth _ rate. These will allow K to remain at its higher level with P restored to its previous value. If the share was not generating the rate of return required by shareholders we should expect a general move to sell the shares. The price, P0, would fall pushing up the dividend yield and raising the overall rate of return.

Notice that we can rearrange [4.3] with interesting results: K= D1 + g P0 [4.4]

The right-hand side now consists of the shares next dividend divided by the current price followed by g, the rate of growth of earnings. These are the two components of the return on a share: its dividend yield and the growth of dividends (or the rate of capital appreciation). So we now discover that the rate at which we were discounting earnings is the rate of return on the share. In equilibrium, that is to say where the share price is stable and investors appear to be happy with the price, then K must be the required rate of return and we _ could write it K.
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The equivalence between the growth of dividends and the rate of capital appreciation can be seen when we consider that if: P0 = D1 (K g)

[4.5]

then the price in the next period must be: P1 = Thus: P1 = Substituting [4.5] into [4.7]: P1 = P0 (1 + g) [4.8] D1 (1 + g) (K g)

D2 where D2 = D1 (1 + g) (K g)

[4.6]

[4.7]

The change in price between one period and the next takes place at the rate (1 + g). That g is the percentage capital gain is then easily shown by rearranging [4.8]: P1 = P0 + gP0 and thus: g= P1 P0 P0 [4.10] [4.9]

What determines the growth of g? The answer is interesting because it reveals a surprising insight, namely that when it comes to valuing shares it is earnings (the firms profits) that are critical rather than the payment of dividends to shareholders. In certain circumstances dividend payments may be irrelevant to shareholder returns! The growth in a firms earnings depends upon (a) how much it adds to its capital stock each year, c, and (b) the productivity of that new capital, r. (a) in turn depends upon how much of this years earnings the firm reinvests, that is upon its retention ratio, p, and the growth in earnings will be the productivity of these retained earnings, that is r p. In symbols we can write: Et + 1 = Et + rp = Et [1 + rp] And since Et [1 + rp] = Et [1 + g], then rp = g In order to see why earnings and dividends may be equivalent when it comes to valuing shares, we need to go back to expression [4.5]. D1 is the next dividend payment and this will be some fraction (= 1 the retention ratio) of earnings. Suppose that earnings are $10 per share and the firm retains 50 per cent of earnings for reinvestment. Then D1 = (1 0.5)$10 = $5. Suppose that = 0.2 and that the productivity of the firms additional investment is also 0.2. g in this case will be 0.2(0.5) = 0.1. Expressing this in the form of [4.5] we have: P0 = 0.5($10) $5 = = $50 0.2 0.2(0.5) 0.1

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Suppose now that the retention ratio increases to 0.6. The firm now pays out only 0.4 of its earnings as dividends and we might imagine that the share is less valuable. But remember that if the firm pays a smaller dividend, it is investing more for the future which should increase its growth rate and so we have two opposing forces. To see the result, we recalculate: P0 = 0.4($10) $4 = = $50 0.2 0.2(0.6) 0.2 0.12

The two forces exactly balance. Changing the payout/retention ratio has no effect on the shares price. It is earnings that matter. In getting to this result, we have made a number of assumptions. The main one is that the productivity of the firms reinvestment, r, is just equal to its cost of capital (the return required by shareholders, K ). This is not unreasonable since, provided that the productivity exceeds the cost of capital it pays the firm to increase its investment until the productivity of the new capital just matches the cost . Another way of understanding our result is to remember that funds retained within the firm for investment remain the property of the shareholders. For this reason, therefore, it is unimportant whether earnings are paid out or retained. Once again it is the size of earnings that matter. Notice that the basic Gordon growth model (and variations on it) are concerned to establish the absolute value of company shares. We have an absolute price and we can trace this back to the expected future earnings, the riskiness of those earnings and the general level of interest rates. The fact that we have an absolute value is another reason why we refer to this approach as fundamental analysis. However, it is often the case that investment decisions are as much concerned with relative as absolute value. This occurs, for example, where a portfolio manager has decided on a strategy which involves allocating so much of the portfolio to certain sectors, for example oil. In other words, some part of the investment decision has already been taken and the question has become which oil companies offer the best value? If this is the question then there are shortcuts, or rules of thumb that we can use which avoid some of the work involved in calculating absolute values. (We shall learn more about rules of thumb when we discuss the efficient markets hypothesis and its critics in Unit 5). One rule of thumb is the price/earnings ratio (or P/E ratio). If we go back to the discussion surrounding Table 4.1 we shall recall that the P/E ratio was telling us what we had to pay in order to obtain a share of a firms earnings. On this basis, we might be inclined to say that a share with a high P/E was expensive since the same claim on earnings could be bought more cheaply by buying another share. In Table 4.1, for example, we might think that shares in Carphone Warehouse are very expensive because we have to pay 73.5 times the earnings attached to each share whereas with Cable and Wireless we need pay only 22 times. But we need to be very careful here in order to ensure that we are comparing like with like. This is one of the reasons why share price tables usually group shares into sectors, rather than listing them alphabetically. If we compare P/Es within the same sector this should help us to avoid being misled into thinking that a firm with a low P/E ratio must be good value when in fact it is a very lowgrowth sector with poor prospects of expanding its earnings in future. But even

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within the same sector, firms can have different characteristics. In our two period growth model, we have already mentioned the possibility that young firms enjoy rapid growth but that growth declines as the firm matures. Nonetheless, used carefully the P/E ratio may provide a useful short-cut. We treat it as part of fundamental analysis since we assume that the price has been arrived at in the market, by the same factors that we used in the dividend discount models. Fundamental analysis points us towards a clearly defined set of variables that determine a shares price and knowing the part played by these variables, we can now understand why share prices react to certain items of news and therefore why the financial analysts and the media give so much attention to certain types of news. Table 4.2 lists some typical events that cause share prices to change, and links them to the key variables that we have discussed above. Remember that these key variables are the established level of dividends (D0), their likely rate of future growth (g), and the required rate of return or rate of discount (K). Learning activity 4e gives you a chance to decode a brief media explanation to see if you can link it to the fundamentals we have discussed. The language used by journalists does not always make this easy!

Event A change in business activity A startling new product Interest rates A profits surprise Forecasts of boom/slump in the economy An increase in inflation Rumours of conflict amongst managers/directors Depreciation of the currency

Acts on K, since this is likely to change the riskiness of the firm and thus the return required by shareholders. g, since profits and dividends are likely to grow more rapidly. K, since returns on alternative assets will have changed. Possibly g too. D1, since this is likely to be different from what was expected and possibly also g depending on the reason for the profit surprise. g, since we expect profits and dividends to grow more rapidly in a boom. On the assumption that the central bank is inflation-averse, this will create expectations of higher interest rates. So, K and maybe g. K, since the future of the firm is more uncertain (riskier) and investors will want a higher return. Exporting firms will benefit, while firms producing for the domestic market will face stiffer competition. In either case, g (but in opposite directions). This is likely to result in a changed attitude towards risk and risky assets and will be reflected in the required return, K. If it goes ahead, this is likely to reduce this years profits and consequently D1. On the other hand, if it is a response to a management decision to cut costs or increase productivity in future, it may have little effect since there may be a compensating increase in g. Table 4.2: Linking fundamentals to the real world

A general change in public confidence about the future Rumours of a strike

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So far, in this section we have focused upon the fundamental factors that determine the price of existing shares. These shares are sometimes said to be traded in the secondary market. As the figures and the discussion in section 4.5 below show, it is this secondary market trading that dominates financial markets and it is this trading (and the prices) that are reported in the media everyday. However, it occasionally happens that a firm wishing to expand (or to enlarge its capital base for other reasons) will issue new shares in what is called the primary market. These issues of additional shares are often referred to as rights issues since existing shareholders have the right to buy them first in order to maintain their proportionate stake in the firm. The question then is at what price to issue the new shares. The first thing we can say is that the price cannot exceed the price at which existing shares are trading. If, for example, shares in XYZ plc are trading at 3 each, no one is going to pay more than 3 for a claim on the same earnings of the same firm. Indeed, since the total number of shares in issue is being increased, the firms earnings have to be spread across more shares and therefore earnings per share will almost certainly be less, at least to begin with. This suggests that the new issue price should be below the existing market price, which is indeed what normally happens. And it should be possible to calculate a theoretically correct price by finding the new dividend (or earnings) per share for the enlarged stock of shares, leaving everything else as it is and then recalculating a price using [4.5]. However, other considerations can complicate the picture. Firstly markets may treat the new issue as a signal about the firms future prospects. The signal may be positive (more capital sending, more profits and so on) or negative (the firms bankers are calling in loans). Secondly, there are reputational issues. A firm does not like to read reports that its new issue of shares has not found ready buyers. This makes it look financially incompetent. A similar issue arises for the investment bank that is managing the new issue. As part of the management deal, the bank will have agreed to buy up any unsold shares. But the bank may not want to hold these shares for long, especially if the new issue is interpreted as a negative sign and the market price of the shares starts falling. Furthermore, it too may feel that its reputation for managing new issues is damaged and that it may not attract this business so readily in future. For all these reasons, new issues are always priced at a discount to the existing market price and sometimes the discount is substantial.

Lear

ga nin ct

4e

The following is a typical report of a firms results and their effect on its share price and on the market as a whole. Read the report and answer the questions below: Intels results helped Wall Street shrug off an unexpected drop in retail sales and pushed it to a fresh 15-month high yesterday. After dipping in and out of the red throughout the day, the S&P 500 edged 0.2 per cent higher to 1148.46. The Dow Jones Industrial Average gained 0.3 per cent to 10,710.55 and the Nasdaq Composite added 0.4 per cent to 2316.74. The market had opened lower after the latest official figures showed retail sales, excluding cars, had fallen 0.2 per cent in December. Analysts had forecast an increase of 0.3 per cent. But during the afternoon session the technology sector helped to lift the market as investors prepared themselves for quarterly results from Intel. The chipmaker beat analysts expectations with profits of $2.3 billion, 77

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Financial Markets

Lear

ga nin ct

4e

continued

875 per cent higher than a year ago. Shares in the worlds largest chipmaker rose 2.5 per cent to $21.48 its biggest daily gain in almost a month. They soon added to their gains in after-hours trading as the company beat estimates. 1. What was happening to the US stock market before the Intel announcement and why? 2. What was the good news from Intel and how does it relate to Intels fundamentals? 3. Why did Intels good news affect the rest of the market?

eedb ac

y ivit

4e

1. We are told that The market had opened lower after the latest official figures showed retail sales...had fallen. The likelihood is that investors took this bad news about retail sales to indicate that sales (and therefore profits and dividends) would be lower than expected in many parts of the economy and so share prices fell generally. 2. The news from Intel was an extraordinary increase in profits ...of $2.3 billion, 875 per cent higher than a year ago. This almost certainly indicates a larger dividend (D1) in future and may even indicate a more rapid growth rate, g, in future. The result was a rise in the Intel share price of 2.5 per cent. 3. We are not told why the market as a whole reacted so positively to the result from a single company, but we know that Intel dominates the market for computer and similar chips. Some of these chips are fitted to consumer products but many are also fitted to equipment and machines that are bought by other businesses. This big increase in profits may, therefore, be an indication that other firms spread throughout the economy are buying new equipment. This is unlikely unless those firms are reasonably confident about their own prosperity in the near future.

Technical analysis
The more popular name for technical analysis is chartism, since the core of the approach involves making a visual study of recent patterns in the behaviour of a shares price. At the simplest level, it may involve no more than applying some simple formula to the data in order to make it easier to understand. For example, calculating a moving average of a shares price over a period of time may make it easier to see a trend, especially if there is a lot of volatility in the day-to-day price. But a moving average is very simple and does not in itself provide very strong signal to buy or sell a share. Hence technical analysis has created a large range of devices known as technical indicators which allegedly convey useful information about future price movements and therefore act as buy/sell signals. Like a moving average, however, they are all concerned with patterns in the data. Some of the best known have been given names like wedge, head and shoulders, flags and so on, but new ones are being developed all the time. (See <http://stockcharts.com/> for a detailed listing and explanation of these indicators and of the approach.) Figure 78
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4.3 illustrates the basic idea. It shows the behaviour of a shares price over a period of time. In practice, the period of time should be as long as possible, so that the maximum information about past behaviour is included. Let us suppose that the horizontal axis covers a 15 year period. Obviously, if we record the price for each trading day in a 15 year period we will have several thousand (approximately 3750) data points in our graph and it will be very difficult to form any general view about patterns. Hence the next step is often to calculate a trend line, showing the general direction of movement (up or down) as well as the rate of change (the steeper the trend line the faster the growth in the share price). This will tell us whether or not this share fits into our overall investment strategy, if that strategy is one of maximising capital growth. This is the dashed line in Figure 4.3. We might also calculate a moving average which smooths out the day-to-day fluctuations in price. This is shown by the solid line in Figure 4.3.
Price

P2

P1

t0

Time

Figure 4.3: Using a moving average How does this help us to make a decision? In Figure 4.3, we are making our decision at time t0. At this point the share price is falling (and is about to cross the trend line). Clearly, if we are interested in capital growth, our strategy will be to buy when the share price reaches its lowest point and begins to recover. In technical analysis, such a point is known as a support level. According to the chart, this support level could be a price of P1 since it is many years since the price has fallen below that level. So our strategy should be to wait a while for the price to fall further but be ready to buy as soon as the price approaches P1.Similarly, the chart may be able to give us a sell signal. This happens when the price reaches a resistance level. In Figure 4.3, this is shown as P2. This has been the maximum price in four of the last five peaks. Certainly, if the price rises above P2, we should be ready to sell the moment that the price starts to fall back. The problem with chartism for many economists is that it conflicts with the efficient market hypothesis that you will study in the next unit. This says that markets use information very efficiently. By efficient we mean that any information that is relevant to an assets price is incorporated into the price immediately it becomes available. Hence, if there is any information in the past

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price of a share that indicates what its price should be now that information will already have driven the price to what its price should be. This seems to undermine the idea that patterns can be found in the data that point to future price movements,. For example, if a head and shoulders pattern means that the price is pausing before a major fall, and it is known that this is what a head and shoulders pattern means, then shareholders will sell instantly and the price will fall so quickly that no one can take advantage of the information. Furthermore, technical analysis does not seek to explain the price of a share. It is mainly concerned with generating buy/sell signals for traders. In Figure 4.3, for example, technical analysis is not seeking to justify the price P1 as the lowest price at which the market will value this share. There is no suggestion that P1 reflects any fundamental characteristics of the share. It merely says that however the market values shares, recent experience tells us that the price of this share is unlikely to fall below P1. Nonetheless, in spite of its lack of intellectual foundation, technical analysis remains very popular.

Lear

ga nin ct

4f

Compare the information required in order to judge whether a share should be bought (or sold) using fundamental analysis and technical analysis.

eedb ac

y ivit

4f

Fundamental analysis claims to be able to explain the fair or correct price of a share. If the market price is below (or above) the fair price, then that is a signal to buy (or sell). The calculation of the fair price is based upon the ability of the share to generate future income for the holder. Hence the first issue is the size of dividends that the share is likely to deliver in future and that in turn depends upon the starting level of dividend payment (the most recent dividend paid) and the rate of growth of dividends in future. (It is sometimes argued that it is the future level of profits rather than dividends that matter since profits retained within the firm still belong to the shareholder). However, because the income lies in the future, each payment is worth less than it would be if received now and so it has to be converted to a present value by the process of discounting. The rate at which the dividends are discounted depends upon the rate of return on assets of similar risk and this can be broken down into the risk-free rate of interest plus a risk premium. In summary we need to know: the latest dividend; the growth rate of dividends (or profits); the risk-free rate of interest and the risk premium. Technical analysis makes no claim to provide a fair or correct valuation of an asset. Instead, it looks at the current pattern of price behaviour and compares it with the past. This history has then to be made to reveal patterns. This is done by using a number of statistical tools like trend lines, moving averages and so on which, when applied to the data, may show up significant patterns. However, what constitutes a significant pattern is a matter of judgement, and may not be the same for all shares. For example, one share may show that after it has met the resistance level three times it

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eedb ac

4f
continued

breaks through on the fourth occasion. This need not be true for another. Hence the requirements of technical analysis are: a detailed record of past price behaviour; a range of statistical techniques, and individual judgement.

Recommended reading: Howells and Bain (2008) Portfolio Theory, Asset Pricing and The Equity Market; Howells and Bain (2007) Capital Markets; Piesse et al (1995) Valuation of Financial Instruments.

Lear

ga nin ct

4.4 The required rate of return

In section 4.3, we established that the term, K, with which we discount the future cash_ flow in order to find the fair value of a share is also the required rate of return, K. We need now to consider how this is arrived at. We already have some clues. We have said that the rate at which we discount any future cash flow from an asset must incorporate the general level of interest rates and a risk premium. This is because our required return must be based upon what we could earn on similar assets. It makes no sense to discount at a rate which can only be earned on another asset with, say, twice the level of risk. Hence, our choice of discount rate must focus on these two elements: the general level of interest rates and a risk premium. In orthodox finance theory it is generally assumed that all the essential features of financial assets can be described under just two headings: return and risk. Since an investment decision is concerned with return and risk in the future we have to form some expectation. One simple way of doing this (but it is not without dangers) is to look at what has happened in the past. Hence if we are interested in the rate of return on an asset that we might be considering for purchase we might look at the average of a series of outcomes measured over a period of time. Hence if we let Ke stand for the rate of return that we expect, then: Ki Ke = [4.11] n where Ki is each one in a series of returns and n is the number in the series. In finance we think of risk as: the probability that the out-turn is different from what is expected. Different from what is expected means different from K and once again we can look at past data and see how widely dispersed around the average K were the individual Kis. This is done by calculating the variance (or standard deviation) of returns around the mean value. The variance is found by: (Ki Ke)2 n and the standard deviation is the square root of the variance, . Var = 2 = [4.12]

4g

You are given the following returns on two shares, A and B, for the last eight years. Find the expected return and the variance and standard deviation for each. A: 5, 8, 3, 6, 9, 11, 7, 6 B: 3, 7, 2, 8, 14, 13, 9, 4

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eedb ac

A: Expected return = 55/8 = 6.875 Variance = (5 6.875)2 (8 6.875)2 (3 6.875)2 (6 6.875)2 (9 6.875)2 (11 6.875)2 (7 6.875)2 (6 6.875)2 3.516 1.266 15.016 0.766 4.516 17.016 0.016 0.766

4g

2 = 42.878 = 6.548 B: Expected return = 60/8 = 7.5 Variance = (3 7.5)2 (7 7.5)2 (2 7.5)2 (8 7.5)2 (14 7.5)2 (13 7.5)2 (9 7.5)2 (4 7.5)2 20.25 0.25 30.25 2.25 42.25 30.25 2.25 12.25 2 = 113.00 = 10.63

portfolio capital asset pricing model (CAPM)

In the light of this discussion, we might therefore think that if we want our required rate of return to incorporate some recognition of the riskiness of the asset, we should look to the variance (or standard deviation). But we do not. This is because the standard deviation measures the riskiness of an asset held in isolation. And this is not what people do. They hold assets in combination in a portfolio and this has major consequences for the risk that we are concerned with. In fact, we get both the general level of interest rates and the price of risk from what is called the capital asset pricing model (CAPM).

diversification

market risk

specific risk

Our starting point is that no rational investor will hold risky assets in isolation. This is because, by combining assets in a portfolio, we can reduce the level of risk associated with any particular rate of return. This is a process known as diversification and the way in which this works is demonstrated in any textbook dealing with finance or financial markets (see Howells and Bain, 2008). Briefly, diversification yields benefits because risky assets suffer from risk which is unique or specific to that asset and risk which arises from events that affect the whole market for risky assets. Events giving rise to market risk will affect the return on all assets in that market. By contrast, events giving rise to specific risk will only affect the asset concerned. While each asset in the portfolio will be subject to its own specific risk events these will occur to some degree independently across assets. When one asset receives a negative shock, there is a chance that another asset will experience a positive shock. Consequently, there will be some tendency for these shocks to offset each other and thus to stabilise the return to be expected from the portfolio.

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Lear

ga nin ct

4h

Imagine that you are analysing shares in a pharmaceutical company. Can you think of two events that represent market risk and two events that represent specific risk?

eedb ac

y ivit

4h

Examples of market risk are a change in interest rates (which causes all asset prices to move in the opposite direction). A slowdown in the economy would be another. An increase in taxation would also have a negative effect on prices as would a rise in the general level of uncertainty about the future direction of the economy. Examples of specific risk could be the results of the trial of a new drug, the expiry of a patent protecting the profits from an existing drug and a change in public policy towards the approval of drugs for use in a publicly-funded health service.

Figure 4.4 shows the risk-reducing effect of diversification. Notice that it is market risk that is progressively reduced as the portfolio is expanded and that the maximum effect is achieved with about 20 assets in the portfolio.
Portfolio risk p

Specific risk

Market risk

10

15

20

Number of assets

Figure 4.4: Benefits of diversification The capital asset pricing model starts, therefore, from the idea that the relevant risk that we have to consider in pricing an asset is not the assets total risk since some of this will be eliminated by its being added to a portfolio. What is eliminated is the specific risk. What remains, and what really matters, is the degree of market risk in the asset. And we can assess this by asking does it respond to market fluctuations in line with some average or benchmark, or is it more or less sensitive? Since we have established that a rational investor will only add the asset to a fully-diversified portfolio, then the obvious benchmark is the riskiness of the portfolio. And since the fully-diversified portfolio is a portfolio containing the whole set of risky assets, the benchmark must be set by the way in which this whole market portfolio responds to market fluctuations. When we know this, we can then compare our asset with this benchmark and this will give us an assessment of its relevant risk.

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beta coefficient

Figure 4.5 is a scatter diagram. It plots the return on the whole market portfolio, KM on the horizontal axis. On the vertical axis, we have the return on the individual asset, call it Z. We can then draw a line of best fit in order to see how a change in KM is related to a change in KZ. The relationship will be captured by the slope of the line. Alternatively, we could run a statistical regression of KZ on KM and the relationship would be expressed by a term called beta (the beta coefficient). This is the slope of the line in Figure 4.5. In the present case, the slope of the line appears to be rather steeper than 45-degrees and so the value of Z appears to be slightly greater than one. An asset with = 1 has the same exposure to market risk as the whole market portfolio while < 1 indicates less exposure (a defensive asset) while > 1 suggests greater exposure that the whole market portfolio. For purposes of illustration, we shall suppose that the value of Z is 1.1
return on assset Z, KZ%

KZ KM = KZ KM

return on market, KM%

Figure 4.5: The beta coefficient This takes us half-way to finding a price for the risk in asset Z since we now know the quantity of relevant risk. To complete the price calculation we now need to know the unit price of relevant risk. We can find this also by reference to the whole market portfolio. Remember that the whole market portfolio is exposed only to market risk, therefore, whatever is the return on the whole market portfolio, over and above the risk free rate, must be the market price of risk. For example, suppose that the whole market return is 12 per cent pa while the risk-free rate is four per cent, then we may say that the market price of risk is eight per cent. And if the quantity of relevant risk in asset Z is 110 per cent of the whole market, then we can say that the price of risk in Z is 1.1 times eight per cent or 8.8 per cent. This is the return that is required over and above the risk free rate and so the total return that we should expect to earn from Z is 8.8 + 4 = 12.8 per cent. In general terms, we can write the calculation as follows: KZ = Krf + Z(KM Krf)
market risk premium

[4.13]

where KZ is the required return on Z, Krf is the risk-free rate of interest (which we might take to be represented by the policy rate or something similar that we discussed in earlier units), Z is the quantity of relevant risk in Z and KM Krf is the market risk premium or the market price of risk. Expression [4.13] is known as the capital asset pricing model.
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Learning activity 4i gives you the opportunity to work another example.

Lear

ga nin ct

4i

(a) Assume that the risk free interest rate is three per cent while the whole market return is 14 per cent. What rate of return would you require from an asset, Q, with a -coefficient of 1.15? (b) What rate of return would you require if the risk-free rate rose to four per cent, all else unchanged.

eedb ac

y ivit

(a) KQ = 3 + 1.15(14 3) = 3 + 12.65 = 15.65%. (b) KQ = 4 + 1.15(15 4) = 4 + 12.65 = 16.65%. Notice that all else unchanged means that the market risk premium is unchanged and therefore the return on the whole market portfolio must increase from 14 to 15. And this is sensible enough, since risk free assets now pay an extra one per cent, one would expect risky assets also to pay more.

4i

Now that we can find the required rate of return on assets with differing degrees of market risk, we can go back to [4.3] and see how things like the risk-free rate, the shares beta-coefficient and the market risk premium all enter into the fundamental determination of share prices. For an illustration, we go back to the case of Thornbury plc in learning activity 4d. You will recall that Thornbury had paid a last dividend of 6p while its earnings had been growing steadily at about 10 per cent pa. We used the 12 per cent rate of return required by shares in this sector as a guide to what we needed from Thornbury and we calculated a price of 3.30. But we can now do better than that since we can decide exactly what rate of return we require in the light of its risk and other factors. For example, suppose that when plotted against the whole market rate of return for the last ten years, Thornbury appears to have a beta-coefficient of 0.9. The risk free rate of interest at the moment is three per cent while the return on the whole market portfolio is 14 per cent. All else remains as before. Then we can find the fair price of Thornbury in two stages. Firstly, we find the required rate of return as follows (where the subscript T stands for Thornbury). KT = 0.03 + 0.9 (0.14 0.03) = 0.03 + 0.099 = 0.129 or 12.9% [4.14] Notice that we have done the calculation using percentages expressed as decimals rather than whole numbers. This is because we need the result in that form for the next step which takes us back to [4.3]. To find the price, we do as we did before: PT = 6(1.01) 6.6 = = 227.59 or 2.28 0.129 0.1 0.029 [4.15]

Notice that the slightly higher return required from Thornbury in this case has resulted in quite a significant fall in Thornburys share price. We can now summarise the CAPM as follows:

The market will price an asset such that its rate of return will be equal to the risk-free rate of interest plus a risk premium which depends upon the market price of risk and the quantity of market risk contained within the asset. 85

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Lear

ga nin ct

4j

In learning activity 4d, we saw what would happen if Thornbury expanded into a new line of business which was rather more risky than the manufacture of chocolate. We predicted that the required return would go up and therefore that Thornburys share price would fall. W can now be more precise about this. Using the data that we had in learning activity 4d, what would happen to the required return and the share price if Thornbury were reorganised so that 80 per cent of the firm continues in chocolate making while 20 per cent of the firm is switched to luxury catering? The beta-coefficient of firms in the luxury catering industry is 1.1. (Hint: think about Thornburys betacoefficient.)

eedb ac

y ivit

4j

Step one: Recalculate Thornburys beta. When 100 per cent of the firm was making chocolate T was 0.9. Under the new structure, the beta-coefficient must be a weighted average of the two betas: T = 0.8(0.9) + 0.2(1.1) = 0.72 + 0.22 = 0.94. Step two: Find the required return: KT = 0.03 + 0.94 (0.140.03) = 0.03 + 0.1034 = 0.1334 or 13.4% Step three: Reprice the share using the new rate of return: PT = 6(1.01) 6.6 = = 197.60 or 1.98 0.1334 0.1 0.0334

Recommended reading: Howells and Bain (2008) The Equity Market; Piesse et al (1995) The Equity Market.

4.5 The trading of company shares

The users of equity markets are the ultimate lenders and borrowers that we identified in Unit 1. In this particular case, the borrowers are large corporations. The ultimate lenders are households, who may hold company shares directly or, more usually hold them indirectly through financial intermediaries that manage pension or mutual funds or life assurance policies. In the UK, most equities are bought from and sold to market makers, directly by large financial corporations or for households via a broker. Market makers hold stocks of all the company shares in which they make a market and it is a condition of their membership of the exchange that they quote continuous two-way prices at which they are prepared to deal. This means that sellers can always find a buyer for their shares and buyers can always find a seller. The price at which they are prepared to deal (in fact a spread between a buying and selling price) is up to the market maker. Hence, when sellers exceed buyers, market makers will reduce their price in order to restore a balance and the media report the market falling (or rising). The consequence of this trading arrangement is that London is known as a quote-driven market, meaning that what drives or causes a transaction is the price that is quoted. Buyers and sellers are motivated. by what they think is a good price.

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This is not the only way to organise trading in shares. New York Stock Exchange (NYSE) Euronext, which calls itself the first global stock exchange was a pan-European exchange with subsidiaries in Paris, Amsterdam, Brussels and Lisbon until it merged with the New York Stock Exchange in April 2007. The Euronext exchanges work on a matching principle. This means that buyers and sellers place their orders without knowing the price at which the transaction will take place. (They know the price of the last transaction and they can place upper and lower limits to the price they will accept.) The exchange technology then tries to match the order with an opposing one so that shares are passing directly from buyer to seller without an intermediate market maker. If the order is not filled after a certain time it can be withdrawn. In London, investors have the option to trade the top 100 shares in this way, or through a market maker. Such markets are known as order-driven markets since what causes a transaction to take place is an order to buy or sell. There is no clear-cut advantage to either system. Quote-driven markets tend to have higher transaction costs since the market makers must cover their costs and earn a profit which provides an adequate return to compensate for the risk they face by holding large stocks of securities on their own books. On the other hand, the same markets have the advantage that buyers and sellers can be certain about the price at which the deal will take place before thy issue the instruction. The arrangements that we have just set out describe the trading arrangements in what is called the secondary market for shares. This is the market in which existing shares are traded. But it is possible also to talk about a primary market as we saw in 3.5 the market which deals with new issues. It is the primary market that channels new funds from lenders to borrowers; trading in the secondary market involves the transfer of ownership of existing shares. In most cases, the organisations involved are the same as those that are making the secondary market. When it comes to trading, secondary market activity dwarfs new issues (as we saw in the case of bonds). Table 4.3 shows recent data from the London Stock Exchange.

No. of listed companies1 1,458

Market cap. bn1 3,252.3

Funds raised by new issues bn2 60.4

Turnover bn2 10,229.1

No. of trades, mn2 144.8

Notes: 1. At end October 2009; 2. 1 January to 31 October 2009

Table 4.3: The London Equity Market, 2009

Source: London Stock Exchange (2009) Market Statistics, November

The table shows new issues raising 60.4 billion in the ten months to the end of October 2009 while total transactions in the secondary market amounted to more than 10,000 billion. The difference between the two shows just how much trading is the consequence of portfolio adjustments investors selling one existing stock and buying another and it also gives us an understanding why, in spite of being strictly speaking irredeemable instruments, company

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shares are made highly liquid. The table also shows the number of companies whose shares are listed on the exchange and the total market value of those companies. Table 4.4 allows us to make some rough comparisons of size. Unfortunately this data is available only at end-October 2008. Furthermore, national values are converted into $US which facilitates comparisons within the table but in order to make comparisons with Table 4.3 the monetary values in Table 4.4 should be divided by about 1.6. Exchange No. of listed companies1 2,382 2,999 1,254 ,863 1,026 ,855 2,414 Market capitalisation, US$bn1 10,312.7 02,579.5 01,228.5 01,341.0 02,083.6 01,097.0 02,884.4 Turnover, US$bn2 30,214.8 13,618.6 1,458.6 2,184.0 4,050.9 3,526.2 4,902.6 No. of trades mn2 3,476.5 1,826.6 92.1 1,034.2 0 165.6 0 128.2

NYSE NASDAQ Hong Kong Shanghai Euronext (exc NYSE) Deutsche Brse Tokyo

Notes: 1. At end-October 2008; 2. 1 January to 31 October 2008

Table 4.4: Selected stock markets

Source: Focus, November 2008 (Paris: World Federation of Exchanges), pp3648.

As well as notable, but expected, differences in size, there are some other interesting points to note. Firstly, the US NASDAQ market (a market for mainly hi-tech firms) has a large number of firms each with a relatively small value. At the same time it is a very active market since the total value of trading to endOctober 2008 was over five times the market capitalisation at the end of October. This compares with rather more than three for London and barely over one for Hong Kong.

Lear

ga nin ct

4k

In most exchanges, the value of funds raised in any period is dwarfed by the amount of trading in the secondary market. What useful purpose (if any) is served by this high volume of secondary market trading?

eedb ac

y ivit

4k

The existence of an active secondary market is essential if shares are to have any liquidity. Without an active market, investors would be very unwilling to hold shares and firms would have to pay a much higher price for their capital. Related to this an active market helps investors to adjust their

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eedb ac

4f
continued

portfolios in response to what they see as profitable opportunities or in response to their own changing needs. The price of shares is set in the secondary market and the movement in share prices may convey useful information. First of all it tells the firm what it will have to pay if it wishes to raise new funds. It also tells the firm how its performance is judged by the market. For example, a declining share price may be an early warning to management that investors have lost confidence in the current strategy and that there should perhaps be a rethink.

Price,

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In economics, it is customary to analyse the functioning of markets within a supply and demand framework. We do this in Figure 4.6 which is essentially the same as Figure 3.2 in our discussion of the bond market. Firstly, we are looking at the price of existing shares, so we are looking at the secondary market where the quantity is fixed. Hence the supply is shown by the vertical supply curve, S. Initially, demand is shown by D. The demand curve is downward-sloping because, other things equal, shares are more attractive at a lower price since (we know) their rate of return is higher. For purposes of illustration, let us suppose that we are looking at the market for shares in Thornbury plc. Then initially, then we have an equilibrium price of 2.28 (from [4.17]). In learning activity 4j we then looked at what would happen to the Thornbury share price if it changed its business model by moving into luxury catering. This increased its risk and we saw that the price fell to 1.97. This is shown in Figure 4.6 by the downward shift of the demand curve from D to D. We could, if we wished plot the corresponding rates of return on a right-hand axis.
S

2.28 1.97 D D

0 quantity of shares

Figure 4.6: The equity market As with bonds, the lesson to be learned from Figure 4.6 is that the pricing discussions in section 4.3 should be interpreted as operating on the demand side of the market. When we calculate the present value of a future dividend stream we are calculating what price holders should be prepared to pay. Any change in that present value corresponds to a shift in demand. 89

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Case Study
Wilton Wanderers plc is a football club. Its shares have just paid a dividend of 30p. Nine years ago, the dividend was 10p. The shares have a -coefficient of 1.3. Assume that three-month treasury bill rates are six per cent and the return on the FT All Share index is 18 per cent.

Lear

ga nin ct

4l

1. Estimate an appropriate price for the shares today. Explain any assumptions you have had to make. Using a supply and demand diagram (like Figure 4.3) show the equilibrium price for Wilton Wanderers plc on the vertical axis. The board of Wilton Wanderers announces that it has just signed a new striker whose addition to the team will help ensure promotion at the seasons end. The likely effect of promotion will be a big increase in profitability. If the club maintains its current dividend policy, for example, next years dividend is likely to be of the order of 40p. Assume that everything else is expected to be largely unchanged. 2. Use the diagram to discuss the likely immediate effect upon the share price. Suppose that Wilton Wanderers is not successful in its bid for promotion, and that several other football clubs who have spent large sums of money on star players also fail to get promotion, win trophies and so on when they were widely expected to do so. 3. Explain how this is likely to affect the price of shares in football clubs generally, using the terms in [4.3].

eedb ac

y ivit

4l

1. The required return can be estimated as 0.06 + 1.3(0.18 0.06) = 0.216 or 21.6%. The growth rate of dividends is such that they have grown from 10p to 30p in nine years. We can use a compound interest table to find the rate of growth, which would cause a value to triple in nine years. The table tells us that this is 13 per cent to a very close approximation. The next dividend therefore we would expect to be 33.9 (= 30 1.13). We can now solve for the price. P = 33.9 + (0.216 0.13) = 33.9 + 0.086 = 394.2 or 3.94. In arriving at this figure, we have had to take three-month treasury bill rate as a proxy for the risk free rate and the return on the FT All Share index as a proxy for the whole market portfolio. Neither of these is absolutely correct in theory, but both are commonly used as the best measures that are readily available. In using compound interest tables to find the dividend growth rate, we have assumed that dividends have grown at a constant rate and, more importantly, we have assumed that that constant growth rate will apply in the immediate future. 2. The news of the signing suggests the possibility of higher profits and shareholder dividends in future. Assuming that investors share the managements optimism about promotion and its estimate of the effect on profits, the shares will be more attractive compared with those of

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eedb ac

4l
continued

other football clubs. The demand curve will shift out and the price will rise. Since we are told that everything else is expected to remain unchanged (once in the higher division, for example, the dividend growth rate will be much as before), we can calculate a new price by substituting the new dividend. In the diagram, the demand curve shifts out and the new equilibrium price on the vertical axis will be 4.65. 3. We would expect their share prices to fall. If the question related only to the share prices of the individual clubs whose achievements disappointed, then we might explain the fall by reference to lower dividends, D1 (and possibly lower future earnings growth, g). But the question asks how and why the shares of all football clubs might be affected. The most promising explanation is that the degree of risk involved in earning profits in football is made clear to shareholders. Notice it is not necessary that there is any objective change in the level of risk it is investors perceptions that drive prices. If, for some reason, they had become complacent (because large transfer deals had hitherto seemed to pay off) then a run of contrary cases may serve to remind them that football is a very risky business. If we are right, then the effect falls upon the -coefficients of shares in football clubs. This means that investors in football shares require a higher risk premium in future and this, in turn, results in a higher overall required rate of return. In [4.3], the value of K increases (and share prices fall).

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k
4.1 4.2 4.3 4.4

Self-assessment questions
Explain the terms: (a) market capitalisation (b) dividend yield (c) price/earnings ratio. A security with a -coefficient of 0.8 has a return of 16 per cent pa while another security with -coefficient of 1.2 has a return of 20 per cent pa. Assuming that both securities are correctly priced: (a) find the risk free rate of interest (b) find the return on the whole market portfolio. You have 100,000 to invest and you propose to create a portfolio of five shares. The distribution of the portfolio and the -coefficients of the shares are as follows: A: 10,000 1.1 B: 30,000 1.4 C: 25,000 0.9 D: 28,000 0.8 E: 7000 0.7 Given the risk free rate and whole market returns in Q4.2, find the rate of return required on this portfolio as a whole. A close friend has 20,000 invested in the shares of XYZ plc. The last dividend was 17p while earnings have been growing at nine per cent pa. The risk free rate is eight per cent while the whole market return is 18 per cent. The shares have a -coefficient of 1.13 and are currently trading at 200p. What advice would you give her? 91

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4.5

Wilton Wholefoods plc is a catering company which operates three divisions. The following table shows the amount of capital allocated to each activity. The table also shows the beta-coefficients for the shares of companies which specialise in these activities. Division Cafs Wholesale supply Restaurants Capital m 30 50 20 Beta 1.2 0.8 1.4

Table 4.5: Capital and beta for Wilton Wholefoods divisions (a) If the risk free rate is current six per cent while the whole market return is 15 per cent, calculate the rate of return that shareholders in Wilton Whole foods will require. Suppose that Wilton decides to reduce its wholesaling activity and start up a natural fruit juice brand using 20 million of existing capital. The shares of firms specialising in health drinks show beta coefficients around 1.0. What effect is this restructuring likely to have on the return required by Wiltons shareholders?

(b)

4.6

Explain what is meant by a quote-driven continuous market for securities. What advantages does it have over other types of trading arrangement?

Feedback on self-assessment questions

4.1 Market capitalisation usually refers to the current market value of a firm. For an all-equity firm this is found as share price number of shares in issue. Occasionally, market capitalisation refers to the value of all the firms quoted in the market (that is it is one measure of market size). In this case, we merely sum the market capitalisation of all firms. Dividend yield measures part of the rate of return on a share. It is found as dividend payment per share share price. It ignores the return that may come in the form of capital appreciation, but is obviously important for investors looking primarily for income from their shareholding. The price/earnings (or P/E) ratio expresses the price of a share relative to the earnings (profits) of a firm per share. Thus, it expresses the price one has to pay to buy a share of the firms profits. Notice that we are interested in the price of profits rather than dividends. This is consistent with the view that it is profits that increase shareholder wealth whether they are paid out as dividends or not. 4.2 (a) You have the data for two versions of the CAPM: 0.20 = x + 1.2(y) (i) 0.16 = x + 0.8(y) (ii) Subtract (ii) from (i) and we have 0.04 = 0.4(y). Therefore y = 0.1. Next, substitute 0.1 in (i) which gives us 0.20 = x + 1.2(y) and 0.2 = x + 0.12. Therefore x = 0.2 012 = 0.08 and so the risk free rate is 0.08 or eight per cent.

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(b)

We can now write (i) as: 0.20 = 0.08 + 1.2(KM 0.08) and then 0.2 0.08 = 1.2(KM 0.08).

0.2 0.08 = KM 0.08. Then 0.1 = KM 0.08 and KM = 0.18 or 18%. 1.2 4.3 4.4 The weighted average of the beta values = 1.028. Therefore: 0.08 + 1.028(0.1) = 0.1828 or 18.28% Firstly, find the required return. K = 0.08 + 1.13(0.180.08) = 0.193 Then the fair price is: 17(1 + 0.09) = 179.9 0.193 0.09 So the correct price is 180p. The advice should be to sell and this could be explained either in terms of the required return (the return is insufficient at 200p) or in terms of risk of capital loss (the price will fall when the market discovers the mistake). 4.5 (a) We first need to find a beta-coefficient for Wilton. This is the weighted average of the betas for its three divisions. So, = 0.3(1.2) + 0.5(0.8) + 0.2(1.4) = 0.36 + 0.4 + 0.28 = 1.04. We then use this in the CAPM formula: K = 0.06 + 1.04(0.15 0.06) = 0.06 + 0.0936 = 0.1536 or 15.36% (b) We do the same for the four divisions of the restructured firm. = 0.3(1.2) + 0.3(0.8) + 0.2(1.4) + 0.2(1.0) = 0.36 + 0.24 + 0.28 + 0.2 = 1.08 We then use this in the CAPM formula: K = 0.06 + 1.08(0.15 0.06) = 0.06 + 0.0972 = 0.1572 or 15.72% 4.6. A quote-driven market is one where buyers and sellers are confronted by prices (quotes) at which market makers are prepared to deal. The price is known before the deal is made and thus the quoted price could be regarded as the central factor triggering the decision to buy or sell (hence quote-driven). Such a market requires dealers to hold inventories of the stocks in which they are prepared to deal. When they buy from sellers, they add to these stocks and when they sell to buyers they reduce these stocks, at least temporarily. Because of the cost and risk involved in holding these stocks, quote-driven markets tend to be more expensive to operate than auctioneer markets. Continuous means that prices must always be quoted for the stocks in which dealers are prepared to make markets. They cannot, for example, stop quoting a buying price when they find that they have surplus stock. The requirement that market makers quote continuous two-way prices is a strict rule of membership of any stock exchange which uses this type of trading. Much trading on the London Stock Exchange is carried out in this way as it is also on the NASDAQ exchange in the USA. The main advantage of these arrangements to shareholders is that they know what price they will deal at before deciding to deal. This limits their exposure to the risk that the price may change between the moment of their decision and the recording of the deal. If prices do move in this period, the effect falls on the market maker. In auctioneer markets, by contrast, there is usually some uncertainty 93

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about the final price at which the deal will be carried out. If limits are placed on the price then it may be that no deal will be done. In these circumstances, shareholders face a degree of risk which is not present in quote-driven markets. Quote-driven markets have the advantage of lower risk to shareholders but this is compensated by the higher transaction costs that we referred to above.

Summary
In this unit we have looked at another of the major capital markets. We have seen what company shares are, how they are priced, used and traded. Having finished this unit you should now be able:

to describe the key characteristics of shares and their uses and to retrieve and understand share price data to price shares according to their fundamentals and to show how, other things being equal, the price varies with the rate of return to analyse the role of risk in determining the required return on shares to show how that required return helps determine the share price to understand something of the institutional arrangements for the trading of shares.

Appendix: More on divided valuation

Variations on the basic Gordon model include dividend discount models with differential rates of growth. For example, rather than assuming a constant rate of dividend growth, we might think it more realistic for firms to go through a rapid growth phase (in its early years) followed by a slower rate of growth in its maturity. Or we might even add a third, possibly slow or even declining phase, when the growth rate is slow or negative. If we are pricing the shares in any phase but the final one, we need to take account of the fact that the growth rate will change at some point in the future. For example, if we assume a two period growth model, then we do two separate valuations and then add them together. We value the dividends received in the first phase and then find a separate value for the subsequent phase, discount this back to the present and add it to the value for the first. This sounds more complex than it is. Consider the following example where the last dividend payment was 55p and this is expected to grow rapidly for two more years at ten per cent when the firm will enter a long-term slower growth phase of six per cent pa. The required return is 14 per cent. The formula is shown below.
T

P0 =

t=1

D0 (1 + g1)1 1 . DT+1 + (1 + K)1 (1 + K)T K g2

In [4.11] the rapid growth takes place for T periods, and so the first part of the expression values the dividends growing at the rapid (g1) rate. At time T we are then faced with a slow rate of growth (g2). Thus, the final part of the expression values this infinite stream of dividends in the same way that we did in the constant growth model [4.3]. But to find the present value of the dividend stream at T we need to discount this back to the present by the middle part of the expression, 1/(1+K)T.

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This sounds more complex than it is. Consider the following example where the last dividend payment was 55p and this is expected to grow rapidly for two more years at ten per cent when the firm will enter a long-term slower growth phase of six per cent pa. The required return is 14 per cent. P= = 0.55(1.1) 0.55(1.1)2 1 . 0.55(1.1)2 1.06 + + 2 1 + 0.14 (1.14) (1.14)2 0.14 0.06 0.605 0.6655 1 . 0.70543 + + 1.14 1.2996 1.2996 0.08

= 0.5307 + 0.51208 + (0.7695 8.8178) = 1.04278 + (6.785) = 7.83 If we had priced this on the assumption of the single, slow growth rate (using [4.3]) the value would have been 7.29. The difference is the result of the two years of rapid growth.

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Unit

The efficient market hypothesis (EMH)

We all invested in a few [dotcoms]. You look at it now and think you must have been crackers.
London fund manager speaking on BBC radio in 2002

Introduction
In the last three units we have seen how selected assets are priced by reference to their fundamentals. In this unit we look at the argument that this is generally the case and hence that assets are, in general, correctly priced. Unit learning objectives On completing this unit, you should be able to: 5.1 Explain the basis and the implications of the efficient market hypothesis. 5.2 Provide a critical analysis of the hypothesis using data from the 2008 financial crisis and elsewhere. 5.3 Demonstrate an understanding of recent contributions from the field of behavioural finance.

Prior knowledge The unit assumes that you have studied Units 14. Otherwise, it requires no prior knowledge, but some basic mathematical skills and familiarity with basic economics and finance is helpful throughout. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: Financial Market Efficiency). In Piesse et al (1995) The Structure of Securities Markets and The Equity Market have some relevance. Mishkin (2007) The Stock Market and the Efficient Market Hypothesis deals with the efficient market hypothesis in some detail, as do many other finance textbooks.

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The efficient market hypothesis (EMH)

5.1 The basis and implications of the EMH

Recommended reading: Howells and Bain (2008) Financial Market Efficiency; Mishkin (2007) The Stock Market and the Efficient Market Hypothesis.

operational efficiency

When we use the term efficient in everyday language we describe something which works well. It delivers the service or the action that we require and it does so with great reliability, and perhaps quickly and cheaply as well. Clearly, we would like a financial system to be efficient in this sense. We would like to know that if we instruct a bank to make a payment to someone on our behalf, the payment is made promptly and goes to the right person. Equally, if we ask a broker to make a bond sale or purchase for us we do not expect the broker to lose the contract note or the exchange to fail to record the transaction. We might call this kind of efficiency operational efficiency. In Unit 1 we made the point that a fundamental purpose of a financial system is to channel funds from lenders to borrowers. When it comes to connections between the financial system and the real economy, therefore, we should like to know that financial markets and institutions will generally channel funds to their most productive use. Generally, this means ensuring that funds go to their most profitable use. If this happens, then firms that are producing goods and services that are in high demand will find it easier to raise new funds than firms whose output is less valued by society. This kind of efficiency might be called allocative efficiency, since it refers to the way in which financial resources are allocated. But the efficiency with which we are concerned in the EMH is something different. This efficiency refers to the way in which information is used and is called informational efficiency. The EMH says that financial markets make the best possible use of all available information. Notice that although the EMH is often discussed by reference to equity markets and tests of the EMH often study share price behaviour, the principles underlying the EMH apply to all financial (and even to non-financial) markets. There are numerous studies of the EMH that use evidence drawn from foreign exchange markets. What is meant by best is not often spelled out carefully. We all know that best means quickly and completely so that all relevant information is incorporated into asset prices so quickly that no one enjoys a sustained information advantage from which they can earn a rate of return in excess of the normal return for a given level of risk. However, the EMH is often presented as meaning that information is quickly incorporated and that the information is used in such a way that prices are generally correct according to their fundamentals. This is another way of saying that the users of the information are incorporating the relevant information into the correct model of asset pricing and that this model is like those we used in Units 2 4. And it is the two propositions together: speed/completeness and correctness, that give the EMH its immense significance. If the EMH holds in its entirety, then it follows that the way that markets behave cannot be improved upon and the fluctuations in prices that we see are somehow correct. Everything is for the best. This has always been a controversial claim and it has become doubly controversial since the 2008 financial crisis. In the rest of this section, we look at the two propositions separately (in section 5.1). We then look at the implications of the EMH, before going on to consider the EMH in the light of evidence (section 5.2) and in the light of some alternative explanations of behaviour (section 5.3).

allocative efficiency

informational efficiency

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Lear

ga nin ct

5a

Distinguish between the meanings which can be attached to efficiency when applied to financial markets.

eedb ac

y ivit

5a

Operational efficiency: The market carries out its functions, quickly, accurately and with low transaction costs. In the case of financial markets, security is an additional characteristic of operational efficiency. Allocative efficiency: The market allocates resources to their most productive use. Resources in the case of financial markets can be read as funds. Informational efficiency: The market makes the most efficient use of all relevant information. Most debates about financial market efficiency are about informational efficiency.

Being well-informed
The starting point of the EMH is that agents are:

rational self-interested.

Together, these assumptions mean that agents will always try to do the best that they can for themselves, and this includes using information as effectively as possible. This includes learning. If one situation is known to lead to another, and we use that information in order to anticipate the second state, then our rationality says that we do this all the time; we do it consistently. We do not use the information sometimes and then ignore it at others. And the reason that we use this information consistently is guaranteed by our self-interest. If we treated our learned information in a casual way, using it sometimes and rejecting it at others, we should be forgoing profitable opportunities. We shall come back to criticisms of these assumptions in section 5.3 but it is worth making the point that they are very attractive assumptions and that the foundations of most economics rests upon them. This makes it difficult to reject the EMH. Rejection seems to require either that we think people do not behave rationally and/or that that they are not fundamentally motivated by selfinterest. Economists are reluctant to accept either. If we confine ourselves now to security markets then the EMH says that: security prices fully reflect all relevant information and since we know (from Units 24) that prices and yields are inversely-related, then the EMH tells us that yields (or rates of return) also incorporate all relevant information. At this point we set aside what exactly might be meant by relevant and examine more carefully this notion that information can be processed so quickly and effectively that no one has an information advantage. Looking at rates of return first, we know from Unit 4 ([4.4]) that the total return on a company share is the sum of its dividend yield (dividend divided by price) plus any capital appreciation (or loss). Thus, where K is the rate of return, 98
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P0 is the purchase price, D1 is the dividend paid during the holding period and g is the rate of capital appreciation: K= D1 +g P0 [5.1]

Recall then that the rate of capital appreciation is merely the change in price divided by the price paid, then: K= D1 P1 P0 + P0 P0 [5.2]

where P1 is the price in the next period. Imagine a security, where the next dividend, D1, is known. (In practice of course it will not be known with certainty but if the EMH holds then it will be forecast correctly on average.) Then the rate of return, Ke, expected at the beginning of the period, is uncertain by virtue of the fact that we do not know, but can only form expectations of, P1. Thus: P P0 + D1 Ke = 1 [5.3] P0
optimal forecast

Since efficient market theory argues that people use all available information in forming expectations of future events, then Ke is an optimal forecast of K, and since making an optimal forecast of K requires that we make an optimal forecast of P1, then Pe1 must be an optimal forecast of P1. Thus: Ke = K and P1e = P1 where signifies an optimal forecast. As we have just seen, this is an attractive argument since the alternative means that agents do not try to make the best forecast of returns and this goes against our deep-seated beliefs that agents are rational wealth maximisers. Another way of looking at the forces that push agents to make optimum forecasts based on all information is to think of equilibrium prices or returns. By equilibrium we mean those prices which produce rates of return that are _ just equal to what people require, K. Let us call the equilibrium return K* and the corresponding equilibrium price P*. Then it follows that if an optimal forecast of K exceeds the required rate of return, informed investors will wish to buy the corresponding asset in order to benefit from the abnormally high return. Buying the share will cause the price to rise and the forecast return to fall until the optimal forecast just equals the required or equilibrium return. Conversely, if the optimal forecast of returns is that they are below what investors require, then well-informed investors again will try to benefit, this time trying to avoid a capital loss, by selling the corresponding asset. Its price will fall until, again, the optimal forecast return rises to that required by the market. Using our symbols, we can summarise: _ If K > K, PK _ If K < K, PK Failing to make the optimal forecast means that an investor will be exposed to capital loss or may fail to participate in capital gain. Once more, there seems 99 [5.4]

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to be a strong case for the idea that agents make the best use of all relevant information, since they have strong wealth-maximising incentives to make the best forecast they can, whether this is a forecast of rates of return or of price. Notice, however, that while agents may have strong incentives to make optimal forecasts, it does not follow that they will always succeed. This is important, since one way of attacking the EMH is to look for exceptions. But to identify genuine and relevant exceptions we have to be very clear about the limits of the EMH, otherwise we reject it for things that it does not claim. Firstly, the EMH does not say that people use all information in forming their expectations. This would be realistic only if information were costless. We noted above that one of the forces that drives markets towards efficiency is the motivation of traders in those markets. Their incentive to trade efficiently is the desire not to miss profitable opportunities. But it makes little sense to pay more in order to acquire information than what the information is worth when it comes to making a profit. It seems likely that there will be some information that is so costly to acquire that it is not worth using. Hence, we should better say that the EMH implies that prices reflect all that information whose marginal cost is less than the marginal benefit from incorporating it in the decision. In section 5.3 we shall see that behavioural economics, much of which is critical of the EMH, lays great stress on the costs and difficulties of acquiring information and argues that agents give up the effort at quite an early stage and rely on rules of thumb or heuristics with the result that prices/returns may behave quite strangely. Secondly, the EMH does not require everyone to behave as well-informed, rational, risk-averse wealth maximisers. The fact that we can always find some trader somewhere who makes a questionable decision, or that we can show that private investors are often impressed by trivia does not disprove the EMH. Market prices are determined by the actions of the majority. The power of the majority can be argued in either of two ways. The first approach is to argue that while some investors may not be well-informed (often referred to as noisetraders) their irrational trades cancel and leave prices and returns to be determined by investors who are rational and well-informed. Note that this amounts to saying that the decisions of noise-traders are uncorrelated. Alternatively, even if noise-traders do behave in the same way (their decisions are correlated and they reinforce each other rather than cancelling) then profitable opportunities for arbitrage will force noise-traders out of business, leaving pricing to well-informed investors. In section 5.3 we shall see that we can find evidence of correlated irrational behaviour. In these circumstances, the argument that profitable arbitrage means the well-informed will drive out the ill-informed, takes on the role of argument of last resort for the EMH. We shall come back to it. Thirdly, the EMH does not say that prices will always be correct. It merely says that the expectations that people form are the best possible forecasts in the prevailing situation. Thus, it will frequently be the case that our forecast of price in the next period, P1, will be: P1 = P1 + [5.6] where is an error term. What the EMH does say is that there is nothing in the behaviour of the error term which enables us to improve our forecast. If, for 100
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example, were always positive this would mean that our forecast of the price was always too high. In these circumstances, we could improve the forecast by adjusting it downwards. In this example, the error term is systematically positive. In fact, we can always improve the forecast if the error term behaves in any way that suggests a systematic connection with the forecast. We simply have to find out how the error term behaves and make the appropriate adjustment. This leads to an important conclusion which is best stated formally. If our forecasts are to be optimal forecasts (and the EMH holds) then it must be the case that the forecast errors have a mean value of zero and that they have zero covariance with the forecast. Thus, a market can make forecast errors of future prices (and yields) and still be efficient, provided that there was no way of doing anything better. Our presentation of the EMH so far has treated it as a single hypothesis which applies to all relevant information without distinction. However, we have already made the point that information can be costly to obtain and therefore it seems quite likely that if we distinguished some categories of relevant information ranging from the easy to find at one end to the highly specialised at the other, we might well find that the EMH applied more readily to the former than the latter. In fact, since Fama (1970) it has been common practice to talk about three levels or forms of the EMH ranging from weak to strong, on the basis of the information being used as shown in Table 5.1. We assume in the table that the EMH is being applied to equity markets. Form Weak Semi-strong Information Past changes in share prices and any information that is in those price movements Past changes in share prices and any information that is in those price movements + all other publicly available information Past changes in share prices and any information that is in those price movements + all other publicly available information + all relevant private information

Strong

Table 5.1: Levels of efficiency The idea that share prices could incorporate not only all public information, but private information as well, obviously makes the strong form of the EMH very demanding and perhaps hard to believe without some consideration of what exactly may be involved. Private does not mean secret. It refers to information that can only be obtained from the firm itself and is not directly available to the public. Typically it is information that can be obtained by professional analysts who specialise in reporting on selected companies. These analysts will have access to all public information but they will also be briefed by the managers of the firm as to the firms plans and progress. Furthermore, since they are being paid to write reports on these shares for their clients who are major investors, they will want to write the most accurate reports and this
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will involve using their knowledge of the industry to put the briefing information into context that enables them to make an informed prediction about future sales, earnings or whatever. The point that the strong form EMH is making is that the moment these reports are sent to clients, the share price adjusts. Notice that if the strong form holds, this calls into question the value of paying for analysts advice. We return to this when we discuss implications of the EMH. Before ending this discussion of the strong form of the EMH, we need to take a look at the practice that is sometimes described as insider trading since this sometimes causes confusion in connection with the EMH. Insider trading refers to the trading of securities by individuals with potential access to non-public information about the company. In most jurisdictions this is illegal although it is defined and enforced with widely differing degrees of strictness. The USA is generally regarded as taking the strongest line on insider trading though even in the USA there are those like Friedman, Manne and others who argue that insider trading should not be prohibited (Harris, 2003, chapter 19) on the grounds (a) that the trade based on inside information automatically releases that information to the market and (b) that the law is inconsistent in prohibiting the use of inside information in connection with financial markets while permitting it elsewhere. 200910 saw some notable cases of insider trading being prosecuted in the USA and the UK in what was regarded as a co-ordinated crackdown by UK and US authorities. The most spectacular case involved the Galleon hedge fund. In this case US federal prosecutors eventually charged 21 people, including a number of corporate executives, employees of investment banks and the founder of the fund himself with the illegal use of inside information in connection with trades in IBM, Sun Microsystems, Google and Hilton in order to net profits of more than $20 million. By January 2010, eight of them had entered into a plea bargain effectively admitting their guilt. At the other end of the spectrum, in November 2009 the UKs Financial Services Authority brought a successful prosecution against a dentist and his son who had made 110,000. In this case the son had been employed by a City broking firm on a temporary placement and was passing information about forthcoming corporate announcements. The FSA explained its actions thus: Insider dealing is not a victimless crime and we remain committed to stamping out this type of fraud by those trusted with inside information. Insider dealing damages the very confidence that underpins the integrity of our markets (Financial Times, 4 November 2009). However, while insider trading may (or may not) be damaging to the integrity of financial markets, it needs to be kept separate from discussions about the EMH. It certainly must not be used as evidence for or against strong form efficiency. No one has ever doubted that it is possible to profit from criminal behaviour. The EMH is concerned with the use of information obtained legally in properly constituted and well-ordered markets.

insider trading

Lear

ga nin ct

5b

Imagine that you are an analyst working for GRQ investment bank. You specialise in the shares of major retail (non-food) stores. You have six major clients to whom you provide advice. You have just been to a meeting (with other analysts) at the head office of a major chain of department stores. It is half-way through the financial year. At the meeting, you learn:
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Lear

ga nin ct

5b

that the firms earnings so far this year suggest they will meet their target for the full-years profits that they are planning in future to make a large expansion of their teenage fashion department that the finance director will be retiring shortly and will be replaced by the finance director of a rival chain.

continued

eedb ac

y ivit

How might you use this information to make a recommendation to your clients?

5b

The target for full year profits will have been announced at the beginning of the year and this will be known. It is quite likely that the current share price reflects this target (if the target was believable). So there is no reason for the news that earnings are on track to cause you to make a buy/sell recommendation. But the news about the change in business focus might be interesting. You might go and look at the recent performance of stores that specialise wholly in teenage fashion. How have they performed in the last year or so? What is the outlook for consumer spending over the next year. Do forecasts suggest boom or recession? Do we expect a change in interest or VAT rates that might affect household incomes? Does the company have strong leadership in the area of fashion? Similarly with the appointment of a new finance director. What has been the financial record at the firm that he is coming from? What about his earlier history/performance? Is this a good fit with what your company requires? Overall, you are trying to use your experience of the sector and your knowledge of the firm and the wider economy to judge whether these developments are likely to improve the performance of the firm in future, or not.

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Using the information

We know now that a large part of the EMH is concerned with the speed and extent to which information is incorporated in asset prices and yields. The other part of the hypothesis is that this is relevant information and that immediately raises the question of what information is required and the answer to this lies in the model of pricing that is being used. The EMH is usually presented in such a way that, if it holds, then prices (and yields) are somehow correct prices and yields and this means, among other things, that funds will be allocated to their most efficient use. In other words, the model is taken for granted it is the correct one, it focuses on fundamentals and involves discounting future earnings using a discount rate that recognises the market risk to which the asset is exposed. In short, the model is the one that we have been using in Units 24. The relevant information referred to in the definition of the EMH is therefore information relating to fundamentals. But although it commonly assumed that the EMH treats relevance as relevance to fundamentals this does not have to follow from the fact that investors are very well-informed and that information is rapidly incorporated into prices and yields. It could be that the information that agents are using 103

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has nothing at all to do with fundamentals. It can still be very rapidly assimilated. We shall see in section 5.3 that behavioural economics suggests that investors (and therefore prices and yields) are driven by a number of factors which have nothing to do with fundamentals. One of these, for example, is the belief that there is always someone prepared to pay a higher price whatever the fundamentals may be (the bigger fool hypothesis). Hence when prices are rising, investors buy because prices are rising, regardless of what the fundamentally correct price might be. The definition that we have given of an efficient financial market, where this refers to the use of information (even if we add the word relevant) does not itself guarantee the happy outcomes that are often claimed for the EMH. These outcomes depend upon what information is relevant and therefore on the pricing-model being used. If we want markets to be allocatively efficient, we want them to be informationally efficient but we also need to know that the relevant information that is playing its part is information about the assets fundamentals, since it is these fundamentals that are linked to productivity and social rates of return. The situation where markets are informationally efficient and the information involved relates to fundamentals is described by Elton and Gruber (1995) as market rationality. There may be strong evidence for informational efficiency but the evidence for market rationality, as we see later, is much weaker. Company A has two million and Company B has six million shares in issue. On day one prices per share are 2 for A and 3 for B. On day two, a private meeting of the management of B decides on a cash takeover bid for A at a price of 3 per share. The meeting is told that a merger of the two companies will produce operating savings with a present value of 3.2 million. No public announcement is made either that the meeting has occurred or of the matters discussed at it. On day three, Company B announces an offer to buy all outstanding shares in Company A for 3 each on day 15. On day ten, Company B announces details of the operating savings the takeover is expected to produce. Determine the day two, three and ten share price of the two companies assuming that the market is (a) semi-strong form efficient and (b) strong form efficient.

market rationality

Lear

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y ivit

5c

eedb ac

k
(a) semi-strong form A price Day two Day three Day ten Table 5.2 2 3 3 B price 3 2.67 3.2 (b) strong form A 3 3 3 B 3.2 3.2 3.2

5c

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eedb ac

5c
continued

Explanation: Eventually, the surviving firm will be firm B. Its value will be the combined value of the two firms, plus the savings from the merger, less the costs to B of buying A. Hence the final value of B will be: Initial market value of A = 2 2 million Initial market value of B = 3 6 million plus PV of savings less cash paid for A = 3 2 million 4 18 3.2 6 19.2 Value of B shares = 19.26 = 3.2 Table 5.3 The issue then is how quickly prices adjust. According to the semi-strong EMH, the price of A will adjust as soon as takeover announcement is made (that is day three) but if EMH is strong form efficient, As price changes as soon as the bid decision is made. If the market is only semi-strong form efficient it will not know about the savings until they are announced (day ten). Thus on the day of the takeover announcement, B will be valued at (19.2 3.2) = 16.2 and 16.26 = 2.67. If it is strong form efficient, savings will also be known as soon as decision is made (that is on day two).

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Implications of the EMH

The implications of the EMH are considerable. Since a market involves buyers and sellers (borrowers and lenders) these implications affect investors but they also affect the ultimate borrowers. If we continue with examples from equity markets, this means that some of the implications relate to corporate finance or the decisions that firms make about how to manage their finances. We take some of these first and then well consider some implications for investors. Firstly, consider firms growth strategies. A firm can grow organically that is by expending its current activities by reinvesting in additional and newer capacity or it can grow by merger and acquisition. In the latter case, it takes over another firm and adds that firms capacity to its own. If the EMH is true this means there are no bargains when it comes to takeovers. By bargain we mean another firm which is underpriced. There will be firms that are cheap. Their share price will be depressed. But the EMH tells us that this is because it is making small profits and/or paying small dividends, or its growth rate is very low or its risk is very high. It is cheap because its fundamentals are weak. If the EMH is correct, maybe firms should concentrate on organic growth rather than takeovers. In the case of contested or hostile takeovers the firms concerned often try to persuade shareholders to back their case by releasing information about the benefits from the merger. And if this doesnt work the first time, there will be 105

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subsequent releases of information about the future prospects for profit and growth. If markets are strong form efficient, there is no point in managing information in order to influence shareholders and the share price. The information will already be known and be in the price. For a company that is financed entirely by equity, the return required by shareholders is the firms cost of capital. This is the return that it has to pay shareholders if it wishes to raise new capital and so this is the rate of return that it has to earn from its investment projects. Even if equity is only part of the firms financing, it will be a component in the overall cost of capital. If the EMH holds, then its shares and its cost of capital will be correctly priced. If the share price is too high or too low, then the cost of capital will be too low or too high and this will lead the firm into making the wrong assessment of capital projects. Related to the cost of capital, the EMH suggests that there is no point in firms trying to manipulate information when they are launching a new issue of shares. Ideally, they would like these shares to sell for the highest possible price (to give the lowest cost of capital) but this will not be possible if the EMH holds, at least in its strong form. The analysts will know what the true position of the firm is. They will have advised their clients and the information will be in the price. When we turn to the implications for investors, they are rather different, but no less dramatic. One fundamental implication of the EMH is that if markets are efficient then it is impossible for investors to exploit information in order to earn excess returns over a sustained period of time. Excess here means in excess of the equilibrium or required rate of return, howsoever that is determined. In these circumstances it is sometimes said that the process determining security prices makes for a fair game. Secondly, if all existing information is in share prices, those prices will only be changed by new information or news. By definition, this news is unknowable until it arrives. It will sometimes be good and sometimes bad, with the result that the change in share prices will be random. An exception to this could be where a firm is changing its business model and moving into higher (or lower) risk activities. During the period of transition there will be more upward (or downward) changes. Even so, the fair game principle still holds since it still will not be possible to use share price movements to earn consistent excess returns. In recent years some economists have become interested in the possibility that share price behaviour may be chaotic rather than random. Chaotic here has a rather special meaning, not that the behaviour is completely disorganised but that it is very complex. If share price behaviour is chaotic, then in principle it can be explained. There will be some equation that links todays price to tomorrows price but it is such a complex equation we do not know what it is nor what are the coefficients. Empirically, it is very difficult to find evidence of chaotic behaviour but this may be because it is very difficult to test for chaotic behaviour. If the market is semi-strong form efficient, a third implication is that there is no advantage to the individual investor in monitoring public announcements,

fair game

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press releases, company reports and so on since any decision drawn from this information will already have been drawn by others and will already be in the price. This raises an interesting issue that centres on the free-rider problem. If all investors believe in the EMH, they will know that there is no advantage in searching out information since others will have done and the information will already be in the price. Since it is only ever possible to buy correctly-priced securities, there is no point in trying to beat the market. It makes sense to let others do the work (to free-ride). But if all investors opt out of the price discovery process by leaving it to someone else, then no one will do it. Information will not be in the price and the market will not be efficient. So, it is the belief that there may just be a small chance of beating the market that keeps the free-rider problem at bay and, in so doing, makes the market efficient and the research pointless. Fourthly, if the market is strong-form efficient then it is not clear why it is worth paying for professional fund management. Under strong-form efficiency it should not be possible for anyone to beat the market consistently. Mutual funds may still offer an advantage to investors in the reduction of transaction costs. Their managers may be able to assemble a widely diversified portfolio of assets more cheaply than individual investors could do it for themselves but this is an argument for investors only buying into a mutual fund where they do not have to pay for active investment management. This means buying into a low-cost tracker fund, for example, where the manager simply buys shares that replicate some index and then holds those shares, avoiding expensive attempts to search out winners and losers. Finally, the EMH suggests that the best strategy any investor can follow is a diversified buy and hold strategy. In Unit 4, we saw that most specific risk could be eliminated by holding about twenty shares, provided these have low correlations with each other. According to the EMH these will be correctly priced and the returns will be correct for the level of risk. Since it is impossible to spot bargains consistently and buying and selling involves transaction costs there is no point in actively managing this portfolio.

Lear

ga nin ct

5d

How might an investment strategy appropriate for a market which is informationally efficient differ from one appropriate for a market which is inefficient?

eedb ac

y ivit

5d

An informationally efficient market is one in which no one has an informational advantage which enables them to earn returns which are consistently above those which are justified by the level of risk to which the investment is exposed. It is often said that the EMH means that one cannot beat the market. However, this does not mean that no investment strategy is required. Decisions have to be made about the desired combination of risk and return and assets being added to a portfolio have to be selected in the light of the effect that they have on the characteristics of the portfolio. Above all, an investor will wish to ensure that the portfolio provides the maximum return

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eedb ac

5d
continued

for a given level of risk. But there is no point in studying information about individual firms with a view to selecting shares which will perform better than others with a similar level of risk. If the market is informationally efficient there will be no advantage in the frequent trading of shares since they will all be correctly priced. It is better to avoid transaction costs by adopting a buy and hold strategy. If markets are informationally inefficient, then it may be possible to find assets which are underpriced (and therefore provide a return which is above that which one would expect for the level of risk). It might be possible to do this by studying past trends in share prices (if the market is weak form inefficient). Or it might be possible to do it by studying a firms current activities and its markets (if the market is only semi-strong form inefficient).

Recommended reading: Howells and Bain (2008) Financial Market Efficiency; Mishkin (2007) The Stock Market and the Efficient Market Hypothesis.

5.2 Evidence on informational efficiency

The EMH has always been controversial. Firstly, this is because some fluctuations in asset prices appear to be more dramatic than can be explained by changes in fundamentals and these fluctuations are not rare. There have been quite a number of which the 2008 is only the latest. Secondly, researchers have found a number of anomalies in the behaviour of share prices, even in normal times. These anomalies are patterns of behaviour which seem to offer the possibility of excess returns something which the EMH says is impossible. We shall look at this critical evidence under these two headings.

Booms and crashes

The first recorded example of what is generally regarded as a speculative bubble is the Dutch tulip mania of 16361637. Cultivation of the tulip, which was regarded as a luxury item, had begun in the Netherlands around 1600. Popularity (and prices) grew slowly through the early years of the seventeenth century and increase in the 1630s as two things happened. The first is that the tulip became a fashion item in France and there was a surge in demand for a subset of tulip bulbs those that could produce multi-coloured flowers (probably the result of a virus, but of course relatively rare). Interestingly, the spot market (for real bulbs) was supplemented by what was, in effect, a futures market. Traders signed contracts for the future sale and delivery of bulbs and eventually these contracts themselves began to be traded. According to one account (Thompson, 2007) an index of tulip bulb prices which stood at 10 in November 1636, reached 200 in February 1637 and fell to about 10 again in May 1637. Another famous historical example is the South Sea Bubble of 1720. This featured a joint stock company, the South Sea Company, which was originally established in 1711 with monopoly trading rights in Spanish South America. The monopoly was granted by the UK government in return for undertakings by the company to buy government debt built up during the War of the Spanish Succession. For several years, the company barely made a profit though it continued to promise the prospects of vast wealth in the future. However, the companys share price began to rise early in 1720, in response partly to the extravagant claims that were being made about imminent profits and also because a number of public figures had been encouraged to buy shares. From about 120 at the beginning of 1720, the shares had risen to 550 by May. 108
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Developments then took on one classic symptom of a bubble. Shares continued to be sold to politicians and other public figures who, instead of paying for them, sold them back to the company after the price had risen, paying the purchase price from the proceeds of the sale and pocketing the difference. There was no interest here in the fundamentals. This was buying on credit simply to take advantage of the higher price. (The bigger fool hypothesis that we met earlier.) While all this was going on, other joint stock companies were floated, several with prospectuses that were barely plausible. To begin with, their shares rose in price alongside those of the original company. It is always difficult to know what causes a bubble to burst. Wiser investors, maybe, knowing that the foundations are insecure, start to sell in order to take their profit. What is for sure is that once the share price stops rising, it must fall, because much of the demand is dependent on continuing price rises. The South Sea Company stock peaked at around 1000 in August and collapsed to 120 by the end of the year. Many were ruined, especially those who had bought on credit. The bankruptcies led to defaults on bank loans and many banks became insolvent and a major financial crisis followed. More recent examples of dramatic rises and crashes in financial markets include the UK railway mania in the 1840s, the years leading up to the US Wall Street Crash in 1929 (perhaps the best-known of all financial panics), the dot-com bubble of 19952000 and the crisis of 2008. If we included booms and crashes in commodity and real estate prices, the list would be much longer. Why do these events pose a problem for the EMH? Figure 5.1 shows the evolution of the UK FTSE-100 index of the share prices of the largest 100 companies from 19962009. It shows the steep rise and falls of 2000 and 2008. The issue is whether or not rapid rises and falls can be explained by fundamentals. The fall in the index from October 1999 to October 2002 is 43 per cent; the fall from August 2007 to March 2009 is about the same. The upswings of similar amplitude (from roughly 4000 to roughly 7000) prior to the crashes are rather more gentle but still quite rapid.
8000 7000 6000 FTSE 100 5000 4000 3000 2000 1000 0

Figure 5.1: The FTSE-100 index 19962009

Source: Office for National Statistics (2009) code HSEG

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O ct 97 19 Ju 98 l 19 Apr 99 19 J a n 99 20 Oc 00 t 20 Ju 01 l 20 Apr 0 20 2 J a 02 n O 20 ct 03 20 Ju 04 l 20 Ap 05 r 20 J a n 05 O 20 ct 06 20 Ju 07 l 20 Apr 08 20 Jan 08 20 Oc 09 t Ju l 19

Dates

19

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On the basis of fundamentals, we have to look for explanations in terms of risk or current profits or growth of profits. In effect, this requires changes in the riskiness and/or productivity of UK firms. The question is do we think these fluctuations of 40 per cent or so reflect that degree of change in risk and productivity over fairly short periods? In the case of 2008, we might be sympathetic to the idea that firms, especially financial firms had become much more risky as a result of having taken some very risky assets in the form of asset backed securities and credit default swaps on to their balance sheets. As we know, the UK and US banking systems were virtually insolvent. Since this information came to light in the summer of 2007, it is not surprising that the downturn was very rapid. However, this still leaves the problem of why the risk was not spotted in the upswing. Why did banks expand so rapidly in the mid 2000s by taking up high-risk assets of doubtful value and markets fail to realise this? If we take the view that the very low share prices of banks after the crash were entirely deserved because they incorporated all relevant information about the toxic nature of the assets, then the high prices in early 2007 could not have been correct. In their major study of financial crises, Reinhart and Rogoff (2009, esp. chapter 17) show how early warnings of financial crisis are repeatedly ignored by investors determined to delude themselves into thinking that this time its different. This does not sound like a very determined effort to make the best use of all relevant information. A similar argument could be made with respect to the dot-com boom/bust. But there are some additional features of interest in this episode. The shares whose prices rose dramatically were shares in mainly new companies that promised to exploit the advantages of new technology, especially the internet. The shares in some of these companies were so popular that the firms earned a place in the FTSE index of largest companies and, consequently, caused the FTSE to rise quite sharply. But some of these were firms that had earned no profits and paid no dividends. At the same time, long-established utilities like Thames Water were pushed out of the index as their share prices failed to keep pace. A serious aspect of these developments which is often overlooked concerns the cost of capital. The point is nicely illustrated by the launch of Lastminute.com. Initially, the investment bank sponsoring the initial offering of Lastminute.coms shares announced a likely price of 190230p. However, during the preparations for the launch, the demand for shares began to look much stronger than expected and so the investment bank raised the price to 320380p. The effect is to raise 60 per cent more capital per share for Lastminute.com and this is a company with no immediate prospect of profit. By the same token Thames Water, a company with a long and steady stream of earnings (and providing a vital commodity), was finding it harder and more expensive to raise new funds.

Pricing anomalies
These are big events. And while they are not rare, they are limited in number. However even when asset prices are stable it has been suggested that they often show behaviour which is to some degree inconsistent with the EMH. Recall that the EMH comes in three levels or forms. Whether or not a certain type of behaviour raises questions about the validity of the EMH, often depends upon which version we are concerned with. We take each in turn. When it comes to testing the weak-form of the EMH, one common approach is to look for evidence of serial correlation. In other words we look to see whether the direction of price change on one day is correlated with the direction of change on 110

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adjacent days. We can do this by running regressions or we can do it by runs tests. In a runs test we plot the price changes + and on successive days. A set of successive +s (or s ) is a run. Statistical tables will tell us the probability of a given number of runs for a given number of observations. For example, if the critical value for the number of runs at a confidence interval of at five per cent is ten, and we have only eight runs, we know there is only a five per cent change of only eight runs by accident. There is a 95 per cent chance that it is not accidental. Another batch of tests are called filter tests. These are tests that have been undertaken to determine whether a trading strategy could be developed that produces excess returns from charting price movements. For example, such a strategy might be buy when the price rises from a low point by five per cent and sell once it has fallen by five per cent from a high. As well as being a test of the weak-form of the EMH, this is to some degree a test of typical chartist techniques. As a general rule, for developed markets at least, such tests appear to find that the weak-form EMH holds to the extent that it is not possible to profit from any of these strategies once the costs of trading are allowed for. However, some interesting anomalies have been widely reported. Firstly, it seems that many markets exhibit a Monday effect in that prices are less likely to rise on Mondays than on other days. There is also a January effect in that returns on average seem to be higher in January than in other months. Returns from smaller companies appear to be higher (even when allowing for their additional risk) than returns from larger companies. These all suggest trading strategies that would yield excess returns and thus, under the EMH, one would expect the strategies to be exploited until the advantage was eliminated. The fact that they persist is a challenge to the EMH but again it is doubtful that the trading strategies would be profitable after dealing costs were taken into account. The fact that the weak-form EMH appears to hold in the financial markets of developed economies is, perhaps, not surprising. Recall that the EMH is about the efficient use of information. Specifically, it requires a high level of price discovery (resources devoted to finding the key information) as well as a system capable of rapid communication. Both of these are typical of developed economies. The question becomes more interesting when we look at emerging markets especially those in countries where free access to information is unusual especially if those emerging markets are growing very rapidly and attracting the attention of investors in more sophisticated markets where high-quality information is taken for granted. In recent years, the so-called BRIC countries (Brazil, Russia, India and China) have become popular with international investors and the question of informational efficiency in China, where the state has a long history of controlling and managing information, is an obvious one to raise. Studies of the weak-form EMH in China go back at least to Wu (1996), who used serial correlation tests of the kind we described above and concluded that that the Shanghai and Shenzhen markets were weak form efficient. Since then, the balance of research has pointed in the opposite direction. Wu (1996) applied the tests to a selection of shares. Mookerjee and Yu (1999) applied serial correlation and runs tests to an index for each market and concluded that both markets were inefficient. Following that Laurence et al (1997) examined indices in four Chinese markets and found some evidence for market efficiency among A-shares but not among B-shares as well as some evidence that the Chinese

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markets were influenced by price movements in Hong Kong and New York. In a larger study, Ma and Barnes (2001) also concluded that Chinese markets were not weak form efficient. Testing the semi-strong form of the EMH usually involves what are called event studies. These involve a day-by-day (or even hour-by-hour) study of price movements in the close vicinity of a public announcement. If the adjustment in a shares price is concentrated in the period immediately prior to the announcement, then the market is semi-strong form efficient. On these tests, markets seem to be semi-strong form efficient, especially where the tests involve shares in large companies.

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Two companies, large and small, announce their half-yearly results on the same day, t = 0. The table below shows the behaviour of their share prices for 10 days on either side of the announcement. 1. To what extent does the market appear to be semi-strong for these shares? 2. How might you explain any difference that you see? Day t + 10 t+9 t+8 t+7 t+6 t+5 t+4 t+3 t+2 t+1 t=0 t1 t2 t3 t4 t5 t6 t7 t8 t9 t 10 Table 5.4 Share price of large plc (p) Share price of small plc (p) 176 178 176 177 175 176 175 174 175 176 175 174 173 170 168 166 163 161 162 161 160 177 175 176 177 175 176 175 174 175 175 173 163 162 163 165 162 160 161 162 160 161

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1. The adjustment of the share price of large plc is complete by the date of the announcement (t=0). If we look at the price on t6 it starts to rise and continues to rise until it settles at 175 on the day of the announcement. After the day of the announcement there is no marked change. This suggests that the market for large plc is semi-strong form efficient. By contrast, the price of small plc shows little direction until t=0 when it jumps from 163 to 173, suggesting that the information in the announcement was news and not incorporated in the price. Furthermore, the price continues to rise a little after the announcement while the news is fully digested. This suggests that the market for small plc shares is not semi-strong efficient. 2. The difference between the two may be due to the difference in size. A large firm which has a large number of shares in issue will be subject to more study and analysis than a small firm because its shares will be held by many more investors. The reduced scrutiny given to small firms may mean that information is not so readily available and that there are more surprises.

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Tests of the strong form of the EMH look for evidence that well-informed professionals can beat the market. The obvious test involves looking at managed funds which promise to earn a superior return for investors. Remember that superior does not simply mean a higher return than some other fund; it means a higher return than could be expected for the level of risk involved. For this reason, the test usually involves a comparison of fund performance with other funds of similar kind, or with an index. If managed funds do not beat the index, then markets are strong form efficient (and there does not seem to be much point in paying for professional analysis and fund management). In this case, the evidence suggests some degree of inefficiency. Some funds do do better than others for a while. But when it comes to comparing the return on the best funds with a buy and hold strategy of similar shares, privately chosen, the benefits are again eliminated by the funds charges. So, in summary, we have a number of tests which suggest that markets do make reasonably efficient use of information. It is not surprising that they are better at doing this when the information is widely available (historic rather than private) and when the information refers to the shares of large firms. Given the small companies effect, it may be that analysis tends to be focused more on large firms and therefore anomalies get overlooked with smaller firms. But these are tests of the markets ability to incorporate information into individual share prices in fairly normal times. We are left with the fact that there may be general and large fluctuations in asset prices as a whole that are difficult to explain by fundamentals. This suggests that markets may be very good at incorporating relevant information so good in fact that no one has an information from which they can create a profitable trading strategy. But it also suggests that the relevant information may not be limited to fundamentals. We turn to this possibility next.

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The following text appeared recently in a brokers recommendation to investors to buy into a UK equity income fund. (The identity of the fund and its manager have been changed.) What does the recommendation suggest to you about the brokers view of the EMH? Tricia Fisher, who manages the Oldtown Higher Income Fund, stands head and shoulders above many of her peers. The fund has an impressive yield of 6.9% (net, variable and not guaranteed); more than double the current FTSE All Share yield of 3.3%. She has grown this dividend by a remarkable 11.3% this year (on a like-for-like basis) during a period when income from the UK stock market has fallen (by 9% in 2008, and forecast to fall by another 11% in 2009). Importantly, she has maintained the funds excellent record of 9 consecutive years of income growth and expects another rise next year...

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The recommendation is based partly on the reputation of the fund manager. This suggests that the broker believes that there are fund managers who can consistently beat the market. This is not consistent with the EMH. It also suggests that the past behaviour of the fund is some indication of what it might do in future. This is not consistent either.

5.3 Behavioural finance

Recommended reading: Howells and Bain (2008) Financial Market Efficency; Mishkin (2007) The Stock Market and the Efficient Market Hypothesis.

Orthodox economics (and finance) begins from the assumption that agents are rational, risk-averse, wealth maximisers. The approach adopted by behavioural finance is to avoid these assumptions and ask what do we know about agents motivation? Much of the knowledge used in behavioural finance comes from experimental psychology. The earliest papers in this field appeared in the 1960s. But the literature has expanded rapidly in recent years and we now have a number of books which provide surveys of the field. These are by Shleifer (2000), Shiller (2001) and Thaler (2005). We can start with a definition: At the most general level, behavioural finance is the study of human fallibility in competitive markets. (Shleifer, 2000) The fallibility gives rise to the mis-pricing of assets which persists. The fallibility and the persistence relate to two issues that we have already discussed. The first is the cost of information. Behavioural finance takes the view that decisions are made under conditions of such uncertainty that the cost (in time and money) of acquiring the necessary information is prohibitive. As a result, agents use short-cuts, rules of thumb or heuristics to guide them. The mis-pricing that results then persists because in practice arbitrage does not drive noise-traders out of the market and does not drive prices to their correct level. We look at each in turn.

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Mis-pricing and heuristics

Why does mis-pricing occur? This is where a theory of how investors process information and form judgements is required and the contributions from psychology are fundamental. Two important behavioural hypotheses in the current literature are conservatism (Edwards, 1968) and representativeness (Tversky and Kahneman, 1974). Together they show (as the result of experimentation) that people are slower to modify or update their understanding than is warranted by the evidence but that once they cross this threshold, they regard what may be random occurrences as confirming a pattern. The classic experiment involves the tossing of a coin which is known to the experimental subjects to be unfair in the sense that it has (say) a 70:30 bias. But the subjects do not know in which way it is biased 70 per cent heads or 70 per cent tails. So far as the subjects are concerned, therefore, the probability of each bias is 0.5. The experimenter then begins tossing the coin (which we will assume is heads-biased). At each successive toss the outcome is the same and subjects are asked after each toss to give their estimate of the probability that the bias is indeed heads. Predictably, their estimate of the probability, beginning at 0.5, rises quite quickly in the face of repeated outcomes of heads. But the striking thing is that in the early stages it does not rise as quickly as it should if the subjects were following truly Bayesian principles. Equally interesting is the discovery that after a few tosses the underestimate of the Bayesian probability switches to an overestimate. The early tosses in a series seem not to have the impact that they warrant, while the later ones are seized on as evidence that the world is more certain than it really is. The first is evidence of conservatism: news has to be repeated until its real significance is appreciated. The second is evidence of the representativeness: if news recurs often enough, it is treated as belonging to a pattern and the possibility of randomness is discounted. It is not difficult to see how these tendencies could be translated to a financial context. For example, we assume that investors have a particular view about a company and the value of its stock. They then receive news about the firm to which their response is less than would be the case if they acted according to true Bayesian principles. But the news keeps coming and eventually is interpreted, falsely, as part of a trend which is going to continue forever. In the first phase, investors underreact to the news and in the second phase they overreact. Evidence that this is in fact what happens comes from numerous studies but the easiest to understand are those where a stock which experiences a sustained period of poor news subsequently outperforms stocks which have been the subject of good news. This evidence suggests that the firm with consistent good news and earnings has become overvalued while the stocks with a run of bad news are undervalued. Investors can therefore earn abnormal returns by betting against this overreaction to news by buying the bad news stocks and selling the good news stocks. The best known of these studies was carried out by De Bondt and Thaler (1985) who, for each year since 1933, constructed a (losers) portfolio of the worst performing stocks and a (winners) portfolio of the best performing stocks judged by their performance in the three previous years. They then computed the performance of each portfolio in the five years following its formation. Averaging the results across the approximately fifty winner portfolios and fifty loser portfolios showed a clearly superior return for the loser portfolios. It is impossible to avoid the conclusion that the good news
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portfolios had been overvalued while the bad news portfolios were undervalued. Representativeness and conservatism are not the only heuristics canvassed by the psychology literature. The classic paper in this field is by Tversky and Kahneman (1974), who endorse the representativeness guideline. But they found experimental evidence for two others which are widely accepted in psychology and might well be relevant to economics (financial or more broadly defined). One is what they call the availability heuristic. People estimate the frequency of an event by the ease with which instances can be brought to mind. This causes biases when some events are more publicised than others. The other they called the anchoring or reference point effect. This suggests that the starting point or frame of reference for an estimate is important. For example, when two groups, randomly drawn, were separately asked Is the Mississippi more or less than 70 miles long? How long is it? and Is the Mississippi more or less than 2000 miles long? How long is it? the mean answers were 300 miles and 1500 miles. In the same spirit, Frey and Eichenberger (1989) discuss eight anomalies which they say are clearly evident in persons processing of information. These include the four heuristics listed above as well as, among others: the opportunity cost effect explicit monetary costs are given greater weight than opportunity costs of the same value and the sunk cost effect people tend to include foregone costs in their decisions.

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The availability heuristic causes people to think that events that are highly publicised occur more frequently than is genuinely the case. Can you think of some non-financial examples of this heuristic at work?

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Typical examples occur with peoples perceptions of safety. Because rail crashes are spectacular and receive a lot of publicity, people think rail travel is more dangerous than it is. Similarly, they overestimate the risk of burglary and assault because these receive a lot of media coverage.

The failure of arbitrage

In section 5.1 we described arbitrage as the last resort argument for the EMH because it suggests that if noise-traders persist in making pricing errors, they will be forced out of the market because they will make persistent losses while the well-informed make profits. A common definition of arbitrage is that it involves the simultaneous purchase and sale of the same asset in two different markets at advantageous prices. This is just a rather formal way of saying that if the same asset has a different price in two different markets, there is a (riskless) profit to be made by buying the cheap asset and selling the expensive one. Clearly such trades will tend to bring prices in the two markets into equality, so arbitrage is an important underpinning of the law of one price. Just as important, however, is the fact that an arbitrage deal delivers a riskless profit and therefore traders who are well-informed and can carry out these trades will make a profit. At the same time, the ill-informed, or noise-traders, will be the ones who are buying the overpriced securities sold by

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the arbitrageurs (and selling the underpriced securities to them). This cannot go on forever. Eventually, the noise-traders must lose all their wealth, drop out of the market and leave pricing to the well-informed arbitrageurs. But behavioural finance asks us to think more carefully about what arbitrage involves in practice. For the trade to be riskless, the arbitrageur has to be able to sell (or sell short) an asset which is overpriced and buy (ideally) the same asset cheaply. The practical problem to which this gives rise is that there is often no (underpriced) close substitute available for the asset which is overpriced. Suppose a trader thinks that stocks in the FTSE-250 index are generally overpriced. He can borrow (and sell short) those stocks in the anticipation that the price will later fall. To make the deal riskless, however, he has to be able to buy the same portfolio at a lower price. This is because he has to return the FTSE-250 stocks to the lender at the end of the deal at their then market value. Suppose he holds no alternative at all. In other words he has simply sold shares which he has borrowed. If (unexpectedly) the portfolio is hit by good news between the day of the sale and the date for their return to the lender, then the trader will have to enter the market and buy the shares at a higher price than that for which they were sold. The only way that the arbitrageur can be sure to make a riskless profit is if he was able to buy at the beginning, at a lower price, the same set of shares that he has sold (or sold short). In these circumstances, any unexpected news that affects the price of the borrowed shares, will automatically affect the value of the shares which are held. This is the problem of being able to find a suitable hedge. Obviously, this tends to be easier when the arbitrage involves a single security and increases in difficulty as we try to hedge portfolios. Another practical problem is one of time. If an arbitrage deal is done with imperfect substitutes (or no substitute at all) then there is the risk that prices which are expected to converge eventually might diverge before the deal has to be closed. For example, the arbitrageur borrows and sells short an asset which is overpriced at the same time buying another (but not identical one) which seems underpriced. The loan will be for a specified period. During that time the overpriced asset might rise further in price. And if the hedge is imperfect, it will not move in the same way and will not offer full protection to the holder. Alternatively, it might be that the hedge itself, while underpriced, falls further. The point of these (and other possible examples) is that the riskless arbitrage deal is more plausible in theory than in practice. In practice, arbitrageurs are forced to take risk and this will limit their ability to guarantee the elimination of mispricing (see Shleifer, 2000, 1316).

Case Study The end of efficient markets?

Read the following and answer the questions below. Capital market theory after the efficient market hypothesis Dimitri Vayanos and Paul Woolley VoxEU.org. 5 October 2009 Have capital market booms and crashes discredited the efficient market hypothesis? This column says yes and suggests a new model that explains

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asset pricing in terms of a battle between fair value and momentum driven by principal-agent issues. Investment agents rational profit seeking gives rise to mispricing and volatility. Forty years have passed since the principles of classical economics were first applied formally to finance through the contributions of Eugene Fama (1970) and his now-renowned fellow academics. Over the intervening years, capital market theory and the efficient market hypothesis have been developed and modified to form an elegant and comprehensive framework for understanding asset pricing and risk. But events have dealt a cruel blow to these theories, as John Authers argued in his recent FT [Financial Times] column. Capital market booms and crashes, culminating in the latest sorry and socially costly crisis, have discredited the idea that markets are efficient and that prices reflect fair value. Some economists still insist these events are simply the lively interplay of broadly efficient markets and see no cause to abandon the prevailing wisdom. Other commentators, including a number of leading economists, have proclaimed the death of mainstream finance theory and all that goes with it, especially the efficient market hypothesis, rational expectations, and mathematical modelling. The way forward, they argue, is to understand finance based on behavioural models on the grounds that psychological biases and irrational urges better explain the erratic performance of asset prices and capital markets. Presented this way, the choice seems stark and unsettling, and there is no doubt that the academic interpretation of finance is at a critical juncture. The need for a science-based, unified theory of finance At stake is the need for a scientifically based, unified theory of finance that is rigorous and tractable; one that retains as much as possible of the existing analytical framework and simultaneously produces credible explanations and predictions. This is no storm in an academic teacup. On the contrary, the implications for growth, wealth and society cannot be overstated. The efficient market hypothesis has beguiled policymakers into believing that market prices could be trusted and that bubbles either did not exist, were positively beneficial for growth, or could not be spotted. Intervention was therefore unnecessary, and regulation could be light-touch. By contrast, a theory of asset pricing that did a good job of explaining mispricing would provide policymakers with a stronger rationale for intervention and more scepticism about mark-to-market, index-tracking, and derivative pricing, to name but a few examples. Principal-agent investment problems: Mispricing with rationality We believe that a first step in the search for a new paradigm is to avoid the mistake of jumping from observing that prices are inefficient to believing that investors must be irrational, or that it is impossible to construct a valid theory of asset pricing based on rational behaviour. Finance theory has combined rationality with other assumptions, and it is one of these other assumptions that has proved unfit for purpose. The

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crucial flaw has been to assume that prices are set by the army of private investors, the representative household as the jargon has it. Households are assumed to invest directly in equities and bonds and across the spectrum of the derivatives markets. Theory has ignored the real world complication that investors delegate virtually all their involvement in financial matters to professional intermediaries banks, fund managers, brokers who dominate the pricing process. Delegation creates an agency problem. Agents have more and better information than the investors who appoint them, and the interests of the two are rarely aligned. For their part, principals cannot be certain of the competence or diligence of their appointed agents. The agency problem has been acknowledged in corporate finance and banking but hardly at all in asset pricing. Introducing agents brings greater realism to assetpricing models and can be shown to transform the analysis and output. Importantly, this is achieved whilst maintaining the assumption of fully rational behaviour on the part of all concerned. Such models have more working parts and therefore a higher level of complexity, but the effort is richly rewarded by the scope and relevance of the predictions. By doing this in our recent paper (Vayanos and Woolley, 2008), we have been able to explain momentum, the commonly observed propensity for trending in prices, which in extreme form causes bubbles and crashes. Momentum is incompatible with an efficient market and has proved difficult to explain in the traditional framework. Indeed, it has been described by Fama and French (1993) as the premier unexplained anomaly in asset pricing. Central to the analysis is that investors have imperfect knowledge of the ability of the fund managers they invest with. They are uncertain whether underperformance against the benchmark arises from the managers prudent avoidance of over-priced stocks or is a sign of incompetence. As shortfalls grow, investors conclude incompetence and react by transferring funds to the outperforming managers, thereby amplifying the price changes that led to the initial underperformance and generating momentum.1 The dot-com boom The technology bubble ten years ago illustrates this well. Technology stocks received an initial boost from fanciful expectations of future profits from scientific advance. Meanwhile, funds invested in the unglamorous, value sectors languished, prompting investors to lose confidence in the ability of their underperforming value managers and switch funds to the newly successful growth managers, a response which gave a further boost to growth stocks. The same thing happened as value managers themselves began switching from value to growth stocks to avoid being fired. Through this conceptually simple mechanism, the model explains asset pricing in terms of a battle between fair value and momentum. It shows how rational profit seeking by agents and the investors who appoint them gives rise to mispricing and volatility. Once momentum becomes embedded in markets, agents then logically respond by adopting

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strategies that are likely to reinforce the trends. Explaining the formation of asset pricing in this way seems to provide a clearer understanding of how and why investors and prices behave as they do. For example, it throws fresh light on why value stocks generally outperform growth stocks despite offering seemingly poorer earnings prospects. The new approach offers a more convincing interpretation of the way stock prices react to earnings announcements or other news. It also shows how shortterm incentives, such as annual performance fees, cause fund managers to concentrate on high-turnover, trend-following strategies that add to the distortions in markets, which are then profitably exploited by longhorizon investors. At the level of national markets and entire asset classes, it will no longer be acceptable to say that competition delivers the right price or that the market exerts self-discipline.
Note: 1. We show that as long as fund flows are gradual, as in the real world, price changes are also gradual. Intuitively, rational long-term investors are eager to buy an undervalued stock even when the stock is expected to become more undervalued in the future because of the risk that undervaluation might instead disappear. We term this the bird in the hand effect.

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1. The authors accept that classical finance theory, including the efficient market hypothesis, has a problem explaining recent asset price movements. How do they view behavioural finance as an alternative? 2. What view do the authors take on the rationality of investors? 3. What do they mean by momentum? 4. What is the principal-agent problem? 5. How do they argue that mispricing occurs if agents are rational?

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1. They argue that behavioural finance claims to offer better explanations on the grounds that psychological biases and irrational urges are the key to agents behaviour. But they go on to say that the first step in building a new theory is to avoid the mistake of jumping from observing that prices are inefficient to believing that investors must be irrational. 2. Investors do behave rationally, or at least they try to make decisions on the basis of the fundamentals we have discussed in this unit, but the ultimate investors are not the people that make the investment decisions. Households have to delegate these decisions to fund managers and this is where the problem lies. 3. Momentum refers to the trending of prices the tendency of prices to keep rising once they have begun (or to keep falling). The authors call this the premier unexplained anomaly of orthodox finance. 4. The principal-agent problem refers to the fact that households (the ultimate investors) must delegate the decision-making to others. The principals are poorly-informed about their agents actions and motives. The authors say that this is a widely-recognised problem in corporate finance and banking but has received little notice in fund management.

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5. When fund managers perform poorly against an index, the principals do not know whether it is incompetence or sound judgement to avoid overpriced stocks. Eventually, they decide that it is incompetence and switch their funds to managers who appear to perform better. The dotcom boom is offered as an illustration. Investors lost confidence in managers of funds invested in slow growth stocks and switched to funds which were invested in dot-com stocks whose prices were rising faster. This increased the differential between dot-com and traditional stocks. Eventually, the cautious managers of slow-growing funds are obliged to buy stocks which they know are over-valued, or risk being fired.

Self-assessment questions
5.1. Decide whether the hypothesis that the market is semi-strong form efficient is contradicted in each of the following situations: (a) (b) On average stock market investors are expected to earn a positive return this year and some will earn considerably more than others. The development of a complex computer-based method of analysing company data has enabled a firm of stockbrokers to predict prices accurately enough to earn a consistent profit three per cent above normal market returns. You have discovered that the square root of any given share price multiplied by the day of the week (Sunday = 1 and so on.) provides an indication of the direction of its next movement with a probability of 0.7. An oil companys employees made unusually high profits on their purchase of company shares after exploratory drilling in a new oilfield had started but before the announcement of the discovery of major oil deposits in this field.

(c)

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5.2. If share price movements are unpredictable, should portfolio managers select stocks with a pin? 5.3. You suspect that directors purchases/sales of shares in their own firms are an indicator of future share price movements. How would you test whether such information could be profitably exploited? 5.4. Explain why arbitrage may fail to eliminate mispricing.

Feedback on self-assessment questions

5.1. (a) No. EMH does not suggest that investors cannot make positive returns, only that they cannot make consistently abnormal returns (returns greater than those required to compensate for risk). An alternative way of putting it is that investors cannot consistently beat the market. But the market is quite happy to provide a positive return for risk. The fact that a few people make abnormal returns from time to time is also allowed, provided they are not the same 121

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(b) (c)

(d)

people all the time. Windfall gains are allowed. EMH only denies the consistent earning of abnormal profits. No, provided that the three per cent is the normal return for the costs and risks involved in all this extra activity. Yes, provided that your formula works consistently for an extended period (that is to say it is not just coinciding with windfalls). The essence of the EMH is that any knowledge that can be used to predict prices will be used and this will make consistent abnormal returns impossible to earn. If you discover this formula and it is discovered and used by everyone else, the gains will disappear (and the EMH holds). If you discover this formula and others do not use it then the market is inefficient No. Semi-strong form efficiency only says that market is efficient regarding public information. This is not public information so it is irrelevant as a test of semi-strong form efficiency. (However, the situation is inconsistent with strong form efficiency.)

5.2. No. Even if the EMH holds, the manager needs to consider the risk/return composition of the portfolio bearing in mind his/her clients preferences and to ensure that the portfolio provides the best return for the level of risk. (that is that it is an efficient portfolio). 5.3. It may help to think of this question as raising two issues. The first is whether or not there is a correlation between directors shares sales/ purchases and movements in the share price. The second, which is the question directly relevant to the EMH, is whether an investor, knowing of this correlation, can use it for profit. Let us suppose that directors behaviour is connected with share price movements. For most investors, the question then is whether they can make abnormal profits by acting on this information as soon as it becomes public. The answer depends on whether the EMH holds in its semi-strong form. One way of testing for this is to use the event-study type methodology (see learning activity 5c above). If the share price movement is largely complete by the time the announcement is made, then the EMH is semi-strong efficient and no excess return can be earned. It might still be possible to make a profit from this information if one could get access to it prior to public announcement (the EMH might not hold in its strong form). 5.4. The idea that arbitrage should eliminate mispricing is based upon the idea that the mispricing gives rise to two different prices for the same security. For example, if Ford Motor Co. shares are trading at 4 in London and at (the US$ equivalent of) 4.20 in New York, then a profit can be made by buying 1000 Ford shares in London and selling them in New York. This will eventually drive the prices together and the mispricing will be eliminated. Notice that if we ignore transaction costs and the possibility of exchange rate fluctuations, the arbitrage is riskless. Because it is riskless, only the most irrational investor would fail to take the opportunity to make a profit. Riskless arbitrage is central to the law of one price the idea that the same item cannot sell at two different prices. Notice that it is the fact that two prices are available at the same time that (a) alerts us to the fact that something is wrong and (b) enables it to be corrected by arbitrage. But is this always the way in which mispricing reveals itself? The notion that arbitrage will always eliminate mispricing is often called in to help protect the efficient market hypothesis the hypothesis that 122

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says that security prices (for example) will always incorporate all information relevant to their fundamental values. And the reason why is because (as a last resort) arbitrageurs will buy any security where it is underpriced and sell it where it is overpriced, making a riskless profit as in the Ford Motor Co. example. But what happens if someone thinks that all shares are overpriced and that prices will shortly fall? Or, as a less extreme example, that a whole sector of the securities market is overvalued? Unlike the Ford example, he cannot buy the underpriced securities to sell in the overpriced market. Alternatively, if he buys at current prices, or already owns them, then he cannot sell for a profit. There is no riskless profit. The problem is that we do not have two simultaneous, known, prices. The only way that two prices can emerge is over time and since we cannot know which way prices are going to move, trading on these prices cannot be riskless. For example, if a potential arbitrageur does not own the shares already he cannot buy them in a cheap market since there isnt one. And he is unlikely to buy at the prices that exist if he thinks they are already overpriced since he would be deliberately exposing himself to the prospect that the price will fall immediately after he buys them. Alternatively, if he already owns the shares, there is no higher priced market in which he can sell at a certain profit. He can, of course, sell, which is what many investors do if they think that the market is overpriced. But this is not riskless.

Summary
In this unit we have looked at the argument that assets are generally correctly priced and at some of the criticisms of this view. Having completed the unit, you should be able to:

explain the and its foundations explain the implications of the EMH for both investors and for firms show how bubbles and crashes have posed problems for the EMH show how recent contributions from the field of behavioural finance endeavour to explain why assets may be wrongly priced.

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Kashima Oil loses $1.5 billion in forex derivatives trading....

A reference to Kashima Oils problems in 1994

Introduction
This is the first of two units related to foreign exchange (forex) markets. In this unit, the emphasis is on the use of foreign exchange market instruments. In the next unit we look at the factors that influence exchange rates. Unit learning objectives On completing this unit, you should be able to: 6.1 Retrieve and use data relating to foreign exchange markets. 6.2 Explain the distinction between spot and forward markets and selected forex derivatives. 6.3 Describe the use of forex derivatives.

Prior knowledge The unit assumes that you have studied Units 15. Otherwise, it requires no prior knowledge, but some basic mathematical skills and familiarity with basic economics and finance is helpful throughout. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: Foreign Exchange Markets, Derivatives and Options ). Pilbeam (2005) is also very helpful on futures and options. In Piesse et al (1995) there is a helpful chapter on derivatives. Howells and Bain (2007) Forex Markets and Exchange Rate Risk also cover much of the material but at a rather lower level. Ritter and Silber (2003) Forex Rates is relevant to reading exchange rate data and there is a chapter on futures and options. You will need a calculator and access to the internet.

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Foreign exchange markets

Recommended reading: Howells and Bain (2008) Forex Markets; Piesse et al Foreign Currency Markets; Mishkin (2007) The Forex Market; Ritter and Silber (2003) Forex Rates.

A foreign exchange market is a market in which national currencies are bought and sold. If we ignore tourists buying and selling foreign currency in the form of notes and coin, then trading in foreign currency means transferring funds into and out of bank deposits denominated in the relevant currencies. If we use the term domestic currency to refer to the currency of the country in which the market is located, then all other currencies are foreign currencies and it follows that there must be a rate of exchange between the domestic currency and each of the foreign currencies and, consequently, between each of the foreign currencies. Each rate of exchange is a price. Exchange rates can be found in the financial press (and the corresponding websites). The Financial Times has an online currency converter which enables you to get an exchange rate for a wide range of currencies against any other (see Financial Times, 2009). Central banks and national statistics databases will often have a limited selection of rates, often as long runs of time series data. When it comes to data on transactions rather than exchange rates or prices, one of the most useful sources of comparative data on forex transactions is the Bank for International Settlements (BIS) (<http://www.BIS.org>). The BIS carries out a comprehensive triennial survey of transactions by type, by currency, by geographical location and even by counterparty and provides a commentary on the results. Because of the triennial nature of the survey, the most recent data relates to 2007 (BIS, 2007). (The next update will include 2010 data.) Table 6.1 shows the evolution of forex trading, by broad category of transaction, in recent years. (We explain the various types of transaction in 6.2 below.) The rate of growth is striking, especially since 2001.

Instrument Spot transactions Forwards Forex swaps Estimated gaps Total

1992 394 58 324 43 820

1995 494 97 546 53 1190

1998 568 128 734 61 1490

2001 386 130 656 28 1200

2004 621 208 944 107 1880

2007 1005 362 1714 129 3210

Table 6.1: Global foreign exchange market turnover (Daily averages in April, US$bn)
Source: BIS (2007), table 1

Table 6.2 shows the distribution of these transactions across the five major currencies. The domination of the US dollar is unsurprising. After that, the most notable feature is the stable share of the Deutschemark and then the Euro (at around 37 per cent of the total) and the declining role of the Japanese yen. This table shows only the dominant currencies in forex trading (hence the percentages do not sum to 100). If we looked at Table 5 in the BIS survey we should see many other currencies, each of them with very little significance for forex trading. However, some of these show a clear upward trend. An interesting case is the

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rupee which was involved in just 0.1 per cent of the whole in 1998 but 0.7 per cent in 2007. The Chinese renminbi (or yuan) was undetectable in 1998 but was involved in 0.5 per cent of forex transactions in 2007. The Russian roubles share of forex transactions grew from 0.3 per cent to 0.8 per cent. Hence, if we try to explain the decline in the share of the Japanese yen in Table 6.2, we should probably look to the growing shares taken by the currencies of emerging markets. Currency US dollar Japanese yen Deutschemark Euro Pound sterling Swiss franc 13.6 8.4 9.4 7.3 11.0 7.1 1992 82.0 23.4 39.6 1995 83.3 24.1 36.1 1998 87.3 20.2 30.1 37.6 13.2 6.1 37.2 16.9 6.1 37.0 15.0 6.8 2001 90.3 22.7 2004 88.7 20.3 2007 86.3 16.5

Note: Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.

Table 6.2: Currency distribution of foreign exchange market turnover major currencies (percentage of average daily turnover in April)
Source: BIS (2007), table 3

Table 6.3 shows the geographical distribution of forex trading. This is not quite the same as Table 6.2, since currencies can be traded in markets outside the country of origin. This is immediately apparent in the first line of the table which shows that the UK remains the dominant centre for forex trading, taking a share in total transactions which is twice as large as the role played by the pound sterling. Country UK USA Japan Singapore Hong Kong 1995 29.5 15.5 10.3 6.7 5.7 1998 32.4 17.9 6.9 7.1 4.0 2001 31.2 15.7 9.1 6.2 4.1 2004 31.3 19.2 8.3 5.2 4.2 2007 34.1 16.6 6.0 5.8 4.4

Table 6.3: Geographical distribution of foreign exchange market turnover major currencies (percentage of average daily turnover in April)
Source: BIS (2007), table 5

When it comes to quoting exchange rates or prices (which we do in a moment) we need to be careful, because we are dealing with two currencies. In a conventional exchange, for example of euros for a flight from Paris to New York, we talk of the cost of the ticket in euros. It would not occur to us to quote the value of euros in terms of international flights. But where two currencies are concerned, there are two ways of doing it and it isnt obvious that one is preferable to the other. 126
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direct quotation

indirect quotation

primary currency

For example, if we are in the UK and are interested in the / exchange rate, we can ask what does it cost (in pounds) to buy 1? or alternatively we can ask what does it cost in euros to buy pounds?, the answer to the first might be 0.9, in which case the answer to the second would be 1.11. When we ask for the price of one unit of the foreign currency in terms of the domestic currency, this is known as a direct quotation. When we ask what will one unit of the domestic currency buy, we are asking for an indirect quotation. In this case, 0.9 is the price of a euro, using a direct quotation; 1.11 is the price using the indirect quotation method. Sometimes the two currencies are distinguished as the primary and the secondary currency. The primary currency is the currency being quoted as a single unit and (perversely) is written second in expressions like / or /$. In our / example, the euro is the primary currency in the direct quotation and the pound is the primary currency in the indirect quotation. You must be careful about the method you use when drawing supply and demand diagrams and when talking about an exchange rate rising or falling. Throughout 2009, most commentators talked about the pound falling or weakening against the euro since it was becoming more expensive to buy euros with pounds. This is correct only if we understand that we are using the indirect method of quotation, since a fall from 0.9 to 0.8, say, would mean that euros were getting cheaper. You are given the following information about exchange rates (closing midpoints): 1 = SFr2.1 (indirect quotation of sterling) $1 = 1.1 (indirect quotation of the dollar) 1 = 0.93 (indirect quotation of the euro) Calculate each of these rates in direct terms.

secondary currency

Lear

ga nin ct

y ivit

6a

eedb ac

(a) SFr = 0.476 (= 1/2.1) (b) 1 = $0.909 (c) 1 = 1.075

6a

Spot rates
spot rate

spread

The exchange rates we have been talking about so far are spot rates. That is they are current prices the rates available for deals to be done now. (In fact the exchange of currencies usually takes place two days after the deal is made.) The spot rate is quoted as a spread. Suppose we see 1.42751.4385 quoted as the /$ spot rate. Sterling is the primary currency and the US dollar is the secondary one. The spread means that 1 will buy $1.4275. So $1.4275 is the dollar-buyers rate. $1.4385 will get 1 and is thus the dollar-sellers rate. The easy way to remember which is which is that the dealer will always give you the worst side. So, if you are starting your holiday to the USA, you know that the lower price is what you will get; but when you get back and want to sell the few dollars you have left, you will have to pay the higher price to get your pounds back. 127

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Cross rates
Even the most detailed sources of exchange rate data provide only a selection of rates. These are usually the exchange rate for the worlds major currencies and perhaps a longer list of currencies quoted against the domestic currency. This is because there is a very large number of different currencies in the world and to provide a quotation for each pair would mean an impossibly large number of quotations. For example, 100 currencies would require 4950 quotations if each were to be quoted against each of the others. However, if we have an exchange rate for each currency against a common currency, then we can establish what are called cross rates between any pair. For example, the Financial Times website quotes eight major currencies against each of the US dollar, pound sterling, euro and Japanese yen (Financial Times, 2009). It does not, therefore, give us an exchange rate for the Australian dollar against the Swiss franc, but since both are quoted against the US dollar, we can use the US dollar as a means of calculating the Australian Swiss cross rate. For example, suppose we know that: 1 Swiss franc buys 0.9 US$ 1 Australia dollar buys 0.8 US$ then an Australian investor looking for Swiss francs can firstly buy 0.8 of a US dollar and use that to buy 0.8 1.11 of a Swiss franc. In other words, one Australia dollar will buy 0.89 Swiss francs and so the exchange rate is 1:0.89. In general, therefore, assuming that the central rate is the US dollar the cross rate can be found as: Aus$ US$ US$ SFr [6.1]

cross rate

Lear

ga nin ct

You are given the following information: 0.9 buys 1, while 1 buys $CA1.68 Calculate the euro price of a Canadian dollar.

y ivit

6b

eedb ac

k
1.68 1 = 1.506. 1 buys $CA1.506 1 0.9 Just as important as spot rates, however, are forward rates. These are prices now for currencies to be delivered at some specified future date, for example, in a months time (one-month forward) or in three months time (three months forward). While the forward rate could be exactly the same as the spot rate, more normally it will be higher (at a premium to) or lower (at a discount

6b

6.2 Forward rates and other forex derivatives Recommended reading:

Howells and Bain (2008) Derivatives and Options; Piesse et al The Derivatives Markets; Mishkin (2007) The Forex Market; Ritter and Silber (2003) Futures and Options; Pilbeam (2005) Futures and Options.

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forward rate

to) the spot rate. By higher, we mean that the price paid for delivery in three months is higher than the price paid for immediate delivery and vice versa. Using our earlier example, if forward rates were at a premium they would be quoted as follows: Spot: 1.4275 1.4385 One-month forward: 0.27 0.25 pm Three-month forward: 0.53 0.51 pm with dis instead of pm, if they were at a discount. Notice that the premium/ discount is shown in cents, so 0.53 is a fraction of a cent, not a fraction of a dollar.

Lear

ga nin ct

Using the data above, calculate the three-month forward rate.

y ivit

6c

eedb ac

6c

The first step is to remember that a premium means that the three-month price is higher than the spot price. The second step is to remember that we are looking at the secondary currency. This means that the figures in the spot quote must be reduced. In other words, we must subtract the premium to get the forward rate: Spot: Less premium 1.4275 1.4385 0.0053 0.0051 1.4222 1.4334 If we are dealing in US dollars for delivery in three months time we get 1.4222 for each pound if we are buying; but we must pay 1.4334 if we are selling US dollars and buying pounds.

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How do we explain the presence of premia or discounts? Leaving aside any expectations about the future trend in spot rates, one factor that must always play a part is the difference in interest rates available on the two currencies. Suppose that US dollar interest rates are two per cent while sterling interest rates are four per cent (in both cases on three-month time deposits). No one would hold US dollar deposits (at least not for investment purposes). Indeed, if you were a US citizen, it might even pay you to borrow in order to buy sterling now and earn the higher rate of interest. If you could convert the sterling back into US dollars in three months time at the original exchange rate, you would make a nice profit because the higher sterling interest rate would pay the interest on your loan and leave you with the balance. And you would have earned this interest by using someone elses money! But how would you guarantee the exchange rate for the reconversion in three months time? Easy. Buy US dollars three months forward. If, for example, you could buy US dollars three months forward at the current spot rate, the scheme would be foolproof.

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Lear

ga nin ct

6d

What name do we give to the kind of transaction in the previous paragraph? (Hint: think back to the discussion of the EMH and our discussion of why noise-traders are supposed to be eliminated from the market.)

eedb ac

y ivit

6d

The transaction is known as riskless arbitrage. Arbitrage means buying at a low price and selling at a higher (that is taking advantage of price differentials here the difference in interest rates) and riskless refers to the fact that the return is guaranteed from the outset. When the deal is done, there are no unknowns. Nothing can go wrong. The prospect of riskless arbitrage should attract a flood of investment and prices should change very quickly to eliminate this prospect of easy profit.

So why does it not happen that investors in the country with the lower interest rate borrow all that they can in order to buy the foreign currency with the higher rate of return? You have probably worked it out already. What prevents this from happening is the price of the forward contract for US dollars. Suppose that you cannot reconvert into US dollars in three months time at the same rate that you convert out now? Suppose that the forward dollars are more expensive than spot dollars. You may have earned more interest in sterling than you would have in dollars, but that is not much benefit if, when you come to turn the sterling into dollars, you find that the dollars are now dearer. And, of course, we can work out exactly what the forward price needs to be in order just to eliminates this possibility of an easy profit. This is illustrated in Figure 6.1.
10,000 converted to US$ at current spot rate

3 month sterling interest at 1%

10,000

1.4275

1.4204 3m forward

US$14,275

3 month US interest at 0.5%

US$14,346.38

Figure 6.1: Riskless arbitrage Figure 6.1 shows the possibility of two investment strategies in a situation where the /$ spot rate is 1.4275, US interest rates are two per cent pa and UK rates are four per cent pa. Starting with an investment of 10,000 this can earn UK interest at one per cent (that is 4% 3/12). At the end of three months it will be 10,100. Alternatively, it could buy 10,000-worth of dollars at 1.4275 and earn US interest of 0.5 per cent (that is 2% 3/12). At the end of three months it would be worth $14,346.38 (= 10,000 1.4275 1.005). If we turn this back 130
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into sterling at the original spot rate, then the value is 10,065.41. Clearly, with these interest differentials and this spot rate, no one will hold US dollar time deposits, provided that the current spot rate is available in three months time. There would be a rush from US dollars to sterling. However, at the time of the decision, all that is known for certain about the exchange rate in three months time is that it can be fixed now by buying a three month forward contract. Given the current spot rate and the interest rate differential, we can calculate that the three month forward rate that just makes riskless arbitrage unprofitable is 1.4204 (= 14,346.39/10,100). It is this that makes the other rates sustainable.
interest rate parity condition

The situation that we have just described is known as the interest rate parity condition and we can summarise it in the interest rate parity formula: Forward rate = 1 + is spot rate 1 + ip [6.2]

where is is the rate of interest on the secondary currency while ip is the interest rate on the primary currency. Using the data from Figure 5.1 for illustration we have: Forward rate = 1.005 1.4275 = 1.4204 1.01 [6.3]

In Unit 7 (section 4) we shall look at the various risks that arise from exchange rate fluctuations. One obvious risk arises where an investor buys US dollar assets in the expectation of making a satisfactory return only to find that the exchange rate has changed when it comes to turn the investment back into sterling. Suppose, for example, that you can buy $4 million bonds at the current exchange rate of 1:$1.4. The sterling cost is 2.857 million. You expect to be able to sell the bonds for $4.2 million. You also expect to receive a coupon payment of six per cent (= $0.24 million). Your expected return is: 4.44 4 = 0.11 or 11% 4 [6.4]

which is what you will receive if you convert the dollars into sterling at 1:1.4 (ignoring foreign exchange dealing costs). But you cannot be sure that the exchange rate will remain at 1:1.4. Learning activity 6e shows what could happen if the exchange rate moved against you.

Lear

ga nin ct

Suppose that in one years time the pound to dollar exchange rate is 1:1.46. 1. What would be your profit in sterling from the deal just described? 2. How could you protect yourself against the change in the exchange rate?

y ivit

6e

eedb ac

6e

1. At the new exchange rate you would receive 3.041 million (4.44/1.46) instead of .3.171 million (4.44/1.4). The rate of return is 3.041 2.857 = 0.0644 or 6.44% (instead of 11%). 2.857 2. You could have bought sterling one year forward. Ignoring dealing costs and spreads, any forward price between 1.4 and 1.46 would have reduced your loss.

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Forward contracts are one way of protecting against this risk. But there are drawbacks, as follows:

You would be locked into the contract at the price you paid and would not be able to take advantage of any favourable movement in the exchange rate. For example, if the forward price you paid was 1.44 and the spot price were, say, 1.42 in a years time, you would have been better off accepting the spot price. And the spot price might have risen above 1.4. The forward contract is for a fixed amount (here, $4.44 million). Suppose that the bond holder defaulted on part of the coupon so that you actually received only $4.3 million. You would have to buy the remaining $0.14 million at the future spot price in order to complete the contract. If the income stream were uncertain (as from an investment in company shares rather than bonds), then you would not know how much sterling you would need to buy forward.

future

These are some of the reasons for the development of other instruments that help protect against currency risk. Two that we look at here are futures and options. Financial futures belong to a class of what are known as derivatives, since their value depends in part, on some underlying asset, or just underlying for short. In the case of futures, the underlying are most commonly stock exchange indices, interest rates on notional amounts of capital and (as here) currencies (that is exchange rates). Futures are exchange-traded products and to increase their tradability they are standardised products. In a futures contract:

option

derivative

The buyer of a future takes on an obligation to buy on a specified date. The seller of a future has an obligation to sell on a future date.

exchange-traded product

The obligations refer to a standardised quantity of a specified asset on a set future date at a price which is agreed today. For example, if we take the case of euro-sterling futures traded on the Intercontinental Exchange in New York we find that the standardised quantity is 100,000 per contract. On most exchanges the set dates for delivery are in December, March, June, and September. If we are looking at currency futures, we expect to see the price for a particular contract to be quoted as an exchange rate and per single unit of currency. Thus, for example, if we looked at the euro-sterling March 2010 contract we might see a price of 0.8531 meaning that the settlement price is 1=0.8531. Other information shown in a table of prices is likely to include:

the opening price at the beginning of the days trading the highest price reached the lowest price reached the change from the closing price of the previous day the number of contracts opened the previous day the total number of contracts currently open.

We have already noted that futures contracts have standard features in order to increase their tradability. For the same reason, futures exchanges use a clearing house in order to reduce the possibility of default risk. This means that 132
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when a buyer or seller enters into a contract, the contract in each case is with the clearing house and neither has to be concerned that the other might fail. The only risk is the possible default of the clearing house itself and this is reduced by requiring all members of the exchange to keep what are called margin accounts with the exchange. Investors then are required to keep similar accounts with the members of the exchange. This margin is some fraction of the price of the contract, so as to cover the maximum daily loss on the contract. For example, at the start of the contract, the buyer and seller are required to pay an initial margin of say between one and five per cent of the contract value. As the value of the contract fluctuates, the exchange moves the corresponding gain/loss between the two accounts. If the price changes sufficiently, the loser may be asked to contribute more into their margin account. The significance of this trading on margin (in addition to protecting the market from defaults) is that it allows investors a high level of gearing. In other words there is the potential to make a very large profit with a very small outlay. Table 6.4 illustrates the process. Suppose that you bought the euro-sterling contract mentioned above and the initial margin were three per cent. You would need to pay 3,000. Suppose then that the value of the contract rises, falls and then rises again until at the end 1=0.95.

Day

Futures price () 0.8531

Daily gain/(loss) ()

Cumulative gain/(loss) ()

Margin account balance ()

Margin call ()

June 5 June 6 June 9 June 10 June 11 June 12 June 13 June 16 June 17 June 18 June 19 June 20 June 23 June 24 June 25 June 26

0.8631 0.8731 0.8831 0.8731 0.8631 0.8531 0.8431 0.8531 0.8631 0.8731 0.8831 0.9031 0.9231 0.9331 0.9431 0.9531

1000 1000 1000 (1000) (1000) (1000) (1000) 1000 1000 1000 1000 2000 2000 1000 1000 690

1000 2000 3000 2000 1000 0 (1000) 0 1000 2000 3000 5000 7000 8000 9000 9690

3000 3000 3000 3000 3000 3000 2000 3000 3000 3000 3000 3000 3000 3000 3000 3000 1000

Table 6.4: Market price and margin requirements

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You pay no extra margin to begin with since the price has been rising. But after a series of losses, on the 13 June, your funds on margin fall to 2000. Commonly, the clearing house sets a lower limit (the maintenance margin) which is often 75 per cent of the initial margin. In this case that lower limit is breached and the clearing house asks for additional funds to be placed in the margin account. After 13 June the market price rises again and at the end of the contract you are able to buy euros at the contract price (0.8531) and sell them in the spot market for 0.95 each. Your profit is 9,6903,000 or 6,690 for an outlay of 3,000. We turn now to the pricing of futures contracts. The good news is that this is really an exercise in covered interest parity which we have already met in connection with forward contracts [6.2]. Assume that a UK firm requires euros to settle an account in three months time and would be happy to buy these euros at the current pound/euro exchange rate. It can either:

buy a futures contract for delivery in three months time buy euros three months forward borrow for three months in sterling, buy euros now and invest the euros at euro interest rates for three months.

Ignoring differences in transaction costs and some other details that we come back to in a moment, each strategy must produce the same result, otherwise there would be opportunities for profitable arbitrage. Since we know from [6.2] that the fair price of the forward contract depends upon the spot exchange rate and the interest differentials between the two currencies, then the same must be true for futures contracts. Hence: Futures price = 1 + is spot rate 1 + ip [6.5]

Futures contracts involve obligations. However, this does not mean that buyers generally take delivery or sellers generally make delivery of the underlying. Once the futures contract has served its purpose it can be closed by entering into a reversing contract. Someone with an obligation to sell an underlying asset on a given date can buy a futures contract requiring him or her to take delivery of the same instrument on the same date. Options contracts, as their name implies, avoid the obligations in future. As with futures they can be bought or sold (written). There are two fundamentally different kinds of options:
call option

a call option gives the right (but not the obligation) to buy an asset at a predetermined price (the strike price) on a specified date a put option gives the right (but not the obligation) to sell an asset at a predetermined price on a specified date.

put option

European option

We have referred to a specified date for the transaction. But this is strictly true only for a European-style option. An American-style option can be exercised at any time up to the specified date at the discretion of the holder (the buyer). As with futures, options can be written on a variety of underlying assets including equities, interest rates, foreign exchange rates, bonds, stock indices and more.

American option

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The buyer of a call option stands to profit if the spot price rises above the strike price. In this case, the holder acquires the asset at the strike (or exercise) price and then sells it at a profit in the spot market. By contrast, the buyer of a put option stands to gain from a fall in the price of the underlying asset. Once the spot price falls below the strike price the holder can buy the asset in the spot market and sell at the higher strike price. Notice that in both cases the holders exercise the options at their discretion. If the price of the underlying does not move in a favourable direction, or to a sufficient extent, the option expires unexercised. The sellers (or writers) of options benefit from what is called the option premium. This is the price per unit of the underlying asset that buyers pay for the option. Table 6.5 shows the information that is typically displayed regarding currency options. Notice that prices are given for both call and put options and that they are given for a range of expiry dates and strike (or exercise) prices. US$/ options 10 February Strike price 12200 12300 12400 Mar 2.00 1.85 0.96

Calls Apr 2.50 2.00 1.50 May 2.91 2.31 1.83 Mar 0.90 1.21 2.10

Puts Apr 1.81 2.01 2.43 May 2.11 2.53 3.01

Table 6.5: Currency option prices Currency options are options on the futures contracts we discussed above. These are usually for the US dollar against non-dollar currencies and buying a call option gives the buyer of the call the right to buy the non-dollar currency at the strike price specified. Prices are shown in US cents, Hence, the strike price of 12300 should be read as an exchange rate of $1.23 = 1. The holder of a call option benefits if the value of the non-dollar currency rises in value. What determines the size of option premium (or price)? Notice that there is a pattern to the distribution of premia and this pattern gives us substantial clues. It reflects two crucial factors that play a role in the options price. The first is called intrinsic value while the second is called time value. Intrinsic value is the absolute difference between the value of the underlying asset and the strike price of the option. For example, if we look at the 12300 calls in Table 6.1, the option will have intrinsic value if the spot value of the euro rises above $1.23 = 1 since the holder of the option can exercise it in order to buy euros at less than their spot price and then sell in the spot market. In this situation, the option is said to be in the money. If the spot value of the euro is below $1.23 = 1 then the intrinsic value is zero and the option is said to be out of the money. Where the spot price equals the strike price, the option is said to be at the money. One might imagine that an option that was out of the money was worthless. But think again about what an option entitles the holder to. If it is a call option, it gives the right to buy at some time in the future up to a specified date. So, one might be holding an option which is out of the money at the moment in other words the spot price is below the strike price and so it is not worth exercising

intrinsic value

time value

in the money

out of the money

at the money

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now. But the option may have some time to run, and circumstances can change. And the longer the option has to run, the longer the period during which prices could change so that the intrinsic value becomes positive. This gives the option its time value and the time value increases with the remaining life of the option. Now we should be able to make sense of the pattern of prices. If we take call options first we see that the price of the option rises with both the strike price and the life of the option. The first is explained by intrinsic value. Suppose that the current spot price is $1.235 = 1. The 12300 option is in the money and the 12200 option is even more deeply in the money. They both have positive intrinsic value, unlike the 12400 option which is out of the money with zero intrinsic value. This explains the negative relation between the value of a call option and its strike price. Nonetheless, even when out of the money, a call option may have time value. It is perfectly possible for the 12400 option to acquire intrinsic value in future. Hence, on 10 February, even the March option has some value. But the April and May options have even more time value, since the chance of moving into the money are even greater.

Lear

ga nin ct

1. What is meant by an in the money option? 2. Why might an option still have a positive market value even when it is out of the money?

y ivit

6f

eedb ac

6f

1. An option that is in the money is an option that would yield a profit if exercised now. For example, a call option whose strike price is below the spot price means that the holder can buy the underlying at the strike price and sell it in the spot market for a profit. An in the money option is said to have intrinsic value. 2. Suppose that the spot price in our call option were below the strike price. There would be no point in exercising the option since this would mean buying the underlying at a price which exceeded the price for which it could be bought in the open market. Such an option is out of the money and has no intrinsic value. However, if there remains some time to expiry, the option may still have time value. It may be worth buying, especially if there is a long time to expiry and the underlying has a very volatile price.

The pattern of prices on put options can be explained by parallel reasoning. Remember that a put option gives the right to sell. In this case the option will have intrinsic value (and be in the money) when the strike price is above the spot price. So, the higher the strike price, the greater the intrinsic value. When it comes to intrinsic value, therefore, the relationship between option premium and strike price will be positive. The time value relationship is explained in the same way as for call options. In summary, therefore, we can write a simple rule which applies to both call and put options: Premium = intrinsic value + time value 136 [6.6]

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We can even go further than this in our search for factors determining option premia. First of all we know that intrinsic value depends on the strike-spot relationship and so a change in the market value of the underlying will affect all the premia. Furthermore, since time value derives from the chance that prices might change further and bring an option into the money before expiry, then the volatility of the price of the underlying must also play a part. For a given length of time, the probability of an option moving into the money must be greater for an asset with large price volatility than one which is comparatively stable. Finally, we need to consider the rate of interest. Buying a call option gives the buyer the right to buy in future. The alternative, of course is to buy now in the spot market. Buying the option, however, costs a good deal less than buying the underlying asset. Strictly speaking therefore the purchase of a call option releases the difference in value between the underlying and the price of the option to be reinvested elsewhere. The higher the rate of interest, the more valuable is this alternative investment and consequently the more valuable is the call option. The premium will rise with the rate of interest. Given the price of a call option we can use what is called the put-call parity theorem to determine the price of a put. Since the put-call prices are inversely-related, it follows that the rate of interest affects put prices in the opposite way. Increase in Asset spot price Exercise (strike) price Volatility Time to expiry Interest rates Table 6.6: Factors in option pricing Impact on call option Up Down Up Up Up Impact on put option Down Up Up Up Down

6.3 Using foreign exchange derivatives

Recommended reading: Howells and Bain (2008) Derivatives and Options; Piesse et al Derivative Markets; Mishkin (2007) The Forex Market; Ritter and Silber (2003) Futures and Options; Pilbeam (2005), Futures and Options.

Foreign exchange markets as a whole (including their derivatives) are used by a variety of agents. Most obviously, they are used by people wishing to buy or sell goods services in foreign countries. Notice also that foreign currency will be required also if an investor wishes to buy an overseas asset and foreign currency will be exchanged for the domestic currency when the foreign asset is sold. Hence it is important to realise that while some forex dealing will be related to trade, a great deal of it will be related to portfolio transactions transactions related to the organisation and reorganisation of wealth. (Dixon, 2001, p250, suggests that only five per cent of forex transactions are related to trade. The rest are speculative.) This dramatically widens the number of potential participants in these markets. We can identify the following groups of players in forex markets:

the end users of foreign exchange: firms, individuals and governments who need foreign currency in order to acquire goods and services from abroad or to undertake portfolio investment the market makers: usually large international banks which hold stocks of currencies to allow the market to operate and which make their profits through the spread between buying (bid) and selling (offer) rates of exchange 137

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speculators: banks, firms and individuals who attempt to profit from outguessing the market arbitrageurs: (usually) banks that make profits from buying in one market at the same time as selling in another, taking advantage of small inconsistencies that develop between prices or rates of return in different markets central banks, which enter the market to attempt to influence the international value of their currency perhaps to protect a fixed rate of exchange or to influence an allegedly market-determined rate.

We have already met the role of arbitrageurs when we talked about covered interest parity. Arbitrageurs ensure that prices are driven to equilibrium levels (allowing for transaction and other costs) by eliminating the possibility of profit from price differences. The presence of speculators buyers or sellers who think they know better than the market are essential to provide sellers when arbitrageurs wish to buy and buyers when they wish to sell. We know about the role of market makers from Units 24 and we shall look at exchange rate regimes in Unit 8. For the rest of this section we look at the use of forex derivatives by end users who need foreign currency for trading or investment purposes and are trying to protect themselves against the risk of exchange rate fluctuations. By contrast, learning activity 6g looks at one of the ways in which a speculator might exploit forex derivatives. The risks that the users of forex markets face can be grouped under three headings:
transaction risk

translation risk

Transaction risk is the risk that the domestic value of any foreign currency receipts or payments may differ from what was expected as a result of exchange rate fluctuations. Typical examples are provided by US firms, say, expecting to be paid in Japanese yen in the three months time. If the yen weakens against the dollar in the meantime, then the US firms will receive fewer dollars than they expected. Translation risk arises where firms have foreign-denominated assets and/or liabilities on their balance sheets. When reported in the home currency, the value of these assets and liabilities will appear to change with fluctuations in exchange rates. Economic risk is the risk that exchange rate fluctuations cause a change in the economic environment in which a firm operates, even though the firm itself may have no forex payment/receipts or assets/liabilities. An example is provided by a domestic producer (for example, of cars) selling in a market to which overseas producers also have access. A weakening of the exchange rate makes the domestic firm more competitive.

economic risk

hedging

Faced with the risks that arise from foreign exchange rate movements, investors may try to hedge these risks. By hedging we refer to actions that can be taken to protect against financial loss, usually by investing simultaneously in two assets whose prices move in opposite directions in response to a common event. We shall compare the use of a currency option contract and a futures contract for the purpose of hedging against future exchange rate movements, which give rise to potential transaction risk. (Bear in mind that the same issues would arise if we were comparing the use of the option against a forward contract.) While options and futures contracts can both be used for this purpose, there are significant differences between the two. In a futures contract, both parties are obliged to go through with the transaction when the time comes; in an options
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contract, the holder can walk away, leaving the option unexercised if the conditions suit. With a futures contract there is a symmetry in the payoff to the buyer and seller. For example, for every dollar the spot price is above the futures rate at expiry, the buyer gains and the seller loses a dollar. But this is not true for an option where the maximum loss that the buyer can make is the loss of the premium paid. For the writer of the option, however, the downside could be unlimited. If we are comparing the two strategies, therefore, the first thing we can say is that: futures may be useful for hedging against symmetric risks but options can be better at hedging against asymmetric risks. Our example follows. Suppose that in June a Japanese company orders 2 million of goods from a UK company with an understanding that delivery (and payment) will occur in a years time. The payment must be made in sterling at that point. At the moment, the exchange rate is 68/1. However, the Japanese firm takes the view that sterling might appreciate in future, which will mean that it will have to pay more (in yen) to settle the deal. In short, the Japanese firm wishes to protect itself against this appreciation of the pound. However, the opposite is obviously a possibility and the firm would like to take advantage of any appreciation of the yen against the pound. The spot rate is 68/1 while the one years future/forward rate is 63/1. A one year call option to buy pounds for 63/1 can be bought for 3. A forward contract would require the Japanese firm to pay 126 million regardless of the exchange rate in one years time. However, the call option would be exercised only if the pound is above 63/1. The following table shows the costs of the two strategies for different future spot rates. It also shows the costs of doing nothing at all and leaving the position unhedged. Spot exchange rate at time of expiry : 71 70 69 68 67 65 64 63 62 61 60 59 58 Cost using option contract 132,000,000 132,000,000 132,000,000 132,000,000 132,000,000 132,000,000 132,000,000 132,000,000 130,000,000 128,000,000 126,000,000 124,000,000 122,000,000 Cost using forward/futures contract 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 126,000,000 Cost of spot contract (unhedged) 142,000,000 140,000,000 138,000,000 136,000,000 134,000,000 132,000,000 128,000,000 126,000,000 124,000,000 122,000,000 120,000,000 118,000,000 116,000,000

Table 6.7: Hedging with options and futures

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The cost of the options contract is 6 million (2 million 3). This gives the future option to purchase 2 million at 63/1 or 126 million, a total of 132 million. However, since this is an option that does not have to be exercised it has the advantage that if the strengthens sufficiently, the option can be allowed to lapse and the yen to be bought in the spot market. The premium will still have been paid of course and so, when the option lapses, the total cost of acquiring sterling will be the spot market price of yen plus the premium already paid. Hence if the yen strengthens to 62/1, the option strategy will still be more expensive than the futures at 130 million (= 124 million + 6 million). However, when the rate has strengthened sufficiently, the option strategy will be the cheapest, notwithstanding the premium. This will occur when 59 = 1. Hence we see the advantage of the option over a futures contract: it allows the holder to take advantage of a strengthening of the currency as well as protecting as a hedge against weakening.

Lear

ga nin ct

6g

A speculator who felt that interest rates were likely to rise or a currencys value decline would go short in the relevant asset by selling a futures contract. 1. Why would a speculator go short rather than long in these two cases? 2. What does going short in interest rates mean?

eedb ac

y ivit

6g

1. Interest rates likely to rise: this means that securities prices are likely to fall and thus there would be a loss associated with holding securities. Similarly there is a loss from holding a currency whose value falls. Other things being equal, people do not wish to hold net amounts of assets whose values are thought likely to fall but to be in a position where they would need to buy the assets in question after the price fall has occurred (that is, to be currently short in the asset). 2. As indicated above, someone who is short in interest rates is short in securities whose prices change as interest rates change. Thus, to hold bonds (be a net lender) is to be long in bonds and in interest rates (the rate of return on bonds). Investors become short in interest rates by selling interest-rate-sensitive securities now in the expectation that interest rates will rise and securities prices will

Case Study When hedging goes wrong

Read the following and answer the questions below: Ravenscroft plcs losses of approximately 200 million, which it puts down to abnormal foreign exchange exposures, arose because the company took a strong but incorrect view on the direction of the yen. It is standard practice for companies with a large portion of yen-based income from both operations and exports, as Ravenscroft has, to hedge against adverse currency movements. But the firm appears to have gone further, taking heavy positions on the expectation of yen weakness. It seems that the 140

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Case Study

continued

company took positions in both derivative and cash markets, writing call options on the yen, and selling the yen short in the foreign exchange market. Although it is quite common for large companies to write call options, it is a practice approached with caution. In buying a call option, the option holder can only lose the nominal cost of the option. Writing that is, selling a call option, on the other hand, leaves the writer with unlimited exposure

Lear

ga nin ct

6h

1. What is meant by hedging against adverse currency movements? How might Ravenscroft have hedged? 2. What must they have done in order to go short in yen? 3. What is a call option in yen? 4. Under what circumstances will the writer of a call option in yen lose? 5. Explain why such losses may be unlimited?

eedb ac

y ivit

6h

1. Hedging is the act of removing the risk associated with a change in the price of an asset by taking out an offsetting transaction in another market, usually the derivatives market. Ravenscroft had net income in dollars. They were thus long in dollars and the risk they faced, as a British company, was that the value of the dollar would fall. They could have hedged this risk, therefore, by selling dollars forward, by buying a futures contract in sterling/dollars so that the contract would become profitable if the dollar weakened, or by buying a call option in sterling/dollars (establishing the price at which it would have been able to sell dollars for pounds). 2. Since they started long in dollars, to go short, they must have taken out more contracts that would produce a profit in the case of the dollar weakening than they needed to hedge their initial long position. In other words, they deliberately moved from one open position where the risk was that the dollar would fall in value to an open position in which the risk was that the dollar would rise in value. 3. An option giving the right to buy dollars at a given price. 4. The writer of a call option in dollars has to sell dollars at the agreed (strike price). If the writer is short in dollars, he will have to buy those dollars in the cash (forex market) to meet his obligation and will thus lose if the cash price of the dollar is above the strike price in the options contract. In other words, the writer loses if the dollar increases in value. 4. The losses may be unlimited because the writer has to meet the obligation in the contract no matter how much the dollar has increased in value: the greater the increase in the value of the dollar, the greater the loss will be. This contrasts with the buyer of the option, whose potential loss is limited to the premium paid for the option, no matter how much the value of the dollar falls.

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Self-assessment questions
6.1. Look at the following set of exchange rates: 1 = 1.458; $1 = 0.753; 1 = $1.886 What is wrong with these rates. Show how, if they did exist, a profit could be made by trading the currencies. 6.2. Consider the relative advantages and disadvantages of using forwards contracts, futures contracts and options as means of speculation. 6.3. Why is it more risky to write (sell) options contracts than to buy them? 6.4. Why might the increased protection provided to individual traders by the derivatives markets increase the risk of the whole financial system running into difficulties?

Feedback on self-assessment questions

6.1. This is an exercise in arbitrage. The first step is to take any two of the three exchange rates and to use these to calculate the cross rate. Since the dollar is the vehicle for calculating cross rates in practice, it makes sense to take the two rates involving the dollar the sterling/dollar rate and the dollar/euro rate and to use these to calculate the cross rate for the euro against the dollar. Thus, we have: $1 = 0.753 1 = $1.886 It is then convenient to express both exchange rates against the dollar (that is as indirect quotations of the dollar the number of units of the foreign currency that exchange for one dollar). To do this, we need to take the reciprocal of the pound/US dollar rate, which gives us: $1 = 0.53 $1 = 0.753 We can now calculate the cross rate between the euro and sterling. To produce an exchange rate in the same form as the third rate quoted in the exercise, we need to treat the sterling rate as the denominator, so that we have: 1 = 0.753/0.53 = 1.421 We could, of course, have calculated the cross rate as 1 = 0.53/0.753 = 0.704. We now have two exchange rates for the euro against the pound, the cross rate of 1.421 and the rate given in the exercise as the market rate, 1.458. It is clear that there is an inconsistency in the three rates given in the exercise in relation to the two rates involving the dollar, the market is overvaluing sterling against the euro. For the set of rates to be consistent, one should get only 1.421 for each pound, but the market is giving 1.458. This means that there is a profit opportunity for arbitrageurs and that their actions in pursuit of the profit will remove the inconsistency.

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The next step is to work out the direction in which one has to trade to obtain the profit. In any market, in order to make a profit one has to buy something cheap and sell it dear. Therefore, one would not wish to buy pounds at the market rate of 1.458. Rather, one has to sell sterling for euro at that rate. No matter which currency you commence in, one of the steps of the transaction must be to sell sterling for euro. 6.2. There are technical differences among the different forms of contract although the relative costs associated with the different contracts should equalise the net benefits of each. Nonetheless, different types of contract will appeal to various market agents depending on their needs and on their views as to what is likely to happen in the underlying cash markets. The three types of contracts can be grouped in different ways to make a number of points: (a) The derivatives contracts (futures and options) give speculators the possibility of making very high rates of profit because of the high gearing associated with them (see section 9.3). (b) In theory, forwards contracts have an advantage over derivatives to the extent that no payment needs to be made until the currency in the contract has to be delivered. With options, the premium needs to be paid when the contract is taken out, while, with futures, margins must be paid to keep the contract marked to market. In practice, this is not so important since a bank entering into a forwards contract with a client will want to assure itself that the default risk is very low and might well require the client to maintain funds on deposit with the bank during the life of the contract. (c) Forward and futures contracts lock in an investor to a given exchange rate, providing a hedge against an unfavourable exchange rate move but reducing the potential profit from a favourable exchange rate change. Thus, options have an advantage in that they allow firms to combine hedging with speculation. (d) Options contracts are capable of almost infinite variety (see, for example, section 9.3) and are thus very flexible. (e) Futures and options may be bought on exchanges and these provide a number of advantages in terms of the liquidity, riskiness and the cost of the contracts. Of course, forwards contracts for common currency pairs and for commonly-demanded periods of time are likely to be relatively cheap. Both futures and options can be bought over the counter as well as on exchanges. 6.3. The potential loss from buying an option is limited to the premium paid for the options, since a loss-making option can be abandoned rather than exercised. A writer of an option that is profit-making for the buyer has to fulfil the contract and thus has to pay the full profit to the buyer. The writer of an option cannot abandon the option if things go against him. The risk is greatest with uncovered or naked calls. Here the writer promises to deliver an asset which he does not have. Since its price may rise (in theory to infinity) before the option is exercised, the potential risk is enormous. In the case of a covered call, the writer already owns the asset and the loss is limited to the gain in the assets value that is enjoyed by the buyer of the option. 6.4. This is the notion of moral hazard, which implies that when people feel protected they will take greater risks than otherwise. We are simply 143

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applying to financial markets here the idea that drivers wearing seatbelts and in stronger and more protected cars are likely to drive faster, leading to an increase in the number of accidents. A common argument in relation to financial markets is that government insurance of bank deposits leads people to pay no attention to the way in which banks are run and allow banks that follow high-risk strategies to flourish. There is some evidence that the confidence generated by derivatives played some part in encouraging banks and other financial institutions to take on high levels of risk leading up to the financial crisis in 2007.

Summary
In this unit, you have seen how exchange rates are quoted and how currencies can be bought and sold directly in spot markets or through forwards, futures and option contracts. Having studied the unit, you should now be able to:

retrieve and understand foreign exchange rate data, bearing in mind the distinction between direct and indirect quotation understand the distinction between spot and forward markets and markets for currency futures and options understand the use of a selection of forex derivatives as a means of hedging currency risk appreciate the comparative merits of futures and options contracts as a means of hedging.

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The foreign exchange market (II)

Canada bullish on loonies outlook.

Financial Times (24 December 2009)

Introduction
In Unit 6 we looked at a selection of instruments traded in foreign exchange markets, including currency itself and forward, futures and options contracts. In this unit we look at what causes fluctuations in exchange rates and at the potential risks to which these fluctuations give rise. Unit learning objectives On completing this unit, you should be able to: 7.1 Explain the main theories of exchange rate determination. 7.2 Interpret evidence on the behaviour of forex rates. 7.3 Explain the role of arbitrage and speculation in the determination of exchange rates. 7.4 Describe the risks associated with forex fluctuations and the implications for trade.

Prior knowledge The unit assumes that you have studied Units 16. Of these, Unit 6 is essential. Otherwise, it requires no prior knowledge, but some basic mathematical skills and familiarity with basic economics and finance is helpful throughout. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: Forex Markets). Pilbeam (2005) Theories of Exchange Rate Determination is also very helpful on exchange rate determination. Howells and Bain (2007) Forex Markets and Exchange Rate Risk also cover much of the material but at a rather lower level. Lawler and Seddighi (2001) part three deals with exchange rate determination and the effects of variability on trade. Ritter et al (2003) Forex Rates has a rather limited discussion of exchange rate theories. You will need a calculator and access to the internet.

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7.1
Recommended reading: Howells and Bain (2008) Forex Markets; Howells and Bain (2007) Forex Markets; Pilbeam (2005) Theories of Exchange Rate Determination; Ritter et al (2003) Forex Rates.

Exchange rate determination

In Unit 6 we referred many times to exchange rate risk the probability that outcomes would be different from what we expected because of a change in exchange rates. Table 7.1 shows that these fluctuations can be considerable, even over fairly short periods. year-end 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1.6081 1.5938 1.6348 1.5342 1.4197 1.4127 1.4552 1.4841 1.3619 1.0342 1.1255 US$ 1.6121 1.495 1.4556 1.6095 1.7905 1.9199 1.7166 1.957 1.9909 1.4376 1.6148

Table 7.1: Exchange rates, euro and US dollar against sterling 19992009
Source: Bank of England (2009)

The table shows that over the period 1999 to 2009 the value of the euro fluctuated between 61p and 90p, while the US dollar was worth between 51p and 70p. How do we explain these variations? The economists first step inevitably is to think in terms of supply and demand and the second step is to think about the fundamentals that might lie behind the supply and demand shifts. We met this approach in Units 35 where we identified the fundamentals underlying bond and share pricing and then discussed the extent to which these really played a part when we looked at the efficient market hypothesis. Many of the same issues arise here. What might the fundamentals be in the case of foreign exchange transactions? A traditional approach has been to focus upon the balance of payments. When producers in Malaysia sell goods to consumers in the USA, they expect to be paid, ultimately, in their own currency (the ringgit). Thus, the movements of goods from Malaysia to the USA creates an opposite flow of currencies. Importers in the USA must firstly buy ringgits with dollars. In the foreign exchange market, therefore, the flow of goods has generated a supply of dollars and a demand for ringgits. Indeed, early exchange rate theories focused on just this part of the balance of payments the balance of trade when looking for an explanation of exchange rate movements. They paid little, if any, attention to the capital account. Hence, an equilibrium exchange rate came to be thought of as the rate of exchange that would produce a balance of payments or more specifically a balance of trade equilibrium. 146

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There are two immediate problems with this approach. Firstly, since exchange rates are continually changing, it is rather difficult to identify equilibrium situations. And even when two currencies enjoy a brief stable relationship, this does not necessarily coincide with an equilibrium in the balance of payments (however defined). The other is that a balance of payments equilibrium is an aggregate concept. For example, if we just focus on trade, then equilibrium requires exports to match imports in total. There is no requirement that bilateral flows also sum to zero, even though an exchange rate is a bi-lateral relationship. Nonetheless, the idea that exchange rates must be linked to international payment flows remains a useful starting point.

Purchasing power parity

What would be the fundamentals if the balance of payments provides the answer? The essential issue is one of international competitiveness, so the fundamentals are those factors that determine the ability of one countrys products (and services) to compete with those of others. These will be a mixture of real factors like labour and other factor productivity, technological progress and economic growth. But it must also include nominal factors like the general level of prices in one country compared with another. The role of differential price levels has drawn attention to the principle of purchasing power parity (or PPP). This is the principle that goods of the same quality should trade at the same price in any country, once its price had been converted into some common currency. The idea is simple enough. If UK goods are dearer than comparable goods in, say, China, then UK citizens will switch from UK to Chinese-produced goods. As we know from our US-Malaysia example, this will result in an increase in the supply of pounds in the forex market and an increase in the demand for the yuan. The value of the pound would fall relative to that of the yuan and this would continue until the currency flows stabilised and that would happen only when Chinese goods ceased to have a competitive advantage, that is when prices in the two countries, expressed in a common currency, were equal. This illustrates the absolute form of PPP:

purchasing power parity

absolute PPP

spot exchange rates in equilibrium are a reflection of differences in price levels in different countries.

relative PPP

However, since we are more usually concerned with changes in exchange rates than in absolute levels, it is more usual to express this idea in the form of relative PPP (RPPP). This says that:

changes in equilibrium spot exchange rates reflect differential rates of inflation in different countries.

In general then: eD eF Eet +1 ES = ES 1 + eF [7.1]

where is the rate of inflation, D and F indicate domestic and foreign, e indicates an expected value and ES is the spot exchange rate expressed in direct quotation. As a rough approximation, we can read [7.1] as saying that:

the difference between the domestic and foreign inflation rates is equal to the percentage change in the exchange rate, defined as domestic units of currency per unit of foreign currency. 147

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PPP (and RPPP) are powerful ideas. It is a variation on the law of one price and it draws on the forces of arbitrage that we have met before (see also section 7.3). In other words, if PPP does not hold then there is a profitable opportunity for someone to buy in the cheap market and sell in the dear. At the theoretical level, therefore, PPP is attractive. But how useful is it in practice?

Lear

ga nin ct

7a

The Australian dollar is worth 6.15. In the course of the next year, inflation in Australia is expected to be seven per cent, while in the Eurozone it is expected to be three per cent. According to PPP theory, what Aus$:euro exchange rate should we expect in a years time.

eedb ac

y ivit

Rearranging [7.1] we have Eet +1 =

7a

eD eF 0.07 0.03 E + ES = 6.15 + 6.15 1 + 0.03 1 + eF S

= [0.0388] 6.15 + 6.15 = 6.389 In one years time we should expect the exchange rate to be Aus$6.389:1, a depreciation of 3.88 per cent.

Let us assume for a moment, that PPP is a major influence on exchange rates, at least in some long-term sense. It then follows that if we had a satisfactory theory of inflation, we could explain movements in exchange rates by reference to differential inflation rates and then by reference to differences in whatever it is that causes inflation. For many years, long-run macromodels posited a connection between the rate of monetary growth and the rate of inflation, derived from a quantity theory of money. Given this, then it is possible to theorise about exchange rate movements starting from differences in rates of monetary expansion. If country A has a more rapid rate of monetary growth than country B, then the combination of PPP and this monetary analysis of inflation tells us that the currency of country A will depreciate against the currency of country B. Although models of inflation which rely on monetary growth have long since been abandoned by monetary policymakers, monetary theories of the exchange rate still have their supporters. We shall look at the testing of forex theories in 7.2. But note at this point that PPP extracts from a number of real world complications. Firstly, it overlooks transport and other costs of moving goods between countries. These might play a small role if we are looking at trade between the UK and Germany, even smaller between Germany and France, but could be considerable between UK and China. Other costs could include tariffs, quotas and a variety of regulations designed to deter foreign competition. Secondly, it assumes that consumers are fully-informed about the quality and prices of goods produced in other countries. Again, proximity may play a part, or at least similarity of culture. Thirdly, goods may be less directly comparable than appears at first sight. Electrical goods work at different voltages and/or frequencies. Video standards differ across countries. Drug approval procedures differ. British cars are driven from the right-hand seat and so on.

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Interest rates, expectations and the capital account

Focusing on international trade may seem an obvious way of trying to explain exchange rate fluctuations. But it is worth remembering, from Unit 6, that only a very small fraction of forex transactions are trade-related. The rest are in some sense portfolio, or more bluntly, speculative transactions and are part of the capital account of the balance of payments. Switching attention to the capital account has brought two other factors into the discussion. The first is relative interest rates and the second is expectations. The interest rate argument is that funds will flow towards the currency that offers the best rate of return. Hence if the interest rate in country A is higher than in country B, funds will flow from B to A, pushing up the value of As currency against that of B. Naturally, if there is any merit in this line of argument, then we are forced to ask what causes differences in nominal interest rates across countries? One answer is the international Fisher hyphothesis. The Fisher hypothesis says that:

international Fisher hypothesis

in equilibrium, the real rate of interest is the same in all countries and therefore the difference in nominal rates is explained by differences in inflation.

Hence, if i is the nominal rate of interest in the home currency (D) and the foreign currency (F), then iD iF eD eF = 1 + eF 1 + iF [7.2]

Since the right-hand side of this expression is the same as the left-hand side in [7.1], we could write: iD iF Ete+1 ES = ES 1 + iF [7.3]

which gives us an explanation of appreciation/depreciation in terms of relative interest rates. However, there are problems with this explanation that have some parallels with PPP. The Fisher explanation also relies on perfect markets, full information and completely free capital movements. In practice, however, investors have to take account of different levels of sovereign and default risk, which also cause interest rate differentials. This helps explain why capital flows between the richest and poorest countries are very small indeed, notwithstanding very high interest rates in poor countries. The second consequence of switching attention to capital flows is that it introduces expectations as an important issue. Since investors are looking for a rate of return over a period of time (instead of buying currency to finance immediate transactions) it makes sense for them to be concerned with future as well as present values of inflation, interest rates and the exchange rate itself. But once we introduce expectations, we also introduce a psychological element into decision-making. Forecasting what is likely too happen in future requires that we form some judgement of what others may be going to do in future and this will include forming judgements of central bank reactions to economic
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news since central banks (generally) set short-term interest rates as a policy instrument. Furthermore, governments themselves may have a view about the desired exchange rate, and may encourage official intervention, even though they may say in public that they endorse the principle of floating exchange rates. This introduces a number of factors that it are hard to describe as fundamentals, especially if it is expectations of these variables, or expectations of other peoples expectations of these variables that really matters. Nonetheless, it helps to explain some of the volatility that one sees in exchange rates, perhaps better than notions of equilibrium based on fundamentals.

Overshooting
A notable attempt to preserve the idea of a long-run equilibrium exchange rate while accommodating fluctuations that moved the actual rate a long way from equilibrium was that of Dornbusch (1976) who initiated a series of what became known as overshooting models.
overshooting

If prices are perfectly flexible, agents fully informed and so on, then differentials in rates of inflation and interest rates will cause the exchange rate to appreciate/ depreciate. Behind this, as we saw above, is the view that it is differential rates of monetary expansion that cause these differences in inflation and interest rates. Thus we have an explanation of exchange rate determination that is based upon PPP and monetary conditions. However, it is much more realistic to assume that prices are sticky. It takes time for goods prices and wages in particular to adjust. There are many reasons for this stickiness. It takes time, and is costly, to adjust prices at frequent intervals. It creates uncertainty. Hence contracts are conventionally made for a fixed period, typically a year but sometimes longer, and breaches of contract and even attempts to renegotiate are often met with hostility. Furthermore, where industries are oligopolistic, firms will be reluctant to make upward price adjustments for fear of losing business to competitors and reluctant to make downward adjustments that might spark a follow my leader stream of competitive price reductions that reduce profits across the sector. The fact of price stickiness, and the reasons for it have been extensively explored in connection with monetary policy where it is widely-accepted that price stickiness causes monetary policy to have real effects (on output and employment). However, while product and labour markets show evidence of price stickiness, it is a characteristic of financial markets that prices adjust very quickly, if not instantaneously (recall the efficient market hypothesis that we discussed in Unit 5). Dorbuschs insight was to bring the two together and recognise the implications. The Dornbusch overshooting hypothesis is easiest to follow (and to show diagrammatically) if we think of change in the price level rather than in rates of inflation, though of course a change in the price level where previously it was static is an increase in the rate of inflation from zero. So, we begin typically, by assuming an equilibrium position in which the exchange rate is given. Furthermore price levels are given and monetary conditions (strictly the money supply) are the same across the countries concerned. Now we introduce a five per cent increase (say) in the money supply. In the long run, this country will experience a five per cent increase in the price level and, under PPP, its exchange rate will depreciate by five per cent. However, money 150

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markets and foreign exchange markets are not constrained by price stickiness. In the money market, the increase in money supply produces an instantaneous fall in the rate of interest and in the forex market there is an instantaneous depreciation of the exchange rate. The critical point is that while there has been no adjustment in prices, there has been no effect on the demand for money in the money market and so the increase in money supply has pushed the interest rate below what will be its ultimate equilibrium position when prices and the demand for money have had time to adjust. This overshooting of the interest rate causes a corresponding overshoot of the exchange rate which depreciates by more than is necessary for equilibrium. As prices adjust over time, both the interest and exchange rates climb back from their low levels to an equilibrium which lies between the initial position and the immediate post-shock level. Figures 7.1 and 7.2 show this in slightly different ways. Figure 7.1 stresses the original and final equilibrium positions while Figure 7.2 illustrates the adjustment dynamics more clearly.
Nominal exchange rate

M M B A D C PPP

Price level

Figure 7.1: Exchange rate overshooting In Figure 7.1, the PPP curve shows the long-run condition, namely that there is an equiproportionate relationship between the nominal exchange rate and the price level. Provided, for example, that a five per cent increase in the price level is met by a five per cent depreciation in the nominal exchange rate, then the real exchange rate is unaffected and we are on the PPP schedule. However, this is a long-run condition. In the short-run we can be off the PPP schedule. The curve labelled M, illustrates money market equilibrium. Since the money supply is assumed to be fixed, then equilibrium requires an adjustment of money demand. Why is it drawn upward-sloping? Imagine an increase in the price level. This causes an increase in the nominal demand for money but the supply is fixed. (There is a reduction in the real money supply.) Equilibrium between MS and MD can only hold if the nominal demand for money is reduced and this requires a rise in the domestic interest rate. Assume that foreign interest rates are fixed, then this rise in the domestic rate must cause an inflow of foreign currency and the exchange rate will appreciate. Hence if we start at point A in the figure (where the money market is in equilibrium and PPP holds) an increase in the price level moves us up the M schedule, say to B. This is possible in the short run. However, at point B either domestic goods are too expensive or the exchange rate is overvalued. In the long run prices must fall and we move back to A.
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Now, starting from A again, imagine an increase in the money supply. This is shown by the shift of M to M. To begin with, the price level is unchanged. But since the money market must always be in equilibrium, the nominal exchange rate must fall to C, which is below its new long-run equilibrium. In the short-run, it does not matter that we are off the PPP schedule. But in the long run the price level and the exchange rate will adjust until we are on PPP at D. Figure 7.2 tells the same story but stresses the adjustment process with respect to time.
E0 E1 i

t0

Time

Figure 7.2: Overshooting adjustment At time t0 there is an increase in the money supply, M. With a lag, the price level begins to rise but in the meantime there has been an instantaneous fall in the interest rate, i and exchange rate, E. Eventually, the exchange rate settles at its new equilibrium level E1 but it does this by appreciating from the artificially low level to which it fell initially. The overshooting hypothesis shows how real exchange rates can show persistent deviations from equilibrium, even when people are well-informed.

Lear

ga nin ct

7b

1. Why do prices in goods and labour markets adjust more slowly than prices in financial markets? 2. Why does this matter?

eedb ac

y ivit

7b

1. In goods and labour markets prices are set in contracts that last for a period of time. Buyers and sellers prefer the certainty that this gives even if it limits the instant adjustment to supply/demand changes. Furthermore, changing prices in goods and labour markets is more costly than in financial markets. Price changes, especially in labour markets, may involve lengthy negotiation. 2. These price rigidities matter in foreign exchange markets because they throw the entire adjustment to a monetary shock immediately onto the rate of interest and thus onto the exchange rate.

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Random walks
The Dornbusch overshooting model had its origin in the frequent empirical observation that, in floating exchange rate regimes the degree of volatility appeared to be greater than changes in fundamentals would suggest or explain. A more extreme attempt to explain exchange rate volatility is to say that exchange rate changes follow a random walk, though this is not so much an explanation as an admission that rational explanations are impossible. We shall say a bit more about this in the next section because it is an idea that comes out of the empirical data (Dixon, 2001). There is no theory that explains why rates should follow a random walk, though such evidence is less surprising in a market where transactions in foreign exchange are largely speculative rather than related to trade. We should recall that there is quite a lot of evidence that company share prices follow a random walk (see Unit 5). By saying that movements in exchange rates follow a random walk, we are saying that there is no better way of predicting the future rate than by looking at the current rate. Where ES is the spot rate, then: ESt = ESt1 + t [7.4]

Adding fundamentals makes no improvement to the forecasting ability. At the time that Meese and Rogoff (1983) announced this discovery, it caused considerable surprise, but the idea that exchange rates are very difficult to explain and forecast over short time horizons in particular has become widely accepted, though fundamentals may play some role over longer periods. We turn to the evidence in the next section.

Lear

ga nin ct

7c

Table 7.1 shows that the euro has appreciated substantially against the pound sterling in recent years. What factors might cause such an appreciation?

eedb ac

y ivit

7c

If we think about fundamentals and the trade balance then it could be that the UK trade balance has been more negative than that in the Eurozone; or that inflation has been higher than inflation in the Eurozone. As regards the capital account it may be that interest rates in the UK have been lower than in the Eurozone. Moving away from fundamentals, any news that undermines confidence in UK financial markets will have an adverse effect or anything that causes an increase in uncertainty. This could involve political factors since financial markets traditionally favour Conservative over Labour governments. We need to bear in mind two other things: 1. that markets are forward-looking and therefore anything that changes expectations about these events is likely to have an effect 2. that we have looked for adverse news about the pound. The answer may lie in news about the euro.

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7.2 Interpreting the evidence

Recommended reading: Howells and Bain (2008) Forex Markets.

When it comes to assessing the evidence on exchange rate determination, the first point to make is that there are a number of practical difficulties. For example, the intuition of PPP is that the exchange rate will adjust so that the price of goods and services is the same in two or more countries, because if that were not so, then arbitrage profits would be available to traders who bought in the cheap market and sold in the dearer one. Clearly, this abstracts from transport and related costs and PPP recognises this. But the fact remains that only some goods (and relatively few services) are internationally traded. This then raises the question of how we are to compare the relevant price levels between two countries in order to test for PPP. Price indices, by their very nature, tend to be very broad. Their function is to chart movements in the price level as a whole. It is very difficult to find an index of prices for tradable goods alone. Furthermore, PPP is meant to apply to similar baskets of goods whereas national price indices are based upon a basket of goods which reflects, so far as possible, the consumption patterns of the population. Suppose that we were fortunate and could find a price index for traded goods produced in the UK and traded goods produced in, say, Zambia. The UK basket would have a small weighting for food and a large weighting for consumer durables. In Zambia, the opposite would be true. Does it make sense to compare the relative prices of traded goods using two such different baskets? That said, we do wish to make such comparisons and we can only use the data that is to hand. Given the data, there are numerous ways of examining it, ranging from simple graphical analysis to more sophisticated, econometric techniques. Figure 7.3 shows the behaviour of the pound:US dollar exchange rate from 2000 to 2009 (the broken line) and compares it with what the exchange rate should have been had it been determined by absolute purchasing paper parity (the solid line). On a PPP basis, there should have been little change over the period, since the dollar was worth between 64p and 68p. In practice, it swung between a high of 70p in 2001 and a low of 50p in 2007.
0.8 0.7 0.6 act s per US$ 0.5 0.4 0.3 0.2 0.1 0 2000 2001 2002 2003 2004 2005 year 2006 2007 2008 2009 ppp

Figure 7.3: The sterlingdollar exchange rate, 20002009

Source: OECD (2009), table 4

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Figure 7.4 compares the actual and PPP exchange rates for the euro and US dollar. Once again, on a PPP basis the exchange rate shows little variation (the solid line), with the dollar strengthening very slightly over the period. The actual rate (the broken line), however, shows that the euro strengthened quite significantly from about 1.1 to the dollar in 2000 to about 0.67 to the dollar in 2009.
1.2 1.0 0.8 0.6 0.4 0.2 0

Euros per US$

2000

2001

2002

2003

2004 2005 year

2006

2007

2008

2009

Figure 7.4: The eurodollar exchange rate, 20002009 In both cases, the figures show that the actual exchange rate exhibits more volatility than is warranted by the fundamentals (in this case PPP) and we shall see in a moment that excess volatility is one of the most general findings of empirical investigations of exchange rate behaviour. In fact, we can link this with the Meese and Rogoff (1983) findings that we mentioned at the end of the last section. You will recall that they found that forecasts of exchange rates, based upon fundamentals, could not improve on a simple random walk model. In fact, their model included a drift term, : ES = ESt1 + + t [7.4]

By adding a number of additional terms to reflect the fundamentals that appear in conventional theories of exchange rate determination, it was possible to show that none of these made any significant improvement. The testing focused on US data. The fundamentals whose role was tested were: 1. the ratio of US/foreign money supply 2. the ratio of US/foreign real income 3. the ratio of US/foreign real interest rates 4. the ratio of US/foreign expected inflation 5. US and foreign trade balances. For the most part, the testing involves placing restrictions on the coefficients on these terms and looking to see whether the restrictions are accepted by the data. For example, the Dornbusch overshooting model makes no reference to cumulated trade balances and so one would expect to find the coefficient of 0 on (5) if the overshooting model holds. The finding that adding these macro155

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economic variables made little improvement was initially surprising. The measurement of expected inflation is always a matter of debate but by and large the results appeared robust. Recent attempts to overturn them have not been notably successful (Rogoff, 1999). But there may be a long-run/short-run issue here. Mark (1995) found that fundamentals did improve the random walk model at long horizons. Against this, Ehrmann and Fratzscher (2004), in a paper for the ECB, showed that certain types of news had significant (instantaneous) effects on the US exchange rate using data over the 19932003 period. They interpret the significant news items as amounting to news about the strength of the economy and therefore as some sort of evidence that fundamentals matter. Disturbingly, however, the news items that appear to be insignificant in their study are equally suggestive of the state of the economy. The surveys of purchasing managers appear to be the most significant factor in short-run exchange rate movements while news about retail sales, housing starts and the trade balance are irrelevant. In spite of much theorising and testing, we do not seem to have advanced much beyond the stylized facts that Mussa (1979) extracted from the evidence. Briefly, his conclusions were: 1. On a very short-term (for example, daily) basis exchange rates are unpredictable. 2. On a month-to-month basis less than ten per cent are predictable. 3. Countries with high inflation rates have depreciating currencies and over the long run the rate of change or the exchange rate between two currencies is roughly equal to the difference in their inflation rates. 4. Countries with rapidly expanding money supplies tend to have depreciating currencies. 5. In the long run, the excess of domestic over foreign interest rates is roughly equal to the expected appreciation of the foreign currency. 6. Changes in the spot rate tend to overshoot any smoothly adjusting measure of the equilibrium exchange rate. 7. In the long run, countries with persistent trade deficits tend to have depreciating currencies; those with trade surpluses tend to have appreciating currencies.

Lear

ga nin ct

7d

To what extent are fundamentals crucial for exchange rate determination in the long run?

eedb ac

y ivit

7d

It is clear that exchange rates frequently differ from any notion of an equilibrium rate determined by fundamentals and in the Dornbusch overshooting model we are given good reasons why this is so. However, it does appear to be the case that the exchange rates of economies that have large balance of trade deficits or high rates of inflation for prolonged periods of time show some of the signs of responding to these fundamentals as theory predict. Furthermore, some of the reasons for

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eedb ac

7d
continued

deviations from equilibrium (in particular sticky prices) may have less effect as time passes. The problem with the short-run/long-run distinction, however, is that shocks may occur too frequently for the long run to be achieved. This seems especially possible with financial variables like exchange rates. If this happens, then we may never be in the long run and fundamentals, though they may be relevant, will never provide a complete explanation.

Recommended reading: Howells and Bain (2008) Forex Markets.

exchange rate arbitrage

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7.3 Arbitrage and speculation in forex markets

In Unit 6 we said that we can identify the following groups of players in forex markets:

the end users of foreign exchange: firms, individuals and governments who need foreign currency in order to acquire goods and services from abroad or to undertake portfolio investment the market makers: usually large international banks which hold stocks of currencies to allow the market to operate and which make their profits through the spread between buying (bid) and selling (offer) rates of exchange speculators: banks, firms and individuals who attempt to profit from outguessing the market arbitrageurs: (usually) banks that make profits from buying in one market at the same time as selling in another, taking advantage of small inconsistencies that develop between prices or rates of return in different markets central banks, which enter the market to attempt to influence the international value of their currency perhaps to protect a fixed rate of exchange or to influence an allegedly market-determined rate.

In this section we look in more detail at the role of arbitrageurs and speculators.

Arbitrage in forex markets

Economists are strongly attached to the law of one price. The law means that comparable goods or service must trade at the same price and the extent to which it applies depends upon the process of arbitrage. Arbitrage refers to the act of being cheaply in one market (or in one part of a market) and selling at a profit in another. The reason that the law of one price is held to have widespread application is because its absence implies that opportunities for profit are being missed and the forgoing of profitable opportunities is inconsistent with the most fundamental characteristics of economic agents: the desire to maximise wealth and the use of rational calculation in so doing. In foreign exchange markets, it is the behaviour of arbitrageurs that is responsible for the interest parity condition (interest rate arbitrage) and for equilibrium exchange rates (exchange rate arbitrage). Exchange rate arbitrage involves taking advantage of differentials in the price of a currency in different markets. Such arbitrage transactions may be classified 157

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in terms of the number of markets involved. Thus we may have transactions in two markets (two-point arbitrage), three markets (three-point arbitrage) or more. Two-point arbitrage operations are very simple, taking advantage of small variations in the one exchange rate in two markets. For example, if the spot exchange rate of the US dollar were $1.40 = 1 in London and $1.45 = 1 in New York, it would be possible for arbitrageurs to make a profit by buying pounds in London and selling them immediately in New York. Indeed, this is an example of riskless arbitrage since, provided the different rates persist long enough for the trade to take place, the value of all variables is known. This act of buying and selling should push up the price of pounds in London and push down the value of pounds in New York until the two were equal. The arbitrage operation would close the gap between the two rates. In practice, the rates would not come exactly into line because of the existence of transactions costs, but the rates should move to being transactions-costs close sufficiently close to remove any possible arbitrage profits. The profits from two-point arbitrage are sufficiently easy to spot (and exploit) that they are extremely rare. However three-point arbitrage, which occurs where exchange rates among different currencies are mutually inconsistent, is a more likely possibility. Arbitrageurs then attempt to profit from these inconsistencies and in the process eliminate discrepancies and establish mutually consistent exchange cross rates. Assume that the following three market rates applied in Hong Kong:

1 = HK$11.1647 HK$1 = 12.000 1 = 131.260

We wish to consider the possibility that these rates are mutually inconsistent. Our first step is to take any pair of these market rates and use them to calculate the exchange cross rates consistent with them: HK$11.1647 Y12.000 1 HK$1 Thus, it is clear that the market price (1 = 131.260), relative to the other pair of exchange rates, is undervaluing the euro in terms of the yen (the yen is overvalued against the euro). In other words, the three market rates are mutually inconsistent and a profitable arbitrage opportunity exists. To realise an arbitrage profit, it is necessary to follow two rules: 1. buy cheap and sell dear 2. finish in the currency in which you started. Assume we hold yen. Our aim must be to organise our transaction to make sure that at some point we sell yen for euros, in order to take advantage of the inconsistency we discovered by calculating the cross rate. In order to be able to do this, we must take the following steps:

Step A: Sell yen for euros Step B: sell euros for HK dollars Step C: sell HK dollars for yen.

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Lear

ga nin ct

7e

Using the data above, and assuming that you begin with 1000, show how you can make an arbitrage profit (ignore transaction costs).

eedb ac

y ivit

1. Selling 1000 for euros at (1/131.260) gives 7.618. 2. Selling 7.618 buys HK$85.05 3. Selling HK$85.05 for yen at HK$1:12.00 gives you 1020.6, a profit of 20.6 In practice, the calculation would be a little more difficult than is suggested here because you would be faced with bid and offer rates for each exchange rate and you would need to choose the correct rate of the pair, depending on whether you were buying or selling.

7e

In Unit 6, we discussed riskless arbitrage in connection with the interest rate parity condition. If you have difficulty recalling this, look again at the discussion surrounding Figure 6.1 where we was that different interest rates in the US than in the UK meant that no one would hold US dollars unless the forward exchange rate compensated them for this. It was the action of arbitrageurs that imposed this condition.

Foreign exchange markets and speculation

Speculation is generally regarded with suspicion, being regarded frequently as the source of market disruption and mispricing. However, there is another side to this activity. Speculators provide liquidity to a market. By this we mean that they are ready buyers and sellers and by taking positions in which they bet against the market, they provide buyers when other wish to sell and sellers when others wish to buy. Thus, it is argued, their presence provides a benefit for agents who wish to use the market for normal business or insurance services. For example, in the absence of the activities of speculators, the number of people wishing to buy or sell a relatively minor currency forward may be so small that no market maker is prepared to offer forward contracts involving that currency. There may also be price implications. For example, if only small volumes of a particular asset (say a forward contract involving, say, Australian dollars and Thai bahts) were sold, the risks to the market maker would be high and the bid/offer spread on the contract would have to be large in order to compensate. Thus, firms wishing to hedge against risks associated with holding Australian dollars would find it expensive to do so. The presence of speculators deepens the market, reduces the volatility of the exchange rates and leads to a lowering of the cost of using the market. During 2009, it became fashionable to argue for a tax on financial transactions in order to discourage short-term risk-taking. It was rarely mentioned that any intervention that reduced the volume of trading was likely to reduce liquidity, increase price volatility and increase costs like spreads.

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In addition, as we have already seen, it is claimed that speculators act to ensure the efficient operation of markets, linking present and future prices of assets. This favourable view holds speculation to be stabilising, always moving the market towards its equilibrium. Destabilising speculators those trying to bet against the natural direction of the market would, it is argued, lose since market forces are so strong that it is not possible to act against them. For example, suppose market forces determine that the value of a currency must fall. Speculators make their profit by seeing this in advance of other people and selling the currency with the aim of buying it back later at a lower price. Thus their action forces the value down towards its new equilibrium value. Again, speculators who realise that a rise/fall from an equilibrium is likely to be only temporary act on the correct assumption that the exchange rate returns to its previous level after the effects of the temporary shock wear off. They sell/buy the currency when it has deviated sufficiently from its equilibrium value for the return to equilibrium to compensate them for the trouble and risk of engaging in the transaction. In doing this, they help to push the currency back to the original equilibrium position. Successful speculators thus are said to ensure that movements to new equilibrium positions occur more smoothly than otherwise would be the case and that equilibrium positions are stable. Since the aim of speculation is to make a profit, it follows that unsuccessful speculators quickly leave the market. Only successful speculators remain in the market. This support for speculation is an important part of the argument that markets left to themselves produce stable equilibrium exchange rates and thus is a major element in the case for floating rates of exchange. Arguments against speculation claim that some speculators do lose they are not the core of professionals in the market but a part of the large fringe of traders, tourists and central banks that take open positions in foreign exchange but to whom the activity is peripheral. If this is so, it does not follow that the outcome of speculation is always to move the market in the direction in which it would otherwise have gone. Of greater weight is the proposition that markets do not always work well and that this allows the possibility of profitable destabilising speculation. Markets might, for example, fail because of time lags, different speeds of adjustment of different prices, lack of information or asymmetric information. In such circumstances, speculators might attempt to amplify price movements. This is more likely where trading volumes are low (thin markets) and market agents form expectations extrapolatively. For instance, speculators might be able to sell a currency sufficiently heavily to force its value down; others within the market observe the fall and assume it will continue. Thus, they also sell, pushing the price down further still. Speculators are then able to buy back in at the lower price, taking their profit. We have also seen the suggestion that even speculators may be risk averse, limiting the amount they bet on any economic outcome that is less than a sure thing. In such a case, their actions would not succeed, for example, in bringing into line forward and future spot rates of exchange.

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7.4 Foreign exchange risk and its implications

Recommended reading: Howells and Bain (2008) Forex Markets.

In Unit 6 we saw that the risks from exchange rate fluctuations could be grouped under the headings of transaction risk, translation risk and economic risk and we looked at some examples of these as they arose for individual firms. But there is more to foreign exchange risk than its effects on individual firms. If those firms are risk-averse (a common assumption) then it seems reasonable to suppose that they will prefer the relative certainty of earning their profits in their home country leading to a reduction in the level of international trade from what it would otherwise have been or they will adopt the hedging techniques that we discussed in Unit 6 which involves them in additional costs. Since the collapse of the Bretton Woods system and the move to floating exchange rates in 1973, the negative effects of exchange rate variability have been a major concern to economists. Why should exchange rate variability influence international trade? The starting point is that many contracts are not denominated in the home currency. Tavlas (1997) shows that there are quite wide variations across countries. In Japan, for example, only 2535 per cent of contracts were denominated in yen in the mid90s while in the USA over 90 per cent were denominated in US dollars (which reflects the fact that some contracts are denominated in US dollars) across the world. This creates a potential problem since most contracts involve a time lag between the agreement to deliver goods or to discharge a service at a given price and the receipt or making of payment. In the intervening period the exchange rate may change. The effect on trade of exchange rate variability will depend on:

the degree of risk-aversion amongst producers and traders the degree of market power (affecting the extent to which variations in cost can be passed on) the size and predictability of exchange rate fluctuations the price elasticity of demand for imports and exports the presence of markets with more stable exchange rates.

In Unit 6 we noted a number of devices that firms could use in order to protect themselves against forex fluctuations. However, there are limits and costs associated with hedging activity. Firstly, the expected receipts may not be known with certainty. This makes it difficult to hedge the exact amount of exposure; forward contracts generally have a maximum maturity of one year while exchange traded contracts have standardised dates and amounts which again makes it difficult to hedge the exact amount for exactly the desired period. And, as we have seen, these hedges carry a price, or premium. All of these may deter firms from pursuing international business. There is also the possibility that variability has differential effects across firms. Small firms, for example, may find it harder to pass on any costs (of the hedging or of the variability). They may have smaller financial reserves with which to withstand risk if they do not hedge. Large firms are likely to trade with a larger range of countries than small firms and this will offer some degree of protection by diversifying their exposure. 161

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A third consideration involves the reaction of governments. They may resort to protectionist policies or drag their feet when it comes to signing up to trade liberalisation measures. They may undertake competitive devaluations to help their exporters or provide them with hidden subsidies under infant-industry type arrangements. All of this will slow down and/or distort the growth of international trade. What is the evidence? There has been a lot of empirical work in this area, summarised by Abbott (2001) and grouped according to type:

aggregate trade studies, which look at the aggregate trade flows of a country or group of countries bilateral trade studies, which analyse trade flows between two countries industry-specific studies, which examine the effects of volatility cointegration analysis, a rather different type of category which distinguishes the method rather than the subject of the investigation.

Another useful survey is provided by McKenzie (1999). What both show is that in spite of a large amount of work covering a wide range of countries and using a number of different approaches, there remains some uncertainty about the extent to which exchange rate variability affects international trade. Part of the problem almost certainly lies in the way in which exchange rate variability is measured, baring in mind that this has to represent the way in which firms actually perceive the uncertainty of their profits.

Case Study The loonie

Read the following report about the Canadian dollar (the loonie) and answer the questions that follow. Canada bullish on loonie outlook Peter Garnham Financial Times December 24 2009 02:00 The Canadian dollar advanced yesterday after Jim Flaherty, Canadian finance minister, extolled the virtues of the loonie as a reserve currency. Mr Flaherty said it would not surprise him if China and Russia, two of the worlds largest holders of foreign exchange reserves, were to raise the share of the Canadian dollar in their stockpiles, adding that many investors were looking around the world to invest in market currencies that are reliable. Analysts said it was notable that the Canadian dollar had outperformed the resurgent US dollar since the US unit hit a 16-month low on a tradeweighted basis late last month. Camilla Sutton, of Scotia Capital, said many of the factors that had led to the recent US dollar rally were also supportive of the Canadian dollar. She said the upward pressure on the US dollar had been caused by the realisation that there were many hurdles ahead for the Eurozone,

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Case Study

continued

including sovereign risk, and that fundamentals in the US were improving faster than many had previously thought. Canada has limited sovereign risk and what is fundamentally good for the US is also good for Canada and therefore the Canadian dollar, said Ms Sutton. Accordingly, we think the recent outperformance of Canadian dollar is justified and expect it to be an ongoing trend. In late trade in New York, the Canadian dollar was up 0.8 per cent to C$1.0487, its strongest level in almost two weeks. Meanwhile, the Swiss franc made ground as traders continued to test the Swiss National Banks tolerance towards a stronger currency. After breaking through SFr1.50 against the euro at the end of last week, a level that the Swiss National Bank had been defending since March in its fight against inflation, investors have been pushing the Swiss franc steadily higher in an attempt to provoke a reaction from the central bank. Jane Foley, of Forex.com, said traders were playing chicken with the SNB

Lear

ga nin ct

1. What is meant by the phrase ...market currencies that are reliable? 2. What is meant by sovereign risk when applied to the Eurozone? 3. What evidence would you look for if you wished to confirm that ...fundamentals in the US were improving... 4. The report says the Canadian dollar was ...up 0.8 per cent to C$1.0487. How do you interpret the value 1.0847? 5. The report refers to the Swiss National Banks tolerance towards a stronger currency. What does this suggest about the SNBs exchange rate policy and what could the SNB do if it was not willing to tolerate a stronger currency?

y ivit

7f

eedb ac

7f

1. Note that it is investors who are looking for reliability. We can be sure therefore that reliable means unlikely to depreciate since a depreciation would mean a loss to investors when they changed back into their own currency. 2. Sovereign risk refers to the possibility that a government may default on its obligations in some way. Given the reference to the Eurozone, we can assume that the article has the problems of Greece, Ireland and Portugal in mind. At the end of 2009, there was widespread concern that credit rating agencies were downgrading their ratings of these governments bonds because of the size of their debt. 3. The fundamentals would include rate of growth of output, labour productivity, inflation. The evidence could be data referring directly to this or data which implied satisfactory values so it might be the growth of retail sales, average hours worked, producer prices and so on.

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eedb ac

7f
continued

4. Where only one value is expressed in an exchange rate quotation, we can usually assume that it is the value of the quoted currency against the US dollar. In this case, we can be certain, since the report is discussing the Canadian dollars strength against the US dollar. So the exchange rate here is C$1.0487:US$1. 5. The report is saying that the Swiss National Bank is prepared to see the Swiss franc appreciate against other currencies (specifically the euro). If it were unhappy about this appreciation, the simplest response would be to lower interest rates in Switzerland to make the Swiss franc less attractive to investors.

Self-assessment questions
7.1. List as many items as you can of news that would be likely to cause the value of your domestic currency to fall. Explain why in each case. 7.2. Explain the following terms in the context of the foreign exchange market: (a) covered interest arbitrage (b) long positions in a foreign currency (c) hedging (d) three-point foreign exchange arbitrage. 7.3. Explain and defend the argument that speculation in markets is desirable. 7.4. How might one use the spot markets to obtain protection against foreign exchange risk? What advantages do the forward markets have for this purpose?

Feedback on self-assessment questions

7.1. This could be a very long list. Some likely items would be: (a) poor balance of trade figures: domestic goods uncompetitive, currency needs to weaken to re-establish competitiveness (PPP) (b) a reduction in domestic interest rates (or an increase in interest rates on other currencies) (interest rate parity) (c) market expectation of a cut in interest rates (d) an increase in domestic inflation relative to inflation elsewhere (PPP) or statistics suggesting that inflationary pressures are increasing (high money supply growth figures, for example) (But note: if the inflation figures were particularly bad, it might persuade the market that the monetary authorities were likely to push up interest rates in response this might cause the value of the currency to rise.) (e) increasing unemployment or low rates of economic growth that might lead the market to expect cuts in interest rates (f) indicators suggesting a low level of confidence about the future among firms and consumers, which might lead the market to expect a weakening of the economy and hence cuts in interest rates (g) anything that causes political uncertainty elections, especially if they look as if they might be won by candidates hostile to financial markets; political scandals that might undermine the Government or weaken the leadership likely to come from the Government.

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7.2. (a)

(b)

(c)

(d)

Covered interest rate arbitrage occurs when there is a profit to be made from moving funds into another currency for a short period of time to take advantage of higher interest rates on that currency while, at the same time, protecting against the associated risk that the value of the foreign currency will fall by selling the currency forward. Covered interest rate arbitrage leads to covered interest rate parity, which occurs when the gains from investing in the country with the higher interest rate are equal to the forward discount on that countrys currency. Taking a position in a market just means undertaking transactions in that market. However, the term is normally used to imply an open position that is, one where the market agent is subject to risk of loss. There are two types of open position depending on whether the risk is that the price of the asset concerned might rise or fall. If the market agent faces a loss when the price of the asset rises, it must be the case that he or she does not currently hold the asset (or, at least, does not hold enough of it to meet his or her commitments). This would be a short position (the agent is short of the asset). If the agent faces a loss if the price of the asset falls, it must be that he or she currently holds more of the asset than needed to meet future commitments. This is a long position. Thus, examples of long positions in the foreign currency market would be: (i) a UK citizen who needs funds eventually in sterling but currently holds US dollars and will lose if the dollar falls in value (long in US dollars) (ii) a French exporter who has shipped goods to the USA for sale and will be paid for those goods in US dollars, which will then have to be converted into euro (long in US dollars) (iii) a US speculator who has bought euro in the hope that the euro will rise in value (long in euro). Hedging is commonly used just to mean acting to protect against risk of loss in a market that is to move from an open to a closed position. However, the idea of constructing a hedge is often thought of more precisely than that. The idea is that hedging involves the process of taking an open position in a market such that the risk is equal to and in the opposite direction from a risk faced in another market. Thus, loss from one transaction will be matched by profit from the other. For example, the French exporter above who would lose if the dollar fell in value before she is paid for her goods, might hedge against this risk by taking a short position in US dollars to the expected amount in either the forward forex market or in a derivatives market. She might, for example, take out an option to sell dollars at some time in the next three months at the existing spot market rate. Then, if the value of the dollar does fall in the spot market, she will lose on her exports but will stand to profit from her options transaction. Three-point exchange rate arbitrage is the process of taking advantage of small differences in exchange rates among three currencies in the same market, for example, the pound/dollar, pound/euro, and euro/dollar rates of exchange.

7.3. There are two points to be made here. The uncontroversial point is that speculators add liquidity to the market, allowing end users to deal in the 165

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market more effectively and more quickly. The second is that speculators stabilise the market because successful speculators guess the direction in which the market is heading and hence cause it to reach its new equilibrium position more quickly. For example, say we start with an equilibrium exchange rate, say pound/euro, but a change occurs in the fundamentals of the exchange rate that will push the value of the pound down. Successful speculators see this before other market participants and sell sterling with the aim of buying it back later at a lower price. This action forces the value of sterling down in the direction that it will head in any case, but because of the action of the speculators it moves downwards more quickly than it would otherwise have done and reaches its new equilibrium more quickly. However, there are two big assumptions here. One is that speculators are small in relation to the market and are unable to influence the equilibrium price. All they can do is to anticipate it by making better use of available information. This seems unlikely especially in relation to less frequently traded currencies. We could easily imagine an alternative set of actions. Big speculators sell an apparently settled currency, pushing down its value sharply. Other market users respond to the fall by also selling, pushing the value down further still. Speculators buy back in and make a profit. The market has been destabilised since there had not been a clear reason for the exchange rate to change in the first place. The second assumption required to support the stabilising speculation argument is that only successful speculators survive in the market. Thus, the great bulk of speculation is towards equilibrium rather than away from it. This proposition can also be attacked. Many participants engage in occasional acts of speculation and many, on average, lose. 7.4. The first step is to decide upon the sort of risk being discussed. Two examples follow: Case A: an importer short in US dollars Assume firstly that we are dealing with a British importer who is short in US dollars. He has entered into a contract to buy goods in US dollars in one months time but currently does not have dollars. Therefore, he has to buy US dollars over the next month. The risk he faces is that the value of the dollar will rise and, thus, that the goods will cost him more in sterling than he had anticipated. In order to make a profit on the goods in the United Kingdom he will then have to sell them at a higher price and this might cause him to lose sales. If only the spot market were available, the only form of protection against this risk would be to buy US dollars immediately and invest them shortterm until the dollars were needed to meet the import contract. This would establish the rate of exchange and remove the risk associated with a strengthening dollar. The importer would receive US interest rates during the period in which he was holding dollars. There would be a cost in buying dollars in advance if US dollar interest rates were lower than sterling interest rates and a lost profit opportunity if the dollar happened to weaken rather than strengthen. The existence of a forward market would allow the importer to buy dollars forward at an agreed rate and would thus establish the rate of exchange in the same way as the spot exchange transaction.

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There would be no potential cost from investing at a lower interest rate but, if US dollar interest rates were lower than sterling rates, the US dollar would be trading at a forward premium. Thus, there would be an equivalent cost arising from the fact that the forward exchange rate would be worse from the importers point of view than the spot rate. That is, buying forward, the importer would need to pay more in sterling for the required US dollar amount than he would need to do spot. Having taken out a forward contract, the importer could not benefit from a subsequent weakening of the dollar and so in this way also the spot and forward transactions would be equivalent. That leaves one potential advantage from using the forward market. In theory, the importer does not need to pay until the delivery date on the forward contract and this would have cash flow advantages. However, whether this advantage would actually exist would depend on the relationship between the importer and his bank. The bank would generally require some guarantee that the importer would be able to meet his obligations under the forward contract and, as a condition of entering into the contract, might require the importer to hold a sterling deposit with the bank. In this case, protecting against risk through the spot and forward markets would be equivalent, except that there would almost certainly be greater flexibility in the forward transaction to cover uncertainties regarding the quantity of dollars required and the date on which the payment had to be made. The limited advantages associated with the forward market help to explain the growth of derivatives markets, as we shall see in the next unit. Case B: an exporter long in US dollars Consider next a British exporter who knows that she will receive a payment in US dollars at a future date. She is long in US dollars and faces the risk that the value of the dollar will fall before the dollars are received and thus she will receive less in sterling for her goods than she had anticipated. This would reduce (and perhaps remove altogether) the profit margin on her export deal. In the absence of a forward market, she would need to take out a loan in US dollars and convert the dollars into sterling at the existing spot exchange rate. She would then be able to deposit the proceeds in the United Kingdom at British interest rates. Then, when she received the dollars from the sale of her goods, she would use these to repay the dollar loan. Thus she would have established the amount of sterling she would receive from the sale but would, of course, have to make interest payments on her US dollar loan. Her net position would again depend on the relative interest rates in the United States of America and the United Kingdom. If, as we assumed in Case A, interest rates were higher in the United Kingdom than in the United States of America, the interest she received on her UK deposit would be greater than that paid on her US dollar loan. In practice, much would depend on her credit rating since this would determine the interest rate she would need to pay to obtain the dollar loan and whether any collateral would be required. If a forward market were available, she would be able to sell the dollars forward at the existing forward rate of exchange. This would establish the exchange rate she would obtain when she received her dollars. With UK interest rates higher than USA rates, sterling would be at a forward discount and the forward rate would be more favourable to her than the spot rate. Again the

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question would arise as to whether the bank with whom she was making the forward contract would require any guarantee that she would indeed have dollars available to meet her obligations on the delivery date. In neither the spot nor the forward case would the exporter benefit from any unexpected strengthening of the US dollar.

Summary
In this unit we look at what causes fluctuations in exchange rates and at the potential risks to which these fluctuations give rise. On completing this unit, you should now be able to:

explain the main theories of exchange rate determination including absolute and relative purchasing power parity appreciate that exchange rates show greater volatility, especially in the short run, than can be explained by fundamentals. understand the role of arbitrage and speculation in the determination of exchange rates appreciate the risks associated with forex fluctuations both for firms and also for the growth and development of international trade.

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Black Wednesday.
Reference to Wednesday 16th September 1992, when the pound sterling was forced out of the ERM

Introduction
In the final part of Unit 7 we looked at the risks to firms and to international trade that are caused by fluctuating exchange rates. In this unit we look at arguments for and against fixed exchange rate systems. Unit learning objectives On completing this unit, you should be able to: 8.1 Explain the benefits and disadvantages of fixed and floating exchange rate regimes. 8.2 Explain the theory of currency union. 8.3 Interpret the development of the European Monetary Union (EMU) in the light of this theory. 8.4 Identify alternative currency arrangements in a selection of developing countries/regions.

Prior knowledge The unit assumes that you have studied Units 17. Of these, Unit 7 is essential. Otherwise, it requires no prior knowledge, but some basic mathematical skills and familiarity with economic principles will be helpful throughout. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008: The EMS and The ECB). Lawler and Seddighi (2001) (especially part three) deals with convergence in the EMU. Ritter et al (2003) discusses fixed and floating exchange rate regimes. Mishkin (2007) The International Financial System covers much the same ground as well as currency boards and dollarisation. You will need a calculator and access to the internet.

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8.1 The advantages and disadvantages of fixed and floating exchange rates
Recommended reading: Mishkin (2007) The International Financial System; Ritter and Silber (2003) Part Three.

From Unit 7 we know that floating exchange rate regimes give rise to considerable exchange rate volatility certainly more than can be explained by an orderly transition from one equilibrium rate to another. Throughout Units 6 and 7 we were concerned that these fluctuations expose firms to a higher level of risk than would otherwise be the case and we explored some possible hedging techniques. In 7.4 we looked at the argument that exchange rate volatility might even reduce the amount and growth of international trade, though the evidence on this was not entirely clear. However, there is a general presumption in economics that free (international) trade increases economic welfare and that fluctuating exchange rates must in some way discourage this trade. Remember that we identified three ways in which these fluctuations pose problems:

exchange rate fluctuations increase the risk faced by firms and it is always costly and sometimes impossible to hedge these risks small firms and new firms may find these risks especially difficult to cope with governments may respond to fluctuations by competitive devaluations, tariffs and other devices.

In this section, we are going to look at the merits of fixed and floating exchange rates, firstly from a theoretical point of view. We shall then look at our experience of fixed exchange rate regimes with different design features. Interestingly, we shall see that one of the prime motivations behind these regimes has been the third bullet point in our list the desire to prevent governments from pursuing the beggar-my-neighbour opportunities presented by floating rates.

The theoretical considerations

When it comes to the merits of fixed and floating exchange rate regimes, there are essentially two theoretical issues. The first is the one that we have been concerned with since Unit 6, namely that fluctuating exchange rates introduce additional uncertainty and risk for firms which engage in international trade (and also for international investors). This must have some negative effect on investment and trade even if it is difficult to pin down the evidence unambiguously. And since we regard the free movement of goods, services, labour and capital as a good thing, this uncertainty reduces world income and welfare. Since this has been a major theme already in our discussions we shall not say much more about it here. The other issue that arises in these debates is the autonomy of monetary policy. For reasons that we shall look at in a moment, a country which opts for a fixed exchange rate regime, surrenders the ability to conduct an independent monetary policy. (You may recognise this as a frequent issue in the debate over the UK joining the European Monetary Union (EMU)). On the face of it, this is a high price to pay for exchange rate stability, but in 8.4 we shall see that there may be circumstances in which the sacrifice brings additional benefits. To understand this second issue we need some diagrams. Figure 8.1 shows the foreign exchange market under a fixed exchange rate regime. 170
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Exchange rate, E

S S

E D D

Quantity of domestic assets

Figure 8.1: Official intervention when the currency is overvalued In Figure 8.1, the exchange rate is expressed as the amount of the domestic currency required to purchase a unit of foreign currency. This means that a rise in the value of E in the figure indicates a depreciation in the value of the domestic currency. Since we are looking at a fixed exchange rate regime, the value of the domestic currency is going to be tied or fixed to that of the foreign currency. For this reason, we shall describe the foreign currency as the anchor currency. (When we discuss regimes in practice, we shall see that the anchor currency has often been the US dollar.) The supply curve, S, shows the supply of the foreign or anchor currency while the demand is shown by the demand curve D. The supply of foreign currency will depend upon the demand for the countrys exports together with the demand for the countrys financial assets. The demand for foreign currency will come from importers wishing to buy goods from overseas together with domestic investors wishing to purchase foreign currency for investment in overseas assets. The initial equilibrium is shown at E and this corresponds to the par or target value of the domestic currency in this system. We now introduce some disturbances. Imagine, for example, that there is a fall in the countrys net exports, other things unchanged. This means an increase in imports relative to exports and this will result in an increase in the demand for foreign currency by domestic importers and a fall in the supply of foreign currency coming from overseas buyers of domestic goods. In the diagram, the demand curve shifts to the right, to D, and the supply curve to the left, to S. In a free market, the exchange rate would rise from E to E. (Remember that this means a depreciation in the value of the domestic currency.) At its par rate the currency is overvalued. But since this is a fixed exchange rate regime, the depreciation is not allowed. The Government (usually in the form of the central bank) is obliged to intervene to preserve the par value. This means that the central bank has to sell foreign currency reserves in order to buy the domestic currency. In effect, the central bank has to return the supply and demand curves to their original positions.

anchor currency

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How does this relate to monetary policy? Note firstly that selling foreign exchange reserves and buying the domestic currency amounts to reducing the domestic money supply. So, if we think of monetary policy in terms of policy changes in the stock of money, then the money supply and monetary policy are being determined by the need to maintain the fixed exchange rate. Alternatively, the central bank might use the domestic interest rate in order to persuade private sector agents to change their behaviour. A rise in the domestic rate, relative to rates overseas. makes domestic assets more attractive to investors who will then buy the domestic currency in order to invest in those assets. This increases the supply of foreign currency. At the same time, domestic investors will be less enthusiastic about investing overseas and so their requirements for foreign currency will fall. Once again, the central bank is trying to push the supply and demand curves back to their original position. But if it does this, then the rate of interest is being determined by the need to maintain the fixed exchange rate and so once again monetary policy is no longer available for macroeconomic stabilisation. We shall see later that this was an issue for the UK economy when it was a member of the European exchange rate mechanism in 1992. Figure 8.2 shows the opposite case. We begin as before with the exchange rate at its target value, E. But this time we introduce a different disturbance. Suppose that the foreign country (the source of the anchor currency) reduces its interest rate. This makes domestic financial assets more attractive (other things unchanged) than assets in the anchor country. There will be an increase in the demand for domestic and a reduction in demand for foreign assets. Consequently, the demand for the anchor currency will fall while its supply will increase as a result of foreign investors offering it in exchange for the domestic currency. This time, the supply curve shifts to the right (from S to S) and the demand curve shifts to the left (D to D). In Figure 8.2, the exchange rate tries to move down from E to E, indicating an appreciation of the domestic currency. At its par rate the currency is undervalued.
Exchange rate, E S S

E D D

Quantity of domestic assets

Figure 8.2: Official intervention when the currency is undervalued

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But once again, this is not allowed under the rules. The central bank must now buy foreign currency, which increases the domestic money supply, or cut interest rates in order to make its domestic assets less attractive. Once again, monetary policy is being determined by the exchange rate, rather than being free to respond to the other needs of the economy. Notice that there is a critical sense in which these operations are asymmetric. Maintaining the value of a weak currency is not exactly the opposite of trying to weaken a strong one. This is because, for a central bank, the supply of reserves is finite, while the supply of domestic currency is not. A central bank that is conducting a support operation by selling foreign currency knows that it can only do this for so long, before it runs out of foreign exchange reserves. By contrast, a central bank that is buying foreign currency can always create domestic currency with which to make the purchase. This can be a major problem for a central bank supporting a weak currency, if central banks with strong currencies decline to see them weaken. Furthermore, speculators are aware of this asymmetry and can therefore bet on the likelihood that a currency will have to be devalued or leave the fixed exchange rate regime altogether. We shall see examples of this also in the following sections.

Lear

ga nin ct

8a

Why does a fixed exchange rate regime mean that a country must give up an independent monetary policy?

eedb ac

y ivit

8a

This arises because monetary policy must be focused on maintaining the fixed exchange rate. For example, if the currency begins to depreciate (suggesting that it is overvalued at its par rate) then the central bank must either use its holdings of foreign currency reserves to buy the domestic currency to maintain the par rate or it must raise interest rates in order to encourage foreign investors to buy the domestic currency. Both of these actions constitute a tightening of monetary policy and will reduce the level of demand in the domestic economy. Notice this means that if a fixed exchange rate regime includes a dominant currency then events in that dominant economy will spillover into the smaller economies. For example, for minor currencies pegged to the US dollar, a rise in US interest rates means that the minor economies will also have to put up interest rates.

Fixed exchange rates in practice

The gold standard
gold standard

The earliest fixed exchange rate regimes were those where the unit of account was a fixed weight of gold. The earliest versions of these gold standards are known as gold specie standards and involved the use of gold itself as the means of payment in the form of gold coins. Variations on the gold specie standard were the later gold exchange standard and the even more recent gold bullion standard. The central feature of all these from our point of view is that the value of the domestic currency was fixed in terms of a quantity of gold and, clearly, if the value of several currencies was fixed in relation to a common standard, then their values must were fixed in relation to each other. 173

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By 1900, most of the worlds significant trading nations had adopted some form of gold standard and so their currencies were fixed to each other by virtue of being convertible into gold which could then be exchanged for any other currency. The emergency conditions of the First World War saw a number of countries suspend convertibility but reinstate it during the 1920s. The end came in 1931 when a major international financial crisis led to a collapse of confidence in several major currencies (including the pound sterling). Since central banks could not meet the demand for gold at the established exchange rates, convertibility was widely suspended but this time never reinstated. Nonetheless, the gold standard was widely credited with having encouraged a massive increase in world trade between 1870 and 1930, which had facilitated the economic development of most of Europe, and North America. (The use of the term suspension in 1931 indicates that many countries hoped it could be revived.) And the arguments in its favour were exactly those that we associate with fixed exchange rate regimes today it eliminates the uncertainty that occurs when exchange rates fluctuate. But it also carried with it the disadvantage that we have just explored, namely, that a country on the gold standard loses control over its domestic monetary policy. This was because a trade imbalance between two countries would result in a corresponding imbalance in the demands for the respective currencies and since the currencies were convertible into gold, the deficit country would have to make net transfers of gold to the surplus country. This would then force corresponding reductions/ increases in their respective money supplies. Central banks could try to reduce gold inflow/outflows through the use of interest rates, but this simply produced the monetary policy problem in another form. In fact, there was an additional problem with the gold standard, namely that world monetary policy was greatly influenced by the discovery and production of gold and its use for non-monetary purposes. If the world gold supply did not expand as rapidly as world trade, then the result was bound to be deflationary.

Lear

ga nin ct

8b

1. In 1925 the gold price of a US dollar was 0.0513 ounces while the gold price of the pound sterling was 0.25 ounces. What was the US dollar: pound exchange rate? 2. What are the drawbacks of linking the value of a currency to gold?

eedb ac

y ivit

1. $4.87:1 (= 0.25 0.0513) 2. Firstly, gold has other uses: in medicine, industry and fashion. Hence there is a resource cost involved in having large quantities of gold in storage as a monetary reserve. Secondly, the supply of gold for monetary purposes will depend on the rate of discovery and extraction of gold and also on the alternative demands for it. If the stock of gold expands more slowly than the growth in world trade, for example, there can be a shortage of international liquidity which has a deflationary effect.

8b

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Following the collapse of the gold standard in 1931, and in the midst of the great depression, governments embarked on a series of beggar thy neighbour policies by, for example, using currency devaluations to increase the competitiveness of their countrys export products to reduce balance of payments deficits. This merely passed the problem of falling economic activity to competitor countries, worsening national deflationary spirals, which resulted in plummeting national incomes, shrinking demand, mass unemployment, and an overall decline in world trade. Trade in the 1930s became largely restricted to currency blocs (groups of nations that use an equivalent currency, such as the Sterling Area of the British Empire). It was against this background and a determination not to repeat these mistakes, that delegates from all 44 allied countries met at Bretton Woods, New Hampshire, in 1944, to establish an international system of monetary management.

Bretton Woods
Although there were differences of emphasis, there was widespread agreement amongst the planners at Bretton Woods that the post-war economic order should be based upon free markets, albeit with some degree of regulation. The acceptance of some need for government intervention had been strengthened by the experience of the great depression in the 1930s. Public management of the economy had emerged as a primary activity of governments in the developed states. Employment, stability, and growth were now important subjects of public policy. In turn, the role of government in the national economy had become associated with the assumption by the state of the responsibility for assuring of its citizens a degree of economic well-being. In addition the US representatives were inclined to the view that both world wars had their origins in economic grievances and so the design of a satisfactory international financial system had security as well as economic implications. The Bretton Woods system comprised four elements. The first was a commitment to fixed exchange rates in order to get most of the advantages of the gold standard but also, it was hoped, without some of the drawbacks. What emerged was an adjustable peg system. Exchange rates would normally be fixed in relation to the US dollar (subject to a margin of fluctuation of +/ one per cent), but there was provision for upward (revaluation) and downward (devaluation) adjustments when it became clear that a countrys exchange rate was fundamentally incorrect. Member central banks were to be responsible for maintaining parity by the kind of interventions that we discussed in 8.1 using holdings of US dollars as the reserve (or anchor) currency. In turn, the US agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. In effect, therefore, Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, as good as gold. The US currency was now effectively the world currency, the standard to which every other currency was pegged. As the worlds key currency, most international transactions were denominated in US dollars. In addition to the adjustable peg exchange rate mechanism, the Bretton Woods system introduced three important institutions. The first of these was the International Monetary Fund (IMF) whose role was twofold. The first was to oversee adjustments to the par value of exchange rates in the event of

adjustable peg

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fundamental disequilibrium. In effect, it was the IMFs job to decide when an exchange rate was unsustainable and to negotiate a new par value. Its other role was to provide assistance to countries experiencing short-term balance of payments difficulties by providing loans of foreign currency to debtor countries. The source of these loans lay in quotas of gold and their own currencies that member countries were required to paid into the IMF as a condition of membership of the system. On this and a related issue, there was a disagreement between the UK and the USA. For the UK, Keynes had originally argued for the creation of an international reserve currency (bancor) to be put at the IMFs disposal (rather than the mix of gold and individual currencies). He also argued for a mechanism that would ensure that balance of payments adjustment would involve both deficit and surplus countries. (This was the point we encountered in section 8.1.) In both cases Keynes lost the argument and the detailed arrangements were those favoured by the US negotiators, though there was much agreement on other issues. The fact that adjustment was to fall entirely on the deficit country did quite a lot to tarnish the IMFs reputation in future years. This arose because it was accepted that, as the provider of loans to deficit countries, the IMF should impose terms and conditions on the future economic conduct of the borrower. Given that the borrower had to make all the adjustments, these terms could sometimes be quite onerous and the IMF acquired a reputation for imposing harsh and uncaring conditions on what were often rather poor countries. Another problem that the IMF inherited was the failure to identify clearly what was meant by fundamental balance of payments disequilibrium. Given that revaluation/devaluation could only take place in such cases, and also that some governments came to see the maintenance of their currencys par value as some test of economic virility, the result was that many countries laboured under repressive economic policies designed to prop up their exchange rate, when it would have been in everyones interest to devalue. The two other creations of the Bretton Woods system were the World Bank (intended to grant loans for economic development projects) and the General Agreement on Tariffs and Trade (GATT), later to become the World Trade Organisation whose purpose was to promote the liberalisation of world trade. The fixed (more strictly adjustable peg) element of the Bretton Woods system came to an end in 1971 after more than 25 years which had seen the rapid economic recovery of nations devastated by World War II, as well as the rapid growth of world trade. This was also a period in which the USA moved from running balance of payments surpluses to running large and persistent deficits. By 1960, it was commonplace to talk about a dollar glut. The origin of these deficits lay partly with US consumers desire to enjoy a high standard of leaving even it meant borrowing to do it and also with the Cold War and the US Governments need for high military spending overseas. To begin with, the supply of dollars was helpful to international stability. Recall that Bretton Woods effectively made the US dollar a reserve currency. A ready supply of dollars was, therefore, essential to ensure adequate growth of world liquidity. But the dollar could also be exchanged for gold (at least by central banks and governments) and the rate of exchange had been fixed at $35 per ounce. As the stock of dollars grew much more rapidly than the US stock of gold, doubts

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Triffin dilemma

began to surface about the value of the dollar. This gave rise to what became known as the Triffin dilemma (or paradox) after the economist Robert Triffin who first drew attention to it in 1960. The paradox was that world liquidity required a steadily expanding stock of US dollars, but increasing the stock of dollars increased the likelihood that countries would not wish to hold liquidity in this form. By the end of the 1960s, it was apparent that the dollar was substantially overvalued at $35 to an ounce of gold. In fact, some governments had begun exchanging dollars for gold at $35 and then selling the gold on the open market for considerably more. The formal end of the exchange rate element of the Bretton Woods system is normally dated at 15 August 1971, the day on which the USA ended its promise to sell gold at the fixed price of $35. But there had been numerous devaluation of other currencies in the years leading up to 1971 (including the UK in 1967). Furthermore, some features continued for a short period afterwards. In December 1971 ten major trading countries met at the Smithsonian Institute in Washington. A general realignment of currencies was agreed, a wider 4 per cent band was introduced and the gold price rising to $38. But these arrangements lasted little more than a year. The pound floated in 1972, in February 1973 the dollar was devalued again, by the middle of the year most major currencies were floating and the US abandoned a fixed gold price in November.

A Bretton Woods II?

The immediate effect of the ending of the Bretton Woods was the emergence of a more free market, less-managed, international financial system. This included floating exchange rates (as we have seen) and also the dismantling of capital controls. Later, in the 1980s and 1990s this was accompanied by market liberalisation in a number of major developing countries, notably China starting in 1978 and India in 1991. The result in the last twenty years has been rapid growth, particularly in SE Asian economies, and rather slower growth in the West. Along with this has emerged an informal currency arrangement whereby a number of SE Asian economies, with large current account surpluses and high saving rates, have been exporting and lending to western states (especially the US) with low savings rates and large current account deficits. Lending to the US means, of course, buying dollar-denominated assets. Because the SE Asian economies have simultaneously, and of their own volition, pegged their currencies informally to the US dollar, there are obvious similarities to the situation that existed under the original Bretton Woods system during the 1960s. In 2003, three economists, Dooley, Folkerts-Landau and Garber, referred to this as a Revived Bretton Woods system and followed it up with several more published and conference papers. More contentiously, the original paper went on to argue that this was a natural and sustainable state of affairs: We argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center.

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Financial liberalization, in turn, requires floating exchange rates among the center countries. But there is a line of countries waiting to follow the Europe of the 1950s/60s and Asia today sufficient to keep the system intact for the foreseeable future. (Dooley et al, 2003) Their argument is clear enough. The international financial system is divided into two parts: the centre (roughly the USA) and a periphery (China and other less developed economies in SE Asia). The periphery is anxious to grow rapidly and seeks to do this by keeping its exchange rates artificially low against the currencies of the centre, principally the US dollar. In doing this the periphery accumulates claims against (that is lends to) the centre. This is the role that was fulfilled by Europe and Japan under the original Bretton Woods system. Rapid growth will eventually allow the periphery to graduate to the centre (just as Europe did). And there is a line of countries waiting to follow in the footsteps of Europe (in the 1960s) and Asia today. The parallels with the original Bretton Woods system are close enough to encourage some commentators to describe this arrangement as Bretton Woods II. But we need to be careful here. The current structure of the international financial system even now is a matter for great concern and some controversy. There are many proposals for change and even requests for proposals (see for example Chowla and Griffiths, 2009). These are sometimes expressed as the need for a Bretton Woods II (which we hope to build in the future). See for example the calls by Sarkozy and Brown (2009). But the argument that the existing informal arrangements themselves constitute a Bretton Woods II has caused considerable controversy, mainly because of the assumptions that underlie the final sentence in the quotation. The weakness of the argument is that other countries may not want to take up this role in future and, worse than that, there is no guarantee that Asian countries will want to do so for much longer. In fact, the danger goes wider than simply a change of attitude on the part of the periphery countries in this arrangement. The central issue is the stability of the US dollar. This would be threatened by future reluctance of any major investors to hold US dollars. Suppose, for a moment, that the enthusiasm for financing the US deficit dries up, whether it is because of a change of heart of Asian countries or countries in Europe. What would be the consequences? The easiest to predict would be a steep rise in US interest rates as Asia dumps US bonds and their price collapses. (Recall the inverse price-yield relationship we explored in Unit 3.) The fall in prices might well bankrupt Asian banks and cause a major financial crisis. Remember too that a sale of (or unwillingness told) US assets will mean a fall in the value of the US dollar against other currencies. Anyone holding assets denominated in US dollars will find the value of their investments falling. This will include not just Asian banks but western banks too, who bought US bonds and other assets in the past. This exposes those banks to the translation risk that we discussed in Unit 7. In the extreme case, these banks will find their liabilities (not denominated in US dollars) exceed their assets and will be insolvent. The fall in US bond prices is almost certain to cause a sell-off of other US assets houses and equities are the obvious examples and we would have financial crisis in the West which would not be so very different from the one we experienced in 2008, with similar

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consequences for the US real economy. Once the US economy slows down, this will destroy the growth on which the Asian countries have been depending. A major world recession then looks quite likely. The question then is how likely are investors to change their minds? It is difficult to tell and if we knew (or had strong reason to believe) that the US dollar was becoming unattractive, then the efficient market hypothesis tells us that everyone would then try to sell dollars simultaneously and its value would collapse. There is no reason to suppose it would be gradual or orderly. Are there any pointers? There is certainly a lot of anxiety, though most of this has focused upon the Asian countries that make up the periphery in Bretton Woods II. For example, Roubine and Setser (2005) were too pessimistic in their timing but their paper highlights the dangers. Collectively, they amount to saying that the system is unsustainable and must change sometime:

There is a tension between the US need to borrow to finance its deficits and the loss that lenders are bound to suffer if or when the US takes steps to eliminate those deficits: The present arrangement threatens internal political stability. The cheap financing of the US deficit enables US consumers with jobs to enjoy cheap goods but puts US workers of internationally traded goods out of work. In order to buy the US debt and to stop the yuan from rising, the Chinese central bank is creating large amounts of. yuan. (Recall the discussion around Figure 8.2 above.) This rapid increase in the Chinese money supply will be inflationary at some point in the future. The yuan will have to be revalued at some point. When this happens, there will be corresponding losses on Chinas holdings of dollars. The losses on existing dollars will be very large (estimated at ten per cent of GDP in 2005 and getting larger with everyday that passes).

Given our earlier discussion of the Bretton Woods (I) institutions, we might also note Eichengreens (2004) argument that this whole structure is voluntary. There are no bodies like the IMF available to discourage an Asian central bank from simply walking away. Notice that all of these problems are potential threats to the world economy because the current value of the US dollar rests on foundations that critics like Roubine and Setser argue are very weak. There is one other feature of the current arrangements that one might argue has already been a problem and played some part in the build-up to the financial crisis of 2008. This is the effect of the Asian demand for dollar assets on the shape of the yield curve. In Unit 3 (3.4) we explained that the yield curve normally slopes upward meaning that it is more expensive to borrow by issuing long-dated bonds than it is to borrow using short-dated instruments. Ultimately, we said, the shape of this curve depends upon the demand for bonds with different periods to maturity and, therefore, depending on this demand, the shape of the curve could change. The strong demand for US bonds and other long-dated assets had the effect in 20067 of flattening the yield curve meaning that the premium required on long-term borrowing was reduced. Bear in mind that the 2008 crisis was caused by excessive and unwise lending by banks (and borrowing by households and firms). The circumstances that encouraged this are quite complex but a contributory factor was the willingness of China and other Asian countries to

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fund the US deficit. Without that, long-term interest rates would most likely have been much higher.

Lear

ga nin ct

8c

1. In what sense could the US dollar be described as weak under the socalled Bretton Woods II arrangements? 2. List five ways in which a fall in value of the US dollar could cause difficulties for the international financial system.

eedb ac

y ivit

8c

1. The weakness of the US dollar that has troubled commentators since 2000, is not a reference to its actual exchange rate. It is more the belief that the value of the US dollar was unsustainable in a sense that it was overvalued by the willingness of China and other Asian currencies to hold US dollars in large quantities, partly to keep their own exchange rates low. 2. If China and other Asian countries changed their policy and the US dollar fell sharply in value the consequences would very likely include: (a) a fall in the value of US bonds (b) a fall in the value of US dollar-denominated assets on bank balance sheets (c) a rise in US interest rates which is likely to cause other rates to rise in line (d) a slow down in the US economy (e) a fall in demand for exports from less developed economies.

8.2 The theory of currency union

A currency union is a situation in which a number of countries share a common currency. In the context of our present discussion, therefore, it is one particular way of operating a fixed exchange rate regime. Hence the arguments for and against a currency union are much the same as those underlying the debates about fixed and floating exchange rates. The term currency union is often used interchangeably with monetary union though this is not strictly accurate. A monetary union usually involves rather more. In particular it involves both a common currency but also a single market. The obvious example (which we turn to in the next section) is the European Monetary Union which is normally regarded as having been established in January 1999. As we have just said the merits (and drawbacks) of currency union are very close to those of any other form of fixed exchange rate regime. Since we have already visited these, we list them only briefly here. The main advantage is:

lower exchange rate volatility, uncertainty and risk (and therefore higher levels of international trade.

However, a currency union will have the additional advantages of:

lower transaction costs for firms trading across national boundaries since all transactions occur in a single currency greater price transparency, and more competition, since prices are expressed in the common currency.

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If we then add the condition for monetary union of no trade barriers, then there should also be an advantage from:

a better functioning internal market (including economies of scale).

Against these benefits, we know that the main cost of any system of fixed exchange rates is:

the loss of an economic policy instrument (that is monetary policy).

In a situation where an economy experiences some form of economic shock, not experienced by other participants in the system, it will not be able to adjust to this shock by a change in the exchange rate. Just how important this loss is, depends upon the nature of the shock and the flexibility within an economy to adjust without a change in the exchange rate. During the planning for European Monetary Union (EMU) this became a major issue as part of a debate over whether the proposed members of EMU constituted an optimum currency area (OCA). There is a substantial literature on the criteria that need to be met by an OCA. The starting point of the debate was a paper by Robert Mundell (1961) in which he set out the criteria for an OCA that were quite demanding and in the absence of which flexible exchange rates would be preferable. Since the EU countries certainly did not meet the OCA criteria, even by the 1990s, Mundells early work was hardly supportive of EMU. The problem is this: Consider a simple model of two entities (regions or countries), initially in full employment and balance of payments equilibrium, and see what happens when the equilibrium is disturbed by a shift in demand from the goods in entity B to the goods in entity A. Assume that money wages and prices cannot be reduced in the short run without causing unemployment, and that monetary authorities act to prevent inflation The existence of more than one (optimum) currency area in the world implies variable exchange rates If demand shifts from the products of country B to the products of Country A, a depreciation by country B or an appreciation by country A would correct the external imbalance and also relieve unemployment in country B and restrain inflation in country A. This is the most favorable case for flexible exchange rates based on national currencies. (Mundell, 1961) From this, we draw the conclusion that one requirement of an OCA is that there should be a high degree of wage and price flexibility amongst its members. But typically, as we know, this is not the case. Of course, if the unemployed workers in country B migrated to the expanding industries of country A this would be another solution to the problem. So another desirable characteristic is a high degree of factor mobility. This might be available in some cases. For example, in the USA workers and their families do migrate across state boundaries in pursuit of better wages and living standards. But the USA does not only have a single currency it also has (largely) a single language and culture. This is not a situation that applied to the EU in the build up to EMU. Ideally, OCAs also need some means of making internal transfers of income to areas/regions adversely affected by shocks. For the single nation state this can 181

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be achieved by a combination of taxation and regional policy (though rich regions are generally reluctant to help the poor). But the European Union had no such mechanism, and one of the features of EMU was a Growth and Stability Pact and a no bail out clause which made it virtually impossible to transfer income from one country to another. The consequence of Mundells early work (and that of others that followed) was a general consensus that nation states alone were natural candidates for OCAs. Since single currencies already prevailed within nation states, Mundell was sometimes accused of stating the obvious. Hence, attempts to create OCAs across natural boundaries would always involve some cost in the surrender of the exchange rate policy instrument. Subsequently, Mundell (1973) changed his view of the possible merits of EMU on the grounds that a large currency area made it easier for individual countries/regions to withstand supply shocks. The argument was essentially about risk. Starting from the view that investors overwhelmingly hold assets denominated in the domestic currency (in other words, there was little international portfolio diversification) then a supply shock to the domestic economy, in which numerous firms failed, could result in significant default on domestic financial assets. In a currency union, however investors would hold claims on firms in a number of countries/regions with the result that defaults in one region would have much smaller effects. Essentially, the fact that investors hold claims across national borders means that prosperous regions help to absorb the shock to poor regions. Not everyone was convinced by this argument but it does explain why Mundell eventually found himself supporting the EMU experiment.

Lear

ga nin ct

How does a currency union differ from a monetary union?

y ivit

8d

eedb ac

8d

Both involve fixing the rate of exchange between nation states by adopting a single, common, currency. However, a monetary union is usually understood to include additional features like a single market. This involves the removal of any trade and capital restrictions between the member states, while a currency union can exist even with these restrictions. A monetary union may also include some degree of political integration between the member states.

Recommended reading: Howells and Bain (2008) The EMS; Lawler and Seddighi (2001) part three.

8.3 European Monetary Union (EMU)

Given this rather gloomy consensus, one might ask how EMU ever got off the ground. But before we consider this, we need a little history since this provides part of the answer. As we have already seen, the EMU is much more than an OCA. It is linked to the development of a single market (if slightly incomplete) and, in the opinion of some critics, to the development of more centralised European political institutions. 182
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The idea of a monetary union was first floated in 1970 by the Werner Committee which optimistically called for completion of the project by 1980. However, little progress was made in the 1970s which were dominated by the break up of Bretton Woods and then by various schemes, including the snake in the tunnel aimed at restraining the degree of exchange rate fluctuations between members of the European Union and between the EU and the US dollar (Gros and Thygesen, 1998). The Single European Act (1986) and the commitment to complete the single internal market by 1992, gave the issue new impetus and in June 1988 the European Council established a committee to make concrete proposals. The Delors Report (1989) proposed a three stage progress towards EMU. The proposals, with minor modifications, were incorporated in the Maastricht Treaty (1992) which set out a timetable as well as a description of the key institutions. The Treaty identified three stages:

Stage 1, beginning 1 January 1993. This established a Monetary Committee to monitor the conduct of monetary policy in member states that had joined the exchange rate mechanism (ERM, of which more in a moment) and to oversee the dismantling of capital controls in member states. Stage 2, beginning 1 January 1994. This established the European Monetary Institute to work out the details of the introduction of the single currency and the role of national central banks within the monetary union. Stage 3, beginning 1 January 1999. This established the European Monetary Institute as the European Central Bank which would fix the exchange rate between national currencies and the euro, introduce the euro for the denomination of bank deposits and take over the official reserves of member central banks.

Stage 3 itself was later divided into three phases which finally saw euro banknotes and coin introduced in January 2002.
European Monetary System (EMS)

Exchange Rate Mechanism (ERM)

In the meantime, in March 1979, the snake was replaced by the European Monetary System (EMS) and a system for linking the exchange rates of countries that wished to participate, known as the Exchange Rate Mechanism (ERM). After a difficult start, this functioned reasonably well until 1990 when the Bundesbank began to raise interest rates in response to inflationary pressures caused by the unification of Germany. Consequently, other ERM members, some in very different situations, had to raise rates too and this provoked speculation that some governments would be forced to devalue rather than impose high interest rates on economies facing recession. After raising interest rates from 10 to 15 per cent in a single day the UK government withdrew sterling from the ERM in September 1992. This incident provides the perfect example of the problem we discussed at the end of the The theoretical considerations in section 8.1. Two year membership of the ERM later became one of the eligibility criteria for countries wishing to join EMU. We return now to the question of why, if the EU met so few of the requirements of an OCA, it managed to introduce a monetary union. Part of the explanation is that the merits of EMU were never judges on solely economic criteria. As we noted above, EMU was essential for the development of the single market and the single market for many of its supporters was part of the political integration of Europe and was linked in turn to questions of peace and security.

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On the economic front, however, there were two arguments in favour of union. The first doubted just how serious a loss of policy instrument was involved when exchange rates could not be adjusted. Let us return to the Mundell example and assume that the shift in demand is a reduction in demand for French goods and an increase in the demand for German ones. With little price flexibility and no exchange rate to devalue, France will face rising unemployment and falling output. A devaluation, making French goods cheaper and German ones more expensive, might help. But the effect of this is to make German goods dearer in France it involves a fall in French real wages. Suppose that labour is not prepared to accept this. Trade unions demand higher money wages to compensate and the advantage of devaluation if quickly lost. Clearly the benefits of this policy instrument depend upon how open economies are and on their institutional arrangements for price and wage setting including indexation, explicit or covert. How much stabilisation capacity the eurozone countries have sacrificed is uncertain (Eichengreen, 1994).

Lear

ga nin ct

8e

Why might exchange rate flexibility be of limited value as an instrument of economic policy?

eedb ac

y ivit

8e

The main issue is that the initial effects may be small and/or will be shortlived. Take the case of a country that devalues in order to lower the foreign price of its exports. This simultaneously involves a reduction in real income for its inhabitants. They are likely to resist this by demanding higher money wages. How successful they will be depends upon political and institutional considerations in the devaluing country. If money incomes are automatically indexed to the price level, there will be no effect. In less extreme cases where there is no indexation but trades unions are strong and there is a widespread consensus in society that real incomes should not fall, then the effects will be temporary.

The second argument concerned the probability of asymmetric shocks. A general shock, such as an oil price rise/fall affects all countries to some degree and is a lesser problem. Furthermore, what matters for EMU is the likely frequency and scale of asymmetric shocks after the creation of the union and this could easily be affected by the union itself. This would be the case if the union had some effect upon the similarities (or convergence) between the member countries since countries with similar economic structures, policies and structures are less likely to be affected differentially by any shock than countries that are radically different. This explains the emphasis on convergence as a condition of EMU membership. We have already noted the requirement for some degree of exchange rate convergence (membership of the ERM for two years with no devaluations. Other convergence requirements include:

Price stability. An applicants rate of inflation must not exceed the average of the three best member countries by more than 1.5 per cent. Public sector finances. An applicants budget deficit must be no more than three per cent of its GDP and the ratio of its debt to GDP should not exceed 60 per cent of GDP.
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Interest rates. An applicants long-term interest rate must not exceed the average long-term rate of the three lowest-inflation member countries by more than two per cent.

Notice that these are requirements for nominal convergence. Reducing the risks of symmetric shocks requires what is called real convergence, that is to say a degree of similarity in labour productivity, living standards, unemployment rates and economic structure. It is only with real convergence that shocks are likely to affect a group of countries or regions in a similar way. Although there no real convergence for membership of EMU, there are numerous features and rules of EM membership that are intended to encourage such convergence. The free movement of labour, and uniformity of employment regulation is one of these, as are rules about access to training and higher education. It is also possible that the nominal convergence encourages real convergence to some degree. Katsoulie (2001) shows how the price stability criterion may affect the convergence of unemployment rates.

8.4 Other currency arrangements

Recommended reading: Mishkin (2007) The International Financial System; Gudmunsson (2008).

So far, we have presented the loss of the variable exchange rate as a policy instrument as a cost, a price that has to be paid for exchange rate stability, though we have also suggested that the cost might sometimes be small. However, there are circumstances where removing the freedom to adjust exchange rates might have positive benefits. This is most likely to arise where a country has rather weak policy and monetary institutions and where its commitment to price stability is in doubt. Situations like this are more common among developing and emerging market economies. In these cases, it may be better to limit the amount of discretion that can be exercised over monetary policy. The paper by Gudmunsson (2008) explains some of the principles that lie behind the choice of an appropriate exchange rate regime and provides a detailed survey of the choice of regimes by countries in Africa. Here we look briefly at three regimes that have been adopted by governments trying to strengthen their antiinflation credentials. The first of these is exchange rate targeting. This involves fixing the value of a domestic currency in relation to some other (anchor) currency. This is usually chosen because it has a history of low inflation. Once again, it is the US dollar that is usually chosen, though the UK adopted a policy of exchange rate targeting using the Deutschemark, informally from 1986 to 1989 and then explicitly as part of the ERM from 1989 to 1992 and France did the same from 1989. The advantage of exchange rate targeting is that it forces the targeting policymaker to follow the monetary policy adopted in the anchor country. If it does not, the exchange rate will appreciate or (more likely) depreciate which is not allowed. Furthermore, if the exchange rate target is credible, then this may encourage price setters in the targeting country to expect low inflation. The lower are agents inflation expectations, the easier it is for a central bank to achieve low inflation, especially if it is trying to lower the rate first. Another advantage of exchange rate targeting is that it makes the objectives of policy easy to understand. Everyone knows what is meant by a sound currency

exchange rate targeting

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(and most would regard it as desirable). This also helps to make low inflation more credible, especially in a country where inflation has been the norm. A disadvantage of exchange rate targeting, however, is that it causes shocks to the anchor country to be automatically transmitted to the targeting country. We have already mentioned the strains caused to ERM by German unification in 1990. This gave rise to inflationary pressure in Germany, which responded by raising interest rates. Interest rates in the targeting countries had to rise in step, with the result that France was forced into recession while the UK abandoned the target in 1992. In the UK case, speculators were facing a virtual one-way bet. Once doubts emerged about the governments willingness to raise interest rates, speculators sold sterling requiring yet a further rise in interest rates. With enough selling, sterling was bound to be devalued. An alternative to exchange rate targeting is the currency board. This requires the domestic currency to be backed 100 per cent by a strong foreign currency. The domestic note issuing authority then establishes a fixed exchange rate between the domestic and foreign currency and guarantees to exchange domestic for foreign currency. As fixed exchange rate regimes go, this is rather stronger than the exchange rate target since there is no scope at all for the domestic authority to exercise any discretion. (In an exchange rate targeting regime, the authorities can increase the money supply or change interest rates, even if it threatens the target.) In a currency board the monetary authority can only increase the domestic money supply by taking in foreign currency in exchange. This reveals one of the disadvantages of the currency board. This is that if there is a speculative attack against the domestic currency, the domestic currency is exchanged for foreign currency and the money supply contracts. A currency board also means that the central bank cannot act as lender of last resort since it cannot create liquidity in excess of its holdings of foreign currency. Some other way of preserving banking stability has to be found. Argentina, Bosnia, Hong Kong and Estonia are amongst the countries that have operated currency boards, during the 1990s. Finally, a currency regime that provides an even stronger commitment to a fixed exchange rate and a monetary policy operated by some external authority is what has come to be known as dollarisation. This involves the replacement of the domestic currency by some other currency altogether, usually the US dollar. The strength of this commitment over the currency board lies in the possibility that the monetary authority in a currency board regime could change the link between the foreign and domestic currency. With dollarisation, that is impossible. A dollar is a dollar. It also has the advantage that the currency cannot be subject to speculative attack unless the attack takes place across all dollar countries. The main disadvantage of dollarisation, not experienced with the other regimes, is the loss of seignorage. Seignorage is the profit that accrues to the note issuing authority (usually the Government) from the difference between the face value of the notes and coin and their cost of production. For some governments in poor countries, this might be significant.

currency board

dollarisation

seignorage

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Lear

ga nin ct

8f

1. Why might it sometimes be advantageous for governments to give up control over their monetary policy by adopting a fixed exchange rate? 2. What kind of exchange rate regime might be suitable for this purpose?

eedb ac

y ivit

8f

1. Imagine a country with rapid inflation, weak government and a central bank with a history of political interference and corruption. Several times in the past the Government has promised to bring down the rate of inflation but it has never happened for long and no one any longer believes these promises. If the country really does now want low inflation then the outcome of monetary policy will almost certainly be improved by handing it over to someone else, especially if the alternative authority has a reputation for maintaining price stability. 2. Tying the countrys exchange rate to a strong currency would be one way of removing the discretion of the home authorities to conduct inflationary policy. This is because a rate of inflation that exceeds that of the anchor currency will cause investors to sell the domestic currency and hold assets in the anchor currency instead. This will cause the domestic currency to depreciate unless the central bank buys the domestic currency and/or raises interest rates. There are various ways of creating this tie including exchange rate targeting, a currency board and or even replacing the domestic currency with the anchor currency.

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Case Study The costs of monetary union

Read the following and answer the questions below. Was the euro a mistake? Barry Eichengreen VoxEU.org, 20 January 2009 2008 was the year of asymmetric financial shocks for the Eurozone, but 2009 will be the year of the symmetric economic shock. All of Europe is slipping simultaneously towards recession and the threat of deflation. Here one of the worlds leading international economists explains that a common monetary policy response is optimal. Euro interest rates should be cut to zero and quantitative easing undertaken, all complemented by fiscal expansion by Eurozone nations that can afford it. What started as the euros greatest challenge could be its salvation, but only if policy makers act swiftly. What started as the Subprime Crisis in 2007 and morphed into the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a euro area member such as Greece might default on its debt. In addition to directly damaging bank balance sheets, this would destroy confidence in its banking and financial system.

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Case Study

continued

Unable to borrow and facing horrific bank recapitalisation costs, the country would have to print money. To do so it would have to abandon the euro and reinstate its old national currency. As not a few critics from Willem Buiter to Wolfgang Munchau to yours truly have observed, the previous paragraph is rife with dubious premises and logical nonsequiturs. To start with, that Greece will be allowed to default is questionable. There is an alternative, namely fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government. To be sure, this alternative will be excruciatingly painful. No one will like it except possibly the IMF, which will relish the opportunity of reasserting its role as lender to developed countries. There will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members. But, ultimately, everyone will swallow hard and proceed, much as the US Congress, having played rejectionist once, swallowed hard and passed the $700 billion bank bailout bill when disaster loomed. Admittedly, if the current crisis has taught us one thing, it is that we should not underestimate the ability of politicians to get it wrong. But even the most blinkered politicians will see what is at stake here. Investors would flee en masse from the banks and markets of a country that contemplated abandoning the euro (Eichengreen, 2007). No matter how serious the crisis, politicians will realise that attempting to jettison the euro will only make it worse. Another lesson of the crisis is that financial shocks can spread unpredictably. No one knows whether or not a Greek default would cause Irish and Italian bond prices to collapse, precipitating full-fledged debt and banking crises there. But no one wants to find out. In the end, the EU will overcome its bailout aversion. Euro adoption is irreversible: Was it a mistake? The euro area will hang together, in other words, because the decision to enter is essentially irreversible. Getting out is impossible without precipitating the most serious imaginable financial crisis something that no government is prepared to risk. But then was the mistake getting in the first place? Opponents of monetary union founded their arguments on asymmetric shocks. They argued that adverse shocks affecting some members but not others were so prevalent that locking them into a single monetary policy was reckless. If those asymmetric shocks hit heavily-indebted countries, then the latter would also have no capacity to deploy fiscal policy in stabilising ways. Absent coping mechanisms like a system of inter-state transfers, the only option would be a grinding deflation and years of double-digit unemployment. More prudent would have been to allow such countries to retain the option of pushing down the exchange rate instead of pushing down wages. Desperately needed improvements in

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Case Study

continued

competitiveness would then be more easily engineered. This is the daylight-savings-time argument for exchange rate flexibility. Part of what we have seen is clearly an asymmetric financial shock. Countries like Greece with debt and deficit problems have been singled out by investors who are now fleeing everything that emits the slightest whiff of risk. Similarly, the countries with the biggest housing bubbles, such as Ireland and Spain, are now suffering the most serious slumps as their bubbles deflate and problems ramify through their financial systems. It is their bond spreads that have shot up. It is there where output has slumped most sharply and where the need for wage reductions is most dramatic. The only mystery is why it took investors so long to focus on their problems why were they not singled out six months or a year ago? Asymmetric financial shock, symmetric economic shock But the more days pass, the more it becomes evident that the truly big event is the negative economic shock affecting the entire euro area. Different euro area members may have felt financial disturbances to a different extent, but they are all now experiencing the economic disturbance in the same way they are all seeing growth collapse. Germany, which thought itself immune from the economic crisis, is now seeing its exports slump and unemployment rise. The rise in unemployment may be small so far, but it is the tip of the iceberg. And there is no longer any doubt about how much ice lies just below the surface. This shock is symmetric it is affecting all euro area members. In turn this means that a common monetary policy response is appropriate. There will now be mounting pressure for the ECB to cut interest rates to zero, move to quantitative easing, and allow the euro exchange rate to weaken. (This last part of the adjustment is already beginning to happen without the ECB having to do anything about it.) Now that recession and deflation loom across the euro area, this is a response on which all members should be able to agree. It can be complemented by fiscal stimulus. If countries in a relatively strong budgetary position, like Germany, are in the best position to apply it, all the better; the result will be help from outside for their more heavily indebted, cash-strapped neighbours who need it most. What the ECB should do Of course, this assumes to return to an earlier theme that policy makers do the right thing. The ECB will have to abandon its fixation with inflation, cut rates to zero, and proceed with quantitative easing. Germany will have to abandon its deficit phobia and apply the fiscal stimulus that it and the larger euro area so desperately need. After wallowing in denial, both are now moving in the requisite direction. But there is no time to waste. If 2008 was the year of the asymmetric financial shock, then 2009 is the year of the symmetric economic shock. In the same way that the former should have been the year of the euros greatest jeopardy, the latter can be the year of its salvation. But for this to be true, policy makers must act. 189

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Lear

ga nin ct

8g

1. Why does the author argue that the alternative solution to Greeces problems will be excruciatingly painful? 2. Why should the IMF not mind this painful alternative? 3. Why would investors flee en masse from any country contemplating leaving the euro? 4. What were the arguments used by opponents against monetary union? 5. What is meant by Absent coping mechanisms like a system of interstate transfers... 6. Why have bond spreads shot up in Spain and Ireland? 7. The author says that the euro exchange rate is beginning to weaken without the ECB doing anything about it. How does that happen? What could the ECB do to encourage a weakening?

eedb ac

y ivit

8g

1. The issue is that Greece might default on its debt since this has increased dramatically in relation to its GDP. If this is to be prevented the first requirement is to stop and reverse the increase in indebtedness. This will require a dramatic cut in government spending and an increase in taxation (fiscal retrenchment). Public services (and employment in the public sector) will be reduced and this will be very unpopular. Wage cuts will make Greek exports more competitive, improving its net exports and output in general. This will also help to improve public finances by increasing tax revenue and reducing spending on unemployment benefits. Loans from other EU countries and/or the IMF will reassure holders of Greek bonds that default is unlikely. 2. This is a reference to the IMFs reputation for bullying countries that are in financial difficulties. This usually takes the form of imposing strict conditions on economic policy before making funds available. Almost invariably, these involve cuts in public spending and the pain falls on lower income groups. It is difficult to know whether the author really means that the IMF gets pleasure from this or whether the remark is meant to be a satirical comment. 3. Fear of the unknown is probably enough in itself. We have stressed many times in earlier units that uncertainty means risk and markets do not like either. A more concrete reason is that once a country leaves the euro, it is not clear where it can turn for support. The Government would almost certainly default on its debt which would bankrupt Greek banks as well as causing huge losses to international holders of Greek banks. The flight from Greece that would follow from even a contemplation of leaving the Eurozone is explained by each investor needing to get out before the other investors (get out while the going is good). 4. We are told that Opponents of monetary union founded their arguments on asymmetric shocks. These are the standard arguments against fixed exchange rates and currency unions that we have discussed throughout this unit. As we said in answer to 8.1 Greece faces years of painful deflation. The critics argue that without the monetary union, Greece would have been able to devalue and this would have helped

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eedb ac

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continued

increase competitiveness without so much downward pressure on wages. 5. Absent here means without and this is making the point that EMU is a currency union which has no facility for using fiscal policy to redistribute income between countries. In fact, there is a no bail out clause that prevents member governments from helping those that are in deficit. The authors argument is that the consequences of forcing Greece out of EMU would spread crisis to other countries very quickly and are so severe that the EU will be forced to change its mind on bail outs. ...a Greek default would cause Irish and Italian bond prices to collapse, precipitating full-fledged debt and banking crises there. But no one wants to find out. In the end, the EU will overcome its bailout aversion. 6. The spreads referred to here are the differences between the rate of interest on long-term Irish and Spanish bonds and the ECBs official interest rate. Since the spreads in other countries have not jumped, then it follows that the spread between Irish/Spanish bonds and French, German, Austrian and other bonds have also increased. The jump is quite simply explained as a reflection of increased risk. The Irish and Spanish debt situations were not much better than the Greek position and bond rating agencies had downgraded Irish and Spanish government bonds (see Unit 3). 7. This means that the value of the euro has fallen against other currencies, primarily of course, the US dollar. This has occurred because investors outside the EMU have become concerned about the security of their investments and have sold EMU assets and withdrawn their funds (in US dollars, sterling, or whatever). The authors argument is that the ECB should further encourage this weakening which it could do by reducing its official interest rate. But the tone of the article suggests that he doubts the ECB will do this quickly enough before this is a major EMUwide crisis.

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k
1. 2. 3. 4. 5. 6. 7.

Self-assessment questions
What is meant by an adjustable peg system of exchange rates? What are its advantages and disadvantages? What is Triffins dilemma (or paradox)? What are the requirements of an optimal currency area? Outline the main features of the original Bretton Woods arrangements. What were the economic reasons for wanting monetary integration in Europe? Why might interest rates differ in different countries, even within a monetary union? What is meant by Bretton Woods II?

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Feedback on self-assessment questions

1. An adjustable peg system of exchange rates is one in which exchange rates are fixed, but can be changed in certain circumstances. Since the maintenance of fixed exchange rates depends heavily on confidence that they will stay fixed, while provision has to be made for changes when rates are permanently out of line, considerable care is required in designing the criteria for permitting realignments. If speculators think that rates might be changed as soon as one country has a problem, then speculators will buy/sell the currencies and force a realignment. The criteria usually refer to fundamental balance of payment disequilibrium, but this may leave fundamental undefined. The Bretton Woods regime of fixed exchange rates was strictly an adjustable peg regime. This is the problem that, in order to function as a world reserve currency, a currency has to increase with the growth in world trade. But being a reserve currency requires that holders have confidence in it and the greater the quantity in circulation the less secure that confidence will be. Free movement of labour, goods, services and capital; wage and price flexibility; a system for fiscal redistribution between regions. The key feature was the adoption of an adjustable peg system in order to fix the exchange rates of participating countries. Another feature included the creation of the IMF to oversee the operation, to provide assistance to countries with temporary balance of payments problems, and to decide on exchange rate realignments. Bretton Woods also established the World Bank, to provide development loans and the General Agreement to Tariffs and Trade (later the World Trade Organisation) to promote free trade. The most obvious argument is that a single currency is required to create a genuine single market. There are two reasons for this: (a) as long as devaluation remains a possibility, countries are able to protect inefficient industries by devaluing; indeed, if all other forms of protection were ruled out by the Single Market Act, there might be an incentive for members to engage in competitive devaluations in an attempt to export unemployment to their partners (b) price transparency consumers are much more easily able to compare prices across the single market and, thus, to choose the products of the most efficient firms, if there is a single currency across the whole market. There are a number of other possible subsidiary arguments. These include: (a) removal of the costs required to convert from one currency to another (b) removal of an important element of uncertainty facing firms, possibly encouraging firms to increase investment in the EU (c) a reduction of the costs of protection against exchange rate risk. 6. The interest rate decisions of the ECB strongly influence short-term interest rates across Europe but interest rates on the various types of loans made by financial institutions include risk premiums. The movement to a single currency removes foreign exchange risk among euro area countries and thus removes a major reason for the interest rates being different in
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2.

3. 4.

5.

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different member countries. However, there are still potential differences in default risk. 7. Bretton Woods II has a number of meanings. For some economists, it refers to a set of informal arrangements that had developed by 2003 whereby by deficits in the USA were being financed by a group of southeast Asian countries that had informally pegged their currencies to each other and to the US dollar, at an artificially low rate. There is an obvious parallel between the role of the south-east Asian states and Europe and Japan during the original Bretton Woods arrangements. There has been much controversy as to whether this arrangement is stable. But since the financial crisis of 2008, Bretton Woods II is often used in connection with the need to develop a new set of formal arrangements to govern international financial transaction.

Summary
In this unit we have looked at arguments for and against fixed exchange rate systems. Having completed this unit, you should be able to:

explain the theoretical benefits and disadvantages of fixed and floating exchange rate regimes describe the details of a selection of fixed exchange rate regimes explain the theory of currency union relate the requirements for a currency union to the development of the EMU identify a selection of alternative monetary arrangements that have been adopted in merging/transition economies.

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Unit

The regulation of financial markets

Guilty! Guilty! verdict will mean prison for ex-Enron chiefs.

Newspaper headline following conviction of Enron executives on charges of conspiracy and fraud

Introduction
In this unit we look at the case for regulating financial markets and at different approaches adopted in different jurisdictions. . Unit learning objectives On completing this unit, you should be able to: 9.1 Explain the economic theory of regulation. 9.2 Describe the key features of financial market regulation in the USA, UK and EU. 9.3 Assess the problems caused by globalisation and the internationalisation of financial markets.

Prior knowledge The unit assumes that you have studied Units 18. Of these, Unit 5 is essential. Otherwise, it requires no prior knowledge, but some basic mathematical skills and familiarity with economic principles will be helpful throughout. Resources The whole of the unit is supported by the core text (Howells and Bain, 2008, mainly The Regulation of Financial Markets but also The US Financial System and The Internal European Market). Mishkin (2007) Economic Analysis of Banking Regulation is also useful, though it focuses more on the regulation of banking rather than market activity. You may find a calculator and access to the internet useful. Many economics textbooks deal with the general issue of market failure.

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9.1 The need for regulation

Recommended reading: Howells and Bain (2008) The Regulation of Financial Markets; Mishkin (2007) Economic Analysis of Banking Regulation.

Broadly speaking, there are two schools of thought on the existence of regulation in a mixed market economy. The first explanation is that regulation arises as a response to some market failure, and that it is carried out in the public interest. The second explanation is that regulation is an economic good of value to certain groups in society, and that the suppliers of this good are various levels of Government. The first of these is the traditional approach that can be found in most textbooks and you should read the rest of this section and the first two parts of section 9.1 as reflecting that approach. We shall then consider the alternative briefly, and then, in the final part of section 9.1, we shall remind ourselves that, from a theoretical point of view, all forms of regulation act like a tax on the activity concerned and that this cost should always be set against any benefits that might follow from the regulation. In a world of perfectly competitive markets, resources (including financial resources) are devoted to the use that produces the maximum social welfare. In the language of textbooks, we shall have the optimum allocation of resources. Since we are talking about financial markets, let us refer to these resources loosely as capital. The users of capital will pay a price which is just equal to the benefit that they expect to get from its deployment, while suppliers will get a reward which just induces them to supply that capital, without any excess profit (or economic rent). However, it is well-known that the conditions required for this perfectly competitive and ideal outcome are very demanding. They include:

Many suppliers with an insignificant share of the market. The decisions of each supplier are too small to affect the overall market. The trading of identical products. One product is a perfect substitute for another. Consumers have full information about prices and about the quality of the products. No barriers to suppliers entering or leaving the market, at least in the long run. All suppliers have equal access to resources (including the current state of technology). No externalities and therefore no divergence between private and social costs and benefits.

market failure

It is unlikely that these conditions, in their entirety, can be found in any market. Sometimes, the absence of one or more condition has consequences that are so serious that we talk of market failure, and it is the consequences of market failure that give rise to the economic arguments for regulation. Interestingly, financial markets are often quoted in textbooks as providing some of the nearest examples to perfectly competitive markets but we can show that they fail to meet several tests. The two major failures involve information and externalities and we look at each of these in moment. But notice that there is also a problem with the very first condition on the list. Participants in financial markets are not all of equally small size. Indeed, some are very large. They may enjoy economies of scale, in which case they will also enjoy a degree of 195

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monopoly power. And if the economies of scale are substantial, this may make it difficult for competitors to enter the market (condition four). Notice that there may be substantial economies of scale in the use of information.

Asymmetric information
Perfect markets require that the participants are fully informed. And there is a great deal of information available to financial markets and we think that, as a rule, it is quite quickly incorporated into prices and rate of return. However, not everyone is equally well-informed. Suppliers of capital generally have less information about how their funds are going to be used what sort of risks they will be exposed to, what level of profit the borrower expects to earn from their use than the borrower has. More generally, savers have a problem in fullyunderstanding the financial instruments and products that they buy. This is because the products themselves are quite complex and are bought very infrequently so that there is little opportunity to learn from experience. This is the situation known as asymmetric information. The connection between asymmetric information and market failure lies with risk. As a rule of thumb we think that borrowers have superior information to lenders. This means that lenders may fail to appreciate fully the risk to which they are exposed and therefore misprice it. Or in the worst case they may simply fail to recognise risk at all. Either of these increases the possibility of insolvency. This in turn could threaten the stability of the financial system, as we saw in the 2008 crisis, and may also lead to some products and services no longer being provided.

asymmetric information

Lear

ga nin ct

Why is asymmetric information associated with risk?

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9a

eedb ac

9a

It depends upon the situation in which the asymmetry occurs. Some examples: 1. For a saver taking out a personal pension, failure to understand the details of the plan completely may mean that the accumulated sum at retirement is inadequate when it is too late to do anything. 2. For a company offering motor insurance, the inability to assess the risk of its clients accurately could make the firm insolvent. 3. The failure to understand that Enron executives were disguising the true financial state of the company meant that many workers lost their life savings.

The threats from asymmetric information are usually grouped under two headings which we have also met in earlier units. These are adverse selection and moral hazard. One useful way of distinguishing these is to think of the first as having its effects prior to a contract being entered into while the second operates after the contract has been signed. Adverse selection describes the situation whereby the buyer of some market instrument (the lender) does not have sufficiently detailed information about the 196

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issuer (the borrower) and the project being funded in order to be confident of the price that should be paid. This may be because the relevant information is not available or could not be obtained by any normal means, or, more frequently, it arises because the level of detail required simply makes it too costly. The consequence is that the lender can only make a rough appraisal of the level of risk. Consider the case of bonds, for example. We know that newlyissued bonds normally carry a rating from a risk-rating agency. But the agency cannot afford the time and effort required to rate each bond individually. It puts bonds into risk bands or categories. The bonds in that category are then treated as if they all carried the same degree of risk and so they all carry the same risk premium. The problem is that the single price offered across the band will be offered to borrowers who still have differing levels of risk and the level of risk will be known only to themselves, if at all. For the riskiest borrowers in the band, the rate they have to pay on the bond will look attractive, while for lower risk borrowers it will look too high. The consequence is that only the riskiest borrowers in each band go ahead with their bond issues with the result that the risk rating exposes buyers to a higher risk than they expected. The buyers then face a rate of default which is higher than was originally calculated for that band. The risk has been underpriced. And the problem will not be solved by raising the price, since the same process will occur again, so long as a uniform price is being offered to borrowers of differing risk. Ultimately, adverse election could discredit the ratings process, bondholders would lose confidence in the system and the market would contract or even fail completely. Moral hazard refers to the situation whereby a borrower has obtained funds and then uses them in some way that is riskier than the lender had expected (and priced for). The incentive to the borrower to behave like this arises because the funds have been obtained on the lenders best guess at the level of risk involved. Imagine the issue of new shares. The new issue will have been accompanied by substantial documentation about the firm and its activities and this will focus on the risk and return on its activities to date. If this is a firm being publicly listed for the first time, then the investment bank sponsoring the offer will have set a price which it thinks makes the shares attractive to investors, by virtue of the likely risk and return. If it is a rights issue, the price will be fixed by the market for existing shares. In both cases, the firms cost of capital is being determined at the time of issue. But once the funds have been obtained, the firm may be tempted to earn higher profits by using the funds for some project that is riskier than it has hitherto been used to. Moral hazard is a very troublesome issue for regulators. This is partly because of the threat that it poses to market participants. But there is a more intriguing problem. This is that regulation itself may promote moral hazard. This is especially a danger where the regulation is intended to reduce risk. The most obvious example from the area of finance is deposit insurance. Almost all regimes offer some degree of deposit insurance in order to avoid the danger of contagion and systemic collapse that would follow from a run on a bank. However, once the deposits are insured, neither the banks management nor the depositors themselves, have any strong incentive to monitor what the bank is doing with those deposits. They could be lent for the riskiest enterprises in order to increase the rate of return. This is why systems of deposit insurance always carry a set of conditions which banks must meet in order to qualify for the protection. So the process becomes circular and cumulative: the regulator intervenes to limit risk but this creates moral hazard and so further regulation
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is required to limit the moral hazard. There is also the point that complying with regulations imposes a variety of costs on the regulated firm which may, in consequence, try to evade the regulation and this may lead it into riskier (because hidden) activity. The issue of moral hazard has played a large part in the aftermath of the 2008 financial crisis. Firstly, it features in many of the explanations. The argument goes that banks were encouraged to pursue extremely risky strategies because they had become used to the idea that the state would always protect them from outright failure. Hence, the saying goes, that profits were privatised [went to the banks and their shareholders] while losses were socialised [were met by the taxpayer]. This plays a fundamental role in the analysis of Alessandri and Haldane (2009), who also show that the one-sided nature of the bank-state contract had shifted in banks favour in the years leading up to the crisis. Secondly, it played a part in the development of the crisis itself, with the US and UK regulators being slow to act in the early stages of the crisis, knowing that if they did bail out failing banks, the bill could be enormous and provide confirmation to banks that they would be perfectly safe in future. When Lehman Brothers was allowed to fail (in September 2008), the shock that followed provided clear evidence of just how confident financial markets had been that a major bank failure was impossible. And moral hazard worries play a major part in the arguments for reform of financial systems to prevent a similar crisis in future. Although the proposals differ in detail, they all contain the common thread that banks (and their traders) have become insensitive to risk because they are too big to fail. Hence we see proposals for a Tobin tax (on financial transactions) to raise the cost and reduce the volume of trading; for the prohibition on banks engaging in trading in securities on their own account (on the grounds that this will force the splitting of banking firms into more, smaller units); and the idea of living wills which maintain a complete record of a banks interbank obligations so that it can more easily be closed down in the event of failure. Needless to say, participants in financial markets do all that they can to protect themselves from the dangers of both adverse selection and moral hazard and they do this by making the best use of the information that is available. And regulators try to help by laying down rules for the disclosure of key information. But the critical question is obviously what information do they have? In section 9.2 we shall see how financial regulations in selected countries try to ensure a minimum level of reliable information to help prevent some of these problems and why all regulatory schemes have strict rules and tough penalties against insider trading. Why is insider trading always treated as a serious offence?

insider trading

Lear

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9b

First of all, insider trading is unfair. It means that people who are closely involved with a firm can buy and sell shares in advance of the general public. This gives them an advantage in making capital gains and avoiding capital losses. More serious for most regulators, however, is that once the ability for insiders to take advantage becomes known (or even strongly suspected) investors lose confidence in the whole market and withdraw from it. This makes it harder for borrowers to raise funds (there are fewer lenders) and raises the price.

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Externalities
While asymmetric information may be commonplace in financial transactions, it is not restricted to financial activity. In many transactions, there will be cases where one party has more information than another. And so to make the case for regulation we have to move on to a second stage of the argument which amounts to saying that the consequences of asymmetric information and the mispricing of risk can be much more serious in a financial context. This links asymmetric information to another category of market failure. This is the case of externalities. An externality is any cost (or benefit) which is not paid by either party to the transaction; it is paid (or received) by those who are external to the deal. The conventional economic wisdom is that if there are positive externalities (benefits) then the goods or services responsible for those benefits will be underproduced if the decision is left to the market; if there are negative externalities (costs) which no one pays for, the goods or services will be overproduced. At first sight, it may be difficult to see how the concept of externalities applied to financial transactions but consider for the moment the case of financial intermediaries (rather than markets) who are lending to each other. In doing so, they are aware of a level of risk and they price their deals to reflect that risk, meaning that the price is adequate compensation for the possibility of say one in one thousand deals defaulting. So far as the two parties to the deal are concerned, this is a fair price. But suppose now that the default, when it happens, means that the lending bank cannot repay its own debts to another intermediary, which cannot then settle its debts. We can see a picture of contagion beginning to emerge very quickly. Suppose now that in this atmosphere of crisis banks simply refuse to make payments to each other. The payments system grinds to a halt and firms (and households) who have nothing to do with the banks, except that they were relying on the payment system operated by the banks, find that they cannot make payment. Trade stops. The costs of the original default are many thousand times greater than the cost to the lending bank (which we know was compensated by an adequate rate of interest). In terms of economic theory, there is potential market failure because banks are not faced with the full cost of their risky behaviour. Risky lending is being overproduced. We mention this case of externalities and intermediaries because it was so obviously in the minds of regulators during the 2008 crisis. We turn now to externalities and markets. Many investors have access to financial markets only through intermediaries like unit and investment trusts or pension funds and life assurance companies. These are managers of very large collective investment funds. They can trade in markets at very low unit costs. This raises the question of whether they may overtrade. That is to say that investors get little benefit from the continuous turnover (or churning) of their portfolios (because the efficient market hypothesis in Unit 5 tells us that fund managers cannot beat the market) and yet are forced to pay fees to fund managers which substantially exceed the cost of trading. So far, this is just an example of monopoly power. But if the frequent trading of stocks and bonds causes other problems like price instability or costs for firms and their registrars of keeping track of ownership, then the question of externalities arises. The private costs incurred by fund managers in frequent buying and selling understate the full (social) cost and the trading is excessive. Externalities are often said to arise from faulty property rights since those who are adversely
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affected cannot charge their loss to the perpetrators. But it also requires that the victims appreciate (that is can identify) the cause of their losses. The idea that a significant amount of financial activity might be socially useless attracted widespread attention following the remarks of the Chairman of the UKs Financial Services Authority in the summer of 2009 (Turner, 2009).

Lear

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9c

Why is it difficult to know whether frequent trading is socially useless or not?

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9c

Firstly, as we know from Units 3 and 4, the trading of existing securities is many times greater (by value and volume) than the funds raised by new issues. From Unit 5, we know that the advantages of professional fund management are slight for the investor, but that fund managers have an incentive to trade actively. Therefore, we can be sure that there is a vast amount of trading taking place that has no direct link with new lending and borrowing and some of it is likely to be of very little benefit to anyone except those carrying out the trading. However, the fact that a large amount of trading takes place continuously, gives the assets a liquidity that they would not otherwise have. This liquidity makes the new issues much more attractive to buyers than they would otherwise be and therefore contributes to minimising the cost of new capital. The difficulty in making a judgement lies in knowing how much trading is required for liquidity and how much is genuinely unnecessary.

The question of externalities arises again in a more diffuse way when we ask whether the development of certain types of instrument or certain types of activity, make the financial system less stable than it might otherwise be. The financial crisis of 2008 provides a powerful demonstration of the colossal externalities that can be associated with a major financial crisis, extending well beyond the participants in the financial system and threatening the livelihoods and security of people with no direct interest in financial activity. Ever since the Dutch Tulip Mania (see Unit 5) it has been legitimate to criticise speculators as somehow seeking to benefit themselves while causing disruption to others. But in more recent times, hedge funds have come under suspicion, together with programme trading and, in the 2008 crisis, the development of exotic instruments like credit default swaps. The argument could be made that these products and practices have been developed at a private cost which has been covered by their earnings, but with very substantial external costs that were not appreciated at the time. Finally, we can combine information problems and externalities just once more to make another case for regulation, very broadly defined. This arises because we think that individuals tend to suffer from financial myopia, meaning that they are short-sighted. They do not appreciate the level of lifetime saving that is required to provide financial security in old age and even if they do, they are deterred from taking action until it is too late because they feel that they do not understand or trust the products they are offered. Most people would agree that a mark of a civilised society is some minimum level of security in old age

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and therefore if people do not provide it for themselves, the cost will fall on the rest of society (via taxation). Hence, an adequate level of long-term private saving has not only private benefits but external benefits also which accrue to future taxpayers. But since private savers do not receive these public benefits, they will underconsume long-term savings unless there is some incentive or pressure provided by the state. This argument featured in the Sandler Report into the UK retail savings market (Sandler, 2002).

Lear

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9d

What kind of market intervention might be used to tackle the problem of underconsumption of long-term savings products?

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9d

Government could subsidise long-term savings. This could be done by giving tax relief on contributions or the Government making a fractional contribution alongside each private payment. The difficulty lies in ensuring that the subsidy goes only to the behaviour that we wish to encourage. Hence the practice of Government contributing support only to recognised pension schemes.

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Economic theories of regulation

These theories of regulation are based on the premise that, rather than regulation being imposed in the public interest, there is a demand for regulation from groups who see some benefit for themselves. Such views enjoyed increasing popularity among economists and government decision makers in the 1970s and 1980s as a trend toward deregulation of previously regulated industries and markets began to gain momentum (see, for example, Stigler, 1971; Posner, 1974). Economic theories of regulation often offer explanations for observed outcomes in situations where public interest explanations are inadequate. Some examples of regulation, relating to financial markets, that might be argued to yield benefits to participants, include:

Membership of exchanges. In order to trade in organised markets it is frequently necessary to be a member of an appropriate exchange (EuronextNYSE, Chicago Board Options Exchange and so on). Members have to satisfy certain conditions and one can argue that there is a public interest argument here in that the rules help to exclude unscrupulous and/or incompetent traders. But they also act as barriers to entry and confer a degree of monopoly power on those firms that are members. The requirement for professional qualifications in order to undertake certain types of financial activity is a more general example of the same principle. Capital requirements. Under international banking regulations, banks are required to hold a minimum level of capital (or equity) against risk-adjusted assets. This is often presented as a tax on banking (which it is) imposed for the public good. But it also acts as a barrier to entry and helps to support monopolistic banking structures, of which the UK is a very good example. Cross-subsidisation. Regulation can sometimes influence the price that firms can charge. For example, banks are often under pressure to provide simple bank accounts at very low cost to customers on low incomes; insurance 201

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companies are pressed to provide low cost, basic pension facilities. Again, one can see a public good argument everyone benefits if the low paid have access to bank deposits as means of payment; everyone benefits if the poor have adequate pensions. But these provisions are often cross-subsidised by higher charges on other banking products and facilities. Low income households benefit at the expense of the better off. In section 9.2, we shall refer to the problem of regulatory capture. This refers to the situation where the regulator starts to identify with the interests of the firms that it is regulating. In consequence, the regulation becomes more lax than it should be. Theories of regulation which see it as a good which is being bid for by interest groups, see regulatory capture as more or less inevitable.

Regulation as a tax
One of several consequences of the recent interest in regulation as something which yields advantage to competing interest groups, rather than being a regrettable necessity for the public good, is the recognition that regulation inevitably acts as a tax. We look at why this is the case now, and we take the example of capital requirements imposed on banks. This may seem strange, when our focus is on financial markets, but there are two good reasons:

Most trading in financial markets is carried out by banks or divisions or subsidiaries of banks. Hence when regulators talk about improving the functioning of financial markets they mean finding ways to change the behaviour of banks (and other financial firms). In the next section, we shall look at selected features of the market regulatory process in the USA, EU and UK. Some of the differences express themselves as different attitudes towards bank regulation and therefore towards capital requirements.

When we say that regulation acts like a tax, we need to be clear what this means. The effect of a tax on any product is to increase its price. The result is a reduction in the equilibrium quantity bought and sold, and an increase in its price. In a supply and demand diagram, the supply curve shifts to the left.
capital adequacy rules

We shall illustrate this now by looking at the Basle capital adequacy rules. These require banks must hold a minimum level of capital equal to eight per cent of risk-adjusted assets. We ignore any distinction between types of capital. The bank in Table 9.1 just meets this requirement. Assets bn Risk weight 1 0.4 0.25 0 Risk adjusted 80 12 8 0 100 Capital 8 144 Time deposits Sight deposits Liabilities and capital bn

Loans Bonds Bills Cash Total

80 30 32 2 144

100 36

Table 9.1: Risk-adjusted assets 202

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To see this ratio working like a tax we shall compare the difference between the situation where the requirement does not apply with the situation where it does. In order to do this, we need some interest rates. Assume:

The rate paid on deposits is four per cent pa. The rate charged on loans is six per cent pa. The cost of capital (the return to shareholders) is 15 per cent pa.

Now suppose that the bank is faced with the demand for additional lending of 1 billion. The bank decides to lend an extra 1 billion. Remember that there is no capital adequacy requirement at the moment. This means that the bank can finance the whole of the loan by holding extra deposits of 1 billion at a cost of four per cent. The banks income position is shown in Table 9.2. Income from loan (1bn 6%) Less paid on deposits (1bn 4%) Net interest income = = = 60m 40m 20m

Table 9.2: Income (without capital regulations) This gives a rate of return to the bank of 20 million 1 billion or two per cent the difference between the two interest rates. By contrast, we now look at the situation where the Basle capital adequacy requirements apply. In this case the bank has to raise additional capital in order to maintain the eight per cent ratio. This means that some of the additional lending of 1 billion is financed partly by additional capital the rest by extra deposits as before. The balance of the financing is: Additional capital required to maintain ratio = eight per cent of 1bn = 0.08bn Remaining funds raised from deposits = 1bn 0.08bn = 0.92bn

The banks income position is shown in Table 9.3. Income from loan (1bn 6%) Less cost of capital (0.08bn 15%) Less paid on deposits (0.92bn 4%) Net interest income = = = = 60.0m (as before) 12.0m 36.8m 11.2m

Table 9.3: Income (with capital regulations) This gives a rate of return to the bank of 11.2 million 1 billion = 0.0112 = 1.12 per cent. In these circumstances, the bank may decide that the additional lending is not profitable at this rate and may raise the price of the loan so as to restore the original rate of return allowing for the capital requirement. By how much does the bank have to raise the cost of the loan? Its original profit was 20 million (= two per cent). With the capital adequacy requirement it earns only 11.2 million. In other words, if 20 million is the minimum acceptable

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return it is short by 8.8 million. It has to increase the interest charged on the loan to bring in the extra 8.8 million, that is a total income of 68.8 million. So, instead of charging six per cent it has to charge 6.88 per cent. Now look at Figure 9.1.
Interest rate % St loans S loans

6.88% +0.88% 6.0%

S deposits

4.0%

1bn

Loans and deposits

Figure 9.1: Showing the tax effect The original equilibrium occurs at six per cent/1 billion. But when we observe the capital requirement, the cost goes up to 6.88 per cent and the (after tax) supply curve shifts vertically by 0.88 per cent. However, with a downward sloping demand curve, 1 billion is unlikely to be demanded at 6.88 per cent, and the new equilibrium is likely to occur at an interest rate between six and 6.88 per cent and a level of lending less than 1 billion. The fact that regulation inevitably acts like a tax is not a convincing argument against regulation, but it is important to remember that regulation does not come free. Designing an optimal regulatory regime is not just a question of fitting the regulations to the problem, it also requires a consideration of these costs.

Lear

ga nin ct

Table 9.4 is a simplified version of a bank balance sheet. Assets Cash and deposits at the central bank Government bonds Corporate bonds Mortgage loans Commercial loans Other Total US$m 500 1,600 1,400 1,000 3,000 500 8,000 Capital Total 300 8,000 Liabilities and capital Customer deposits US$m 7,700

y ivit

9e

Table 9.4: Simplifed bank balance sheet 204

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Lear

ga nin ct

9e

Assume that cash and central bank assets have a risk-weighting of 0, while government bonds are weighted at 0.2. Corporate bonds and mortgage loans have a risk weight of 0.5, while all else has a weighting of 1. 1. Calculate the risk-adjusted capital ratio for this bank. 2. Suppose that the result of 1 shows that the bank is just complying with the current capital requirements. What adjustments might the bank be able to make in order to increase its commercial lending without raising more capital?

continued

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9e

1. Firstly, find the risk-adjusted value of assets (= 0 + 320 + 700 + 500 + 3000 + 500) = 5020. The risk-adjusted capital ratio is then 300/5020 = 0.06 or six per cent. 2. To create room for additional commercial lending, it needs to raise its current capital ratio above the six per cent minimum. It could do this by selling some corporate bonds and buying government bonds. A more extreme solution would be to sell the bonds and hold increased deposits at the central bank. Both strategies will bring down the risk-adjusted capital ratio and allow more risky lending.

Recommended reading: Howells and Bain (2008) The US Financial System, The Internal European Market and The Regulation of Financial Markets; Mishkin (2007) Economic Analysis of Banking Regulation.

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9.2 Financial regulation in the USA, UK and EU

We begin this section by looking at international regulations which affect market behaviour in all countries. We then look at additional features of regulatory regimes in the USA, the UK and EU.

Capital adequacy
We begin by looking at successive attempts to regulate the behaviour of international banks by what is usually called the Basel Committee. We have some understanding of what is involved, from our discussion at the end of section 9.1. The reason that the Basel regulations are relevant to markets is that much trading in financial markets is carried out by banks (or their divisions, or subsidiaries) and, indeed, trading (as opposed to loan and deposit-taking) has become increasingly important to banks and their profits. The Basel Committee was established by the central bank governors of the G10 group of countries in 1974 and reports to them. In 2009 the Committees members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The representatives are all people with experience of and interest in banking supervision. The Committees Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions. For this reason, details of the 205

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Basel Committees work, its reports, consultations and pronouncements can be found on the website of the BIS (<http:// www.Bis.org>). In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basle Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of eight per cent by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with internationally active banks. In June 1999, the Committee issued a proposal for a revised capital adequacy framework which is usually described as having three pillars. However, one of these remains a requirement that banks hold capital (or equity) equal to eight per cent of their risk-adjusted assets, as in our illustration above. Why this preoccupation with banks capital? The answer is that this capital represents the banks net worth (the excess of its assets over its liabilities) and belongs to the shareholders, the owners of a bank. Since a banks solvency requires net worth to be positive, the size of this net worth shows by how much a bank could take a reduction in asset values before it became insolvent. The capital acts as a buffer against negative shocks to asset values (and also means that the cost of such shocks falls upon the shareholders and not on the other creditors of the bank, for example, its depositors). The strength of the bank is usually represented by the ratio of capital to total assets. However, since the purpose of the capital is to provide a buffer against negative shocks to asset values, it is hardly appropriate to treat all assets equally. For example, notes and coin and deposits with the central bank are entirely risk free. Government bonds are low risk. Loans to commercial property companies, by contrast are quite different. Therefore, capital adequacy requirements tend to express capital in relation to risk-adjusted assets (again, as we saw above). Until recently, capital adequacy ratios were a matter of international agreement, being laid down in the Basle Capital Accord (I) which was agreed in 1988. Basle I defined exactly what qualified as bank capital (dividing it into tier 1 and tier 2) and provided a set of risk weights. It then specified that banks must hold capital equal to a minimum of eight per cent of risk-adjusted assets, although some national regulators insisted that banks hold a higher level and some banks held a higher ratio as a matter of choice. The Basle I terms were amended several times, in particular to take account of bank activities which did not appear on the balance sheet. Much of this had to do with the trend toward securitisation. But a major overhaul followed with Basle II in 1999. After lengthy discussion and amendment, the Basle II requirements began to be adopted in 2006. Compared with Basle I, Basle II had three pillars. The first continued the concept of a risk-adjusted capital requirement (which also remained at eight per cent). However, it introduced a greater range of weights and also allowed banks with adequate risk-management skills to calculate their own weights (the internal risk-weightings). The idea was to produce a more risk-sensitive capital ratio. In addition, a second pillar laid down procedures for supervisory review of banks. This was intended to give the national regulator a greater and more uniform role in bank supervision. The third pillar laid down requirements for the disclosure of key information relating to risk management by banks. The argument here was that with this additional

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information, financial markets would be able to discipline banks that were lax in their risk management by selling the shares and making the bank a takeover target. How do these requirements relate to financial markets? The obvious connection is that they were intended to give banks some protection against financial market shocks. Although bank loans are not tradable assets (and Basle I was mainly concerned with loan defaults) many other assets on banks balance sheets are traded and therefore negative shocks may take the form of market price falls as much as defaults. Basle II made more effort to take this into account.

Lear

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9f

In learning activity 9e, we observed a bank working at the limit of its capital adequacy ratio and we asked what it could do in order to increase its lending without raising new capital. Suppose, instead, that we asked what else could a bank do to expand, without raising additional capital?

eedb ac

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9f

Since the capital adequacy ratio is calculated from assets on the balance sheet, the bank cannot expand by increasing its visible assets. But it might be able to engage in various kinds of off balance sheet activity. This activity will generate profit without requiting any additional assets (or liabilities) to appear. For example, instead of lending to established clients (which increases its assets) it could offer to underwrite clients issues of their own securities. This would enable a small, unknown firm to sell bills in the money market at a good price/ low interest rate since the bills have a well-known banks backing. The bank of course would make a charge for the guarantee, but it would have no corresponding asset. The bank might start trading in financial securities and do it through a subsidiary. What is feasible, depends upon the regulations. Under Basle I, as originally designed, banks could engage in many off balance sheet activities. But with the passage of time Basle I (and then Basle II) began to demand capital held against these activities, though often at levels which were low enough to encourage banks into off balance sheet activity.

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But there is another connection between banks and markets. Depending on the nature of a bank, financial market trading may be a large or small part of its activities. For investment banks, for example, proprietary trading will be the dominant activity. There will be very little traditional lending and deposittaking, if any at all. For large banking groups with substantial retail business, trading will be of less importance. However, for all types of bank, securities trading and lending/deposit holding will be alternatives to some degree and banks will allocate resources between them on the usual commercial criteria. As we have just seen, the profitability of various lines of business can be substantially influenced by regulation and one effect of Basle I, which was mainly focused on the credit risk attaching to on-balance sheet assets, was to encourage banks to develop their off-balance sheet activities amongst which was the trading in financial markets. Basel II recognised this. It required banks

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to hold capital against certain types of off-balance sheet activity at the riskweighting that would have been given to it had it been on the balance sheet, but reduced by a credit conversion factor which could range from a maximum of 0.5 to a minimum of 0. When it came to trading activity, banks were required to hold capital equal to 0.15 of the value of the gross income from the activity. Notice that the riskiness of the activity did not feature in the requirement. With the benefit of hindsight (after the 2008 crisis) it now looks as though the capital requirements on trading activity were set far too low, especially since they were unrelated to the risk. One reform of banking regulation that appeared to have widespread support in 2009 was a modification of the capital adequacy rules, in three respects:

a general increase from eight per cent a linking of the requirement to the rate of growth of lending in order to give the requirement a counter-cyclical character an increase in the capital required against financial market trading.

The last has the potential to affect the volume of trading quite sharply, depending upon how it is done.

Market regulation in the USA

We turn now to three particular jurisdictions and the way that they approach the regulation of financial markets. Suppose that we imagine a short continuum described by the degree of market optimism the degree of confidence that free markets generally produce the best results. Then, we can place the USA at one end and the EU at the other, with the UK in between (but not in the middle). We see this, the moment we ask who does the regulating?, and before we get to any examination of the regulations themselves. With regard to the form of regulation, we must first ask who should carry out the regulation the Government or a government agency, or the industry itself (self-regulation). The argument for self-regulation has two elements. Firstly, the industry has a commercial incentive to protect its own reputation and so members will be prepared to pay to achieve this, thus overcoming one of the principal market failure arguments for government regulation. Secondly, practitioners understand the needs of the industry and are likely to interfere less with its efficient functioning. This counters a common complaint against public regulatory bodies that, because they will be heavily criticised over the collapse of firms but not praised for actions that lead to lower prices, they will always impose excessive safety standards, raising the cost of regulation to both producers and consumers. The assumption then is that self-regulation is almost certain to be lighter than regulation by an external body. There is a danger, however, that self-regulation may turn out to be an awkward halfway house. To begin with, it must be supported by some government regulation at least to the extent that firms are legally required to join the industry regulatory scheme. Otherwise, an incentive would be created for some firms to act as free riders, hoping to benefit from any increase in reputation of the industry resulting from the behaviour of firms within the regulatory organisation without paying the costs of membership. In the USA, the high-level of market optimism has inevitably created a preference for self-regulation over regulation by government agency. Where

market optimism

self-regulation

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financial markets are concerned, the chief authority is the Securities and Exchange Commission (SEC) whose job is ...to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation (SEC, 2009). The SEC was created by the Securities Exchange Act, 1934, which was passed in the aftermath of the Wall Street Crash and the following great depression of 19313. The SEC claims that its role is based on two basic notions, which reveal a great deal about its approach. These are:

Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing. People who sell and trade securities brokers, dealers, and exchanges must treat investors fairly and honestly, putting investors interests first. (SEC, 2009).

Together they tell us that the SEC is primarily concerned with the issue of information. It is the asymmetry of information that is the real danger. Provided that everyone is well-informed, or is not prevented from being well-informed, then the best form of regulation is caveat emptor meaning let the buyer beware. In other words, it is up to individuals to look after their own best interests. The job of the SEC is only to ensure that everyone has reasonable access to the key information. This is typical of the light touch approach that one would expect to see in a regime that starts from the assumption that markets work well. The Commissions responsibilities include:

interpretation of federal securities laws issuing of new rules and amendment of existing rules overseeing the inspection of securities firms, brokers, investment advisers, and ratings agencies overseeing private regulatory organisations in the securities, accounting, and auditing fields (see FINRA below) co-ordinating US securities regulation with federal, state and foreign authorities.

Over the years securities trading has been the subject of several key pieces of legislation, amongst which are:

The Glass-Steagall Act 1933. This established the Federal Deposit Insurance Company (FDIC) and introduced a number of banking reforms designed to reduce the riskiness of commercial banks whose deposits were being insured. From the securities trading point of view, the most significant innovation was to prevent deposit-taking (commercial) banks from undertaking investment business. It also prohibited a bank holding company from owning other types of financial company and it gave the US Federal Reserve the power to regulate interest on savings accounts (Regulation Q). Many of these provisions were repealed by later legislation listed below. Depository Institutions Deregulation and Monetary Control Act 1980. Repealed Regulation Q and some other restrictions on bank operations. Gramm-Leach-Bliley Act 1999. This removed the restriction on bank holding companies owning other types of financial institutions. Hence a bank holding company could also own investment companies and this allowed commercial banks to engage in securities trading again. 209

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Sarbanes-Oxley Act 2002. This laid down enhanced standards for financial reporting of listed companies. The Act followed a number of corporate and financial scandals (Enron, WorldCo, Tyco and others) where investors had lost billions of dollars when their share prices collapsed. It was subsequently discovered that much critical information had been concealed by the firms published accounts. The Act focused on 11 areas of improvement. Among them were enhanced disclosure requirements, the role of auditors and conflicts of interest, and a controversial requirement that senior executives take individual and personal responsibility for the accuracy of company reports.

The subject matter of Sarbanes-Oxley reminds us that, whatever regulations may be laid down by authorities like the SEC who are trying to regulate the behaviour of financial markets, additional, relevant regulation will be provided by the legislation governing the conduct of publicly owned companies. Each country will have a set of companies acts, laying down the obligations on firms owned by shareholders. In particular, these will lay down rules for the disclosure of information, for the rights of existing shareholders to be consulted about major decisions and to be given the first opportunity to buy newly-issued shares in order to prevent their share of ownership being diluted.

Lear

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9g

How does the Sarbanes-Oxley Act seek to tackle the problem of asymmetric information?

eedb ac

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9g

The aim of Sarbanes-Oxley was to restore public confidence in corporate financial information following the scandals at Enron, WorldCom and others. There are eleven provisions or titles. These include:

creates a board to oversee the conduct of auditing firms lays down standards to ensure the independence of auditors and remove conflicts of interest requires senior executives to take personal responsibility for published financial information increases the degree of financial disclosure especially regarding off balance sheet items sets out rules to reduce conflicts of interest for securities analysts increases the power of the SEC to censure or bar securities analysts guilty of misconduct increases the penalty for white collar crimes like fraud and false accounting.

We noted above that the USA has opted largely for self-regulation where market participants are concerned. The SEC makes the regulations and the responsibility for ensuring compliance rests with a body made up of representatives of the securities trading industry. This body is known as FINRA, The Financial Industry Regulatory Authority. FINRA was created in July 2007 through the 210
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consolidation of the National Association of Securities Dealers (NASD) and the member regulation, enforcement and arbitration functions of the New York Stock Exchange. FINRAs objective is to promote investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. This involves registering and educating industry participants, examining securities firms, writing rules, enforcing those rules and the federal securities laws (from the SEC), informing and educating the investing public, providing trade reporting and other industry utilities, providing resolution and arbitration facilities and administering the largest dispute resolution forum for investors and registered firms. It also has regulatory responsibility for the NASDAQ Stock Market, the American Stock Exchange, the International Securities Exchange and the Chicago Climate Exchange.

Market regulation in the UK

Where financial services are concerned, the UK also has a history of selfregulation. The principal Act is the Financial Services Act 1986, which created an overall regulatory authority, the Securities and Investment Board (SIB) and, answering to the SIB, a number of self-regulatory organisations (SROs), which were composed of investment practitioners and which were given the responsibility of regulating their own segment of the industry; a group of recognised professional bodies (RPBs) whose task it was to maintain the standards of the lawyers, accountants, insurance brokers and actuaries who participate in the market, and a number of regulated exchanges. Three problems quickly emerged. The first was that it was very difficult to define SROs so that all activities are covered. This arises because financial firms engage in many different types of activity and so a firm may belong to the SRO to whom most of its activities are relevant, while some lesser ones will go unsupervised. The only solution to this would be to require a firm to be a member of multiple SROs which is oppressive. A second problem was the danger of competitive laxity. This occures when one SRO tries to attract members by offering less intrusive and burdensome regulation than others. This can develop into a race to the bottom. The third problem is regulatory capture (see above). SROs are staffed by representatives of the industry that they regulate. They will have friends and loyalties in the regulated firms and indeed may well plan to work again in the regulated industry. It could be argued that this encourages them to be unduly sympathetic and insufficiently critical in their role as regulator. In 1997, the new Labour Government announced that it would create a statutory regulator, the Financial Services Authority or FSA. The current regulatory arrangements in the UK are shown in the following chart, which is adapted from Blake (2000, p45). The first column indicates that there are numerous pieces of legislation that have some bearing on the functioning of financial markets. The three most important are shown in the centre. But there are companies acts which regulate the conduct of publicly listed firms, including their behaviour regarding the raising of capital. Financial activity is also subject to the general provisions of the criminal law (regarding theft, fraud, deception and so on). The 1987 Banking Act places responsibilities on banks which extends to some degree to 211

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their use of financial markets and the Panel on Takeovers and Mergers operates two sets of regulations a code on takeovers and mergers which specifies, inter alia, how shareholders must be treated in the event of a takeover and rules on the disclosure of information in connection with the substantial acquisition of shares.
Authorisation of market participants Companies Act 1985 Prudential supervision of financial intermediaries and fund mangers Investigation, enforcement and discipline Regulation of investment exchanges and clearing houses

Criminal Justice Act 1986 Financial Services Act 1986 Bank of England Act 1998 Financial Services and Markets Act 2000

Financial Services Authority (FSA)

HM Treasury

Banking Act 1987 Panel on Takeovers and Mergers Bank of England

Regulation of collective investment schemes Operation of monetary policy

Ensuring stability of financial system

Figure 9.2: Regulation in the UK financial system The figure also shows that the core authority when it comes to the regulation of financial market behaviour is the FSA which authorises participants, supervises financial intermediaries (who are often the main market participants), has powers of investigation, enforcement and discipline and regulatory powers over exchanges and collective investment funds. The detailed operations under these headings are detailed in Blake (2000, 1.5).

Market regulation in the EU

At the EU level the regulation and supervision of financial markets and financial services providers remains fragmented. European member states still have diverse regulatory and supervisory cultures, for example, with regards to the role of the state, which is generally seen in a more positive light than in the UK 212
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and (certainly) in the USA. They have retained a variety of regulations and supervisory systems with competences remaining at national level with parliaments, banks or other supervisory institutions. This fragmentation of financial regulation and supervision contrasts starkly with the expansion of the EU-wide financial markets and financial services providers. Several banks now have a presence in multiple EU countries, conducting trans-border capital transfers and trans-border selling of highly complex and risky financial services. The creation of a European Financial Common Market was first envisaged in the Treaty of Rome (1957) but made little progress until the Single European Act (SEA) of 1986. To achieve a single market in financial services, it was necessary to ensure:

the free mobility of capital the right of establishment by firms in other member states the right to supply cross-border services the acceptance of common supervisory regulations the harmonisation of taxes.

Fully mobile capital, in turn, could only be achieved with the removal of all exchange controls, ideally the disappearance of exchange rate uncertainties and the full acceptance of the rights to raise capital and to invest in all EU markets. It was clearly always going to be difficult to meet all or even the majority of these requirements. The first three were largely met by the creation of the European Monetary Union. But the acceptance of common supervisory regulations still has some way to go (and the harmonisation of taxes further still). The EU has facilitated liberalisation of financial services providers and of financial markets. Based on the Nice Treaty and the Lisbon Strategy the principles behind this liberalisation have been stronger competition in EU markets, with the purpose of reducing financing costs and improving allocation of resources, thus boosting the global competitiveness of the EUs financial industry. An effort to compete with the US financial industry, which has been dominant in some big earning sub-sectors such as investment banking, has had an important influence on EU policies. But the harmonisation of regulation and supervision lags behind the growth of cross-border activity.
Lamfalussy process

At the centre of attempts to improve cooperation, convergence, harmonisation or standardisation of financial regulation and supervision is the Lamfalussy process. It has dealt with some important issues such as bank capital requirements, and transparency in the issuing and selling of shares and other equities. Originally developed in March 2001, it is named after the chair of the EU advisory committee that created it. It is composed of four levels, each focusing on a specific stage of the implementation of legislation. At the first level, the European Parliament and Council of the European Union adopt a piece of legislation, establishing the core values of a law and building guidelines on its implementation. The law then progresses to the second level, where sectorspecific committees and regulators advise on technical details, then bring it to a vote in front of member-state representatives. At the third level, national regulators work on coordinating new regulations with other nations. The

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fourth level involves compliance and enforcement of the new rules and laws. From our point of view, the most significant European directive developed according to this approach is the Markets in Financial Instruments Directive, or MiFID. The MiFID is a European Union law that provides harmonised regulation for investment services across the 30 member states of the European Economic Area (the 27 Member States of the European Union plus Iceland, Norway and Liechtenstein). The main objectives of the Directive are to increase competition and consumer protection in investment services. Firms covered by MiFID will be authorised and regulated in their home state (broadly, the country in which they have their registered office). Once a firm has been authorised, it will be able to use the MiFID passport to provide services to customers in other EU member states. These services will be regulated by the home state (whereas previously under the EUs 1993 Investment Services Directive a service was regulated by the member state in which the service takes place). Amidst many other provisions, MiFID requires:

firms to categorise clients as eligible counterparties, professional clients or retail clients (these have increasing levels of protection). Clear procedures must be in place to categorise clients and assess their suitability for each type of investment product firms to capture specific information when accepting client orders, ensuring that a firm is acting in a clients best interests and lays down how orders from different clients may be aggregated that operators of continuous order-matching systems must make aggregated order information on liquid shares available at the five best price levels on the buy and sell side; for quote-driven markets, the best bids and offers of market makers must be made available firms to publish the price, volume and time of all trades in listed shares, even if executed outside of a regulated market, unless certain requirements are met to allow for deferred publication.

The overall objective of MiFID is to ensure that firms take all reasonable steps to obtain the best possible result in the execution of an order for a client. The best possible result is not limited to execution price but also includes cost, speed, likelihood of execution and likelihood of settlement and any other factors deemed relevant. Other Lamfalussy Directives affecting financial markets include:

The Prospectus Directive (PD): The PD sets out the initial disclosure obligations for issuers of securities that are offered to the public or admitted to trading on a regulated market in the EU. It provides a passport for issuers that enables them to raise capital across the EU on the basis of a single prospectus. The Market Abuse Directive: The Market Abuse Directive creates a regime to tackle market manipulation in the EC and update the existing EC insider dealing legislation. The Transparency Directive (TD): The Directive is designed to enhance transparency on EU capital markets by establishing minimum requirements on periodic financial reporting and on the disclosure of major shareholdings
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for issuers whose securities are admitted to trading on a regulated market in the EU. The TD also deals with the mechanisms through which this information is to be stored and disseminated.

9.3 Globalisation and financial markets

Recommended reading: Howells and Bain (2008) The US, Financial System, The Internal European Market and The Regulation of Financial Markets; Mishkin (2007) Economic Analysis of Banking Regulation.

Since the 1970s there has been a substantial increase in the internationalisation and globalisation of economic activity. This can be measured in a number of ways. If we are interested in real economic activity, for example, we could look at the size of imports and exports as a fraction of GDP, calculate a cross-country average and look at the trend over time. Alternatively, we could use measures of the size of world trade. As a measure of financial integration Obstfeld and Taylor (1998) have compiled the existing data on the stocks of foreign assets relative to world GDP as well as foreign liabilities relative to GDP at benchmark years over the period 1825 to the present. The sample of countries covered before 1914 are many of todays advanced countries and a number of other countries. The picture portrayed by this data, although it is fragmentary for the early years, is of a U-shaped pattern. At its pre-1914 peak the share of foreign assets to world GDP was approximately 20 per cent. It declined from that level to alow point of five per cent in 1945 with the pre 1914 level only being reached by 1985. Since then it has risen to 57 per cent. A similar picture emerges from the ratio of liabilities to world GDP. A number of organisations now publish their own indices of globalisation. The University of Maastrichts website is useful in listing the criteria used in the construction of the index as well as providing a series of maps which show the degree of globalisation (and its rate of change) for many countries (Maastricht, 2009). Behind this sharp rise in the stocks of financial assets/liabilities relative to world GDP is, inevitably, an internationalisation of capital flows. The key factors that brought about the growth in these flows and in the structure of the global financial market include the following:

liberalisation of national financial markets and the related growing competition among financial institutions technological progress in IT and telecommunications faster flow of information and its standardisation globalisation of national economies in their various aspects (commerce, institutions, ownership structure, capital and knowledge).

The potential benefits of globalisation are considerable. Firstly, globalisation allows investors to benefit from international diversification. In theory, this reduces the degree of market risk to which they are exposed (see Unit 4) since they can invest in several countries where market fluctuations are likely to be less than perfectly correlated. It also allows firms access to a larger range of capital sources, some of which may be cheaper than domestic sources. The globalisation process itself is closely linked with technological innovation, which itself benefits in reducing costs. Globalisation requires large amounts of information to be available instantly at a large number of locations. Communications technology is especially important here. And it is the same technology that has allowed large firms to relocate some of their activities to less developed
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parts of the world where costs are lower and where the relocation may have a major impact on local incomes. However, it also poses considerable problems for regulators. We have just seen how the growing internationalisation of financial markets and services in the EU has out-run the regulatory framework, and much the same is true at the international level. The nearest the world has to any form of international regulator is the Basle Committee and it is worth remembering that the first Basle Accord (1988) was an attempt to lay down some rules of conduct for international banks. But for markets, regulation still relies heavily on national institutions (including euro-wide institutions within the EU). Leaving aside the efforts of the Basle Committee, responses to the challenge posed by globalisation of markets include:

improved standards of information, including the quantity, quality and comparability of data unification of principles that govern the functioning of individual financial market areas (see for example the Lamfalussy Directives above) the development of international accounting standards (over 100 countries have adopted or based their own accounting standards on the International Accounting Standards (IAS) or the International Financial Reporting Standards (IFRS)) introduction of master agreements on executing transactions on the interbank and other markets sponsored by professional bodies in those markets development of statistical methodologies elaborated by, inter alia, the IMF, the BIS, and the World Bank that ensure compliance of the data gathered with the statistical guidelines and their international comparability the principles of best practice, elaborated by professional associations of financiers the development of the modern financial market infrastructure has also covered regulatory changes (for example, the bankruptcy law) and the establishment of modern transactional systems, payment systems, settlement systems, risk management systems, and information services such as Reuters or Bloomberg.

Lear

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Consider critically the argument that globalisation reduces the level of risk faced by investors.

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The argument that globalisation reduces risk rests upon the benefits of diversification. In Unit 4, we saw that diversification reduces the level of risk relative to the rate of return, because the returns on assets are imperfectly correlated. Furthermore, in Figure 4.1 we distinguished between specific risk (which is reduced by diversification) and market risk (which is not). Market risk persists because all assets are subject to some degree to market-wide events and therefore while correlation is imperfect, it remains positive. However, markets themselves are unlikely to be perfectly correlated. Rapid

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economic growth in one country is not necessarily accompanied by rapid growth in others. Hence, assets which are drawn from different national markets are likely to have lower correlation coefficients than those drawn from just one. Adding overseas assets to a portfolio should therefore reduce risk below what can be achieved only by diversification across the domestic market. Notice, however, that the argument rests upon the fact that markets throughout the world are less than perfectly correlated. This may be true, but it is not fixed for ever and it may well be that another consequence of globalisation is to increase the degree of convergence between economies. As the world emerged from recession in 2009, countries in the West hoped that rapid growth in China and sout east Asia would help them recover; in earlier years, it was the performance of the US economy that mattered to other countries. While globalisation may offer some benefits from diversification at the moment, those benefits may well be eroded by the consequences of globalisation.

Case Study Preventing market abuse

Read the following and answer the questions at the end. Extract from a speech by Jamie Symington, Head of Wholesale Department, FSA City and Financial Market Abuse Conference 6 November 2008 We live in interesting times people keep saying to me. There have been seismic shifts in the financial markets in the last few months, as we all know, and the landscape has changed in ways that seemed unimaginable. For the regulators (along with governments, central banks and the banking industries) the world over, it has been all hands to the pumps to fight the fires that have raged through the markets. It has been an extremely busy time for all of us. But no-one should make the mistake of thinking that this means that the business of ordinary regulation of the markets does not go on. Our remit is to maintain clean as well as orderly markets at all times. The FSAs commitment to combating market abuse remains as high as ever. We may have other immediate and pressing priorities, but the effort and resourcing that we put into the prevention, detection, investigation and prosecution of market abuse has not diminished. On the contrary, it has been enhanced in the last year. Markets and the outlook for the economy are changing on a daily basis. This makes it difficult to predict what the future holds for us in terms of the risks of market abuse. Take mergers and acquisitions, for example. This has been identified as a

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key risk area for us. Unusual trading around takeovers is something we have monitored closely. It is an indicator of the incidence of market abuse. It has been the source of many of our enforcement referrals. Who knows what will happen to M&A activity in the near or medium term? M&A activity may increase or decrease during a recession. It is hard to say. Sometimes harsh economic conditions lead to consolidation of enterprises in particular sectors. Sometimes there isnt the money there to finance it. But even if the corporate merger sector is less active there will still be particular risks to abuse of information in the markets. For example, information concerning re-financing packages. One of the FSAs landmark market abuse cases, our record fines for GLG and Philippe Jabre in 2006, concerned misuse of information about the re-capitalisation of a Japanese bank. That, Sumitomo bank, was going through a similar re-financing process in the aftermath of Japans financial crisis to what many of our own banks are doing today. Also, if we are entering into a recession, the likelihood is that we will see more examples of companies needing to give profit warnings, or even announcements concerning liquidity. Again, this poses a high risk of market abuse. Ordinary investors need to be protected. So we are keeping a very close eye on the changing world and the developing trends in markets. Also, as you have all seen, we have demonstrated that we are prepared to use all our regulatory tools as necessary to prevent and deter market abuse in response to the challenging market conditions. One example is the introduction of new rules concerning short selling. While the FSA still regards short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, the FSA has taken decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability. In July we introduced the provisions requiring disclosure of net short positions over a certain threshold. In September we took more targeted measures to prevent short selling completely in the shares of financial institutions. These provisions have been reviewed and will remain in place until January. Meanwhile, a wider review of short selling is ongoing and we will seek to look at, amongst other things, legal issues, the cross-border landscape and the quantitative impact of ban/disclosure requirements. We aim to publish a Consultation Paper in early January. Another example is the thematic work we have done concerning market rumours. Disseminating false or misleading information, particularly in nervous market conditions, can be very damaging. This has been the case particularly in the recent months, when unfounded rumours contributed to substantial share price movements in a number of UK financial institutions. While the most publicised cases pertained to falls in share prices resulting from the spread of unsubstantiated stories, all price movements triggered

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by unfounded rumours have the potential to distort markets and undermine market confidence.

continued

Since spring 2008, our Market Conduct team has investigated a series of unfounded rumours which were circulated in the market and we reported on this work at the start of August. We also began a tailored review of firms policies in relation to handling of market rumours. Obviously different firms have different compliance resources. Unsurprisingly, we identified a great disparity amongst firms approach to the issue of rumours. We take this matter very seriously. We will publish the findings of our rumours thematic review, including a case study, in Market Watch 30 this is due out later this month and will build on what I have said here. In short, therefore, in answer to the question what is the FSA doing about market abuse in the current market conditions I would say three things: One we are staying on the beat. We are busy with other things, but we are continuing to monitor market abuse and enforce with our usual rigour. Two we are carefully watching events and developments in market conditions. We are monitoring what risks areas are emerging for market abuse in the changing world. And three we are using all the tools we have to respond rapidly but thoughtfully to market conditions. Where necessary, we are changing the rules to address the needs of the day.

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1. In section 9.1, we identify two major sources of market failure. To which of these does the speech relate? (Hint: answering question 2 might help.) 2. What is meant by market abuse? 3. In the paragraph relating to mergers and acquisitions, how does the regulator detect suspicious behaviour and why might that behaviour be illegal? 4. Why might the need for firms to give profit warnings (and other announcements) increase the possibility of market abuse? 5. Why might rumours be a matter of concern to a financial regulator?

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1. Of the two sources of market failure that we discussed, the speech is mainly concerned with information. There is a hint of this in the second paragraph which refers to clean and orderly markets. But it becomes clear in the paragraph about mergers and acquisitions where it mentions suspicious trading. It also mentions rumours or potentially false information as a problem. 2. Market abuse can take many forms but (see answer 1) the FSA here is mainly concerned about the improper use of information in order to obtain an unfair advantage in market trading. 219

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3. It mentions unusual trading as the first sign of improper behaviour. We do not know the details, but it may mean that there has been a sudden increase in the demand for shares in a company before a merger or takeover bid is announced. One of the consequences of the introduction of electronic trading platforms in recent years is that every trade that takes place, its size, timing and other details is recorded and the records can be searched at almost zero cost and the information analysed and displayed in many different ways. Unusual patterns are easy to spot. If there is suspicious trading behaviour, this may be an indication of insider trading, meaning that someone inside the firms concerned is using their privileged information to buy the shares (or more likely to tipoff someone else to buy the shares on their behalf). Spotting the unusual trading may be easy but proving abuse may be difficult. Remember that in Unit 5, we noted that the stronger forms of the efficient market hypothesis expected prices to have adjusted by the time a public announcement too place. And this is what event studies show. Prices cannot change unless trading takes place, so relying on timing alone to prove insider trading is usually insufficient. 4. Most securities markets require firms to make an immediate disclosure of a significant change in their trading position. In a recession, therefore, we can expect a number of profit warnings and other statements of a negative kind. On the other hand, firms will be wanting to maintain as positive an outlook as possible. Remember that a sharp fall in the share price may make the firm a target for a takeover. The regulator is concerned that some of these negative announcements may not tell the whole truth. 5. Rumours are unsubstantiated information. Nonetheless, since financial markets are very sensitive to news of all kinds, rumours can move prices. Rumours may start for all sorts of reasons and many will be quite innocent. But suppose that a firm wished to raise its share price, or a seller of stock who feared bad news in the future wanted to sell the stock now at a good price, they might think it worth spreading some good news rumour. There may be a link here to the earlier paragraph that mentions short-selling. Short-selling is a situation where investors borrow and sell stock that they do not own, hoping that it wall fall in price. They then buy at the lower price, return it to the owner and pocket the difference in price. In this case, short-sellers might be tempted to spread negative rumours about the stock. Recall, though, that if the efficient market hypothesis holds, investors should not be easily deceived by rumours.

Self-assessment questions
1. 2. Consider the arguments for and against self-regulation of financial markets as opposed to statutory regulation. Under what circumstances might regulation decrease rather than increase the stability of an industry?

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3. 4 5.

Why is it thought that simple capital adequacy ratios are insufficient as a basis for supervising the activities of firms engaged in securities trading? What have been the impacts on financial markets of: (a) internationalisation of the markets; and (b) technological change? Why might you expect the theories of regulation outlined under Economic theories of regulation in section 9.1 to be critical of self-regulatory arrangements?

Feedback on self-assessment questions

1. Self-regulation is held to be more flexible and to be carried out by people who understand the needs of the industry. They are, thus, held to be less likely to interfere with the efficient functioning of the industry. The costs to firms in the industry are likely to be much lower than with statutory regulation. The problem with self-regulation is that it might be too light, leaving too large an element of risk for consumers and producers, particularly consumers. Self-regulation might also result in existing producers using regulation to increase barriers to entry to the industry. One possibility follows from the previous answer. Regulation gives participants a feeling of greater security. As individuals, they then take greater risks, adding to the total riskiness of the system as a whole. Another possibility is that regulation greatly increases compliance costs and encourages people to avoid these costs by behaving illegally. Regulators seeking to tighten the rules and participants find new ways around the regulations. It becomes difficult for consumers to know what the regulations are or who is following them. The major concern has been with the speed with which positions in derivatives trading can change. This, together with the complexity of derivatives trading, makes it very difficult to estimate the degree of risk faced by financial institutions and hence to calculate the amount of capital banks should maintain to cover themselves against potential losses. This is particularly so in the case of market risk, the variation in return on assets that results from events that affect all assets. The 1988 Basel Concordat, which stressed static capital adequacy ratios, dealt only with specific risk. We should note initially that the word globalisation has taken over from internationalisation. We should also note that the ideas of globalisation and technological change are linked since one of the several causes of globalisation has been the great improvement in the speed and quality of international communications. (a) Globalisation has allowed investors to gain from international portfolio diversification and has increased the ability of firms, faced by increased foreign exchange risk, to manage that risk. It has also increased the ability of borrowers to raise funds in the currency and form that best suits their needs. On the other hand, globalisation carries with it a loss of local knowledge, the possibility of crises in one country spreading to others, and increased problems in detecting wrongdoing. It has thus posed many problems for regulators. It may well, also, have increased even further the dominant position of developed countries in relation to the Third World. 221

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(b)

Technological change has led to screen-based trading in stock exchanges and in many derivatives markets. Improved information systems have allowed much easier and quicker transfer of pricesensitive information around the world. The greater ability to store and analyse vast amounts of data has aided the development and pricing of complex new products. Technology has also dramatically affected the way in which banks process and dispense payments and has permitted the financial industry to become more efficient and to offer its clients a better range of products and quality of service. Many operations have been moved to cheaper locations away from expensive financial centres. On the other hand, the introduction of new technology can be very expensive and a number of expensive mistakes have been made. Savings in a number of areas have been partially offset by an increased dependence on expensive IT staff. There has been considerable concern about issues of security and reliability of information. New technology has changed the balance between fixed and variable costs and, in so doing, has made market share more important. Together, globalisation and technological change have increased the importance of size and contributed to the consolidation of the industry through mergers and takeovers.

5.

The approach taken in our original discussion is to see regulation as a good which agents wish to consume because it brings them benefits of some sort. Thus they explain the presence of regulation by reference to benefits or advantages that it brings to the regulated. These often take the form of barriers to entry (since one can only enter by meeting the requirements of the regulator). For those who are already in the industry, the higher the barriers (the more regulation) the better. Having excluded potential rivals, the next step is to ensure that the regulations do not disturb the smooth running of the business. This can be achieved by regulatory capture ensuring that the regulator is sympathetic to the requirements of the regulated. The theories outlined see regulatory capture as widespread and it is particularly likely to happen in connection with self-regulation since the regulators are drawn from the regulated firms and may well intend to work again in the regulated firms. They have a strong incentive to remain on good terms with the firms they regulate.

Summary
In this unit we look at the case for regulating financial markets and at different approaches adopted in different jurisdictions. On completing this unit, you should be able to:

identify the need for regulation as a result of market failure identify information as the principle source of financial market failure distinguish between public interest and self-interest approaches to regulation be able to show why regulation acts as a tax distinguish different approaches to market regulation in the USA, UK and EU understand how globalisation presents major challenges for regulators.
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References
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Tavlas, GS (1997) The international use of the US dollar: an optimum currency area perspective, World Economy, 87, 85103. Thaler, R (1995) Advances in Behavioral Finance. Princeton: Princeton University Press. Thiel, M (2001) Finance and economic growth: a review of theory and the available evidence <http://ec.europa.eu/economy_finance/publications/ publication884_en.pdf>. Thompson, E (2007) The tulipmania: Fact or artifact? (PDF), Public Choice 130 (12): 99114, doi:10.1007/s11127-006-9074-4, <http://www.econ. ucla.edu/thompson/Document97.pdf>, retrieved 15 August 2008. Turner, A (2009) How to tame global finance, Prospect, 27 August, London: Prospect Publishing. Tversky, A, and D Kahneman (1974)Judgement under Uncertainty: Heuristics and Biases, Science, 185, 112431. Vayanos, D, and P Woolley (2008), An Institutional Theory of Momentum and Reversal, The Paul Woolley Centre for the Study of Capital Market Dysfunctionality, Working Paper Series No.1. Vayanos, D, and P Wolley (2009) Capital Market Theory after the Efficient Market Hypothesis, <http://www.voxeu.org/index.php?q=node/4052>. World Federation of Exchanges (2008) Focus, November, (Paris: World Federation of Exchanges) <http://www.world-exchanges.org/statistics> Wu, SN (1996) The analysis of the efficiency of securities market in our country, Jin Ji Yan Jiu (Economics Research, in Chinese), 6, 139.

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2008 financial crisis 187 ABS see asset-backed securities absent coping mechanisms 1889, 190 absolute purchasing power parity 1478 accounting, regulation 216 accrued interest 4950, 612 acquisitions, regulation 211, 21718, 21920 adjustable peg system 175, 1767, 1912 adverse selection 1967, 198 aggregate trade studies 162 allocative efficiency 978 American options 134 anchor currency 171 arbitrage efficient market hypothesis 11617, 121, 1223 foreign exchange markets 1301, 138, 142, 1579, 164, 165 money market users 36 Asian economies 17780 asset-backed securities (ABS) 43 assets, company shares 82, 83 asymmetric information, regulation 7, 1968 asymmetric shock 184, 189 at the money options 135 Banking Act (1987) 21112 Bank for International Settlements (BIS) 1256, 216 Bank of Japan 39, 40 Bank Of England 35, 367 Basel Capital Accord 206 Basel capital adequacy 2028, 221 Basel Committee 2056, 216 Basel I & II 2067, 209 basis points 25 behavioural finance 11421 best practice principles 216 beta coefficients 846, 902, 93 bid-ask spread 11 bills 2630, 334, 3740 BIS see Bank for International Settlements bonds bond spreads 18991 capital markets 4264 expectations hypothesis 546 financial system end users 6 fixed interest securities 4264 interest rates 446, 5060, 624 liquidity premia 54 market segmentation 567 market trading arrangements 5862 maturity 51, 612, 65 period to maturity 65 price elasticity 528, 614 pricing 323, 378, 4458, 615 spreads 18991 trading arrangements 5862 users 5862 yields 323, 378, 446, 502, 54, 568, 634 booms and crashes 10810, 11721 borrowing 57, 914, 58 BP share prices 701 Bretton Woods 17580, 1913 Bretton Woods II 17780, 1913 BRIC countries 111 bubbles 10810, 11920 call options 1347, 141 Canadian dollar 1624 capital account 14950 capital adequacy 2028, 221 capital asset pricing model (CAPM) 826, 913 capital costs 1718 capital markets 4195 bonds 4264 company shares 6695 efficient market hypothesis 11721 financial systems 4 fixed interest securities 4264 money markets 24, 38, 39 capital ratio 2025, 221 capital requirements 201 CAPM see capital asset pricing model CD see certificates of deposit CDO see collateralised debt obligations central banks exchange rate systems 1715

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foreign exchange markets 138, 157 money market users 348 certificates of deposit (CD) 302, 3740 chartism 72, 7881 China 11112, 17780 clean price 48, 4950 cointegration analysis 162 collateralised debt obligations (CDO) 43 collateralised loans 323 commercial banks 356 common stock 67 company shares 73, 816, 905 beta coefficients 846, 902, 93 capital asset pricing model 826, 913 capital markets 6695 characteristics 678 data 6872 discounting 723, 756, 812 dividends 726, 902, 945 earnings/price ratios 69, 756, 91, 92 equity 67, 87, 8990 interest rates 82, 913 market capitalisation 88, 91, 92 portfolios 823, 878, 91, 93 price/earnings ratios 69, 756, 91, 92 pricing 6881, 8990 quote-driven markets 87, 924 rate of return 73, 816, 903 returns 73, 816, 903 risk 816 trading 8691, 924 types 678 uses 678 competitive laxity 211 conservatism 116 constant growth models 73, 75, 94 contagion issues 89 contract costs 9 convergence requirements 1845 convertible bonds 42 convertible preferred shares 68 corporate bond data 446 corridor systems 35, 36 costs economic development 1718 financial systems 910, 1718 monetary unions 18791 reduction 1011 coupon payments 479

coupon rates 423, 62, 63 coupons 423, 479, 63, 64 crashes 10810, 11721 crisis of 2008 187 cross rates 128, 142 cross-subsidisation 2012 cumulative preferred shares 68 currency board 186 regimes 1867 unions 1812, 18793 see also foreign exchange markets data company shares 6872 fixed interest securities 446 foreign exchange markets 1258 daylight-savings-time arrangement 189 Debt Management Office (DMO) 59 deep discount bonds 42 delegation 119 demand frameworks bond market users 5960 company share trading 8990 pricing money market instruments 334 deposit certificates of deposit 302, 3740 contracts 2930 financial institutions 3 Depository Institutions Deregulation and Monetary Control Act (1980) 209 depreciation 1712 derivatives financial systems 5 foreign exchange markets 12844 regulation 2028, 221 devaluations 175 Directives 21415 direct quotations 127 dirty price 48, 4950, 612 discount/discounting bonds 42 company shares 723, 756, 812 fixed interest securities 478 foreign exchange markets 12930 money market instruments 245, 278, 38, 39 diversification 82, 83 dividends 726, 902, 945 see also returns

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Financial Markets

DMO see Debt Management Office dollarisation 186 domestic currency 125 Dornbusch overshooting hypothesis 1503, 155 dot.com boom/bust 110, 11920 downgrading 601 duration, bond price elasticity 528, 612, 63, 64 Dutch tulip mania 108 earnings/price ratios 69, 756, 91, 92 ECB see European Central Bank economic growth 1320, 21 economic risk 138, 161 economic theory in regulation 2015, 2212 economy financial systems 1320, 21 market efficiency 1316 money markets 39, 40 efficiency informational efficiency 1517, 97114 operational efficiency 1314, 978 efficient market hypothesis (EMH) 16, 96123 allocative efficiency 978 arbitrage 11617, 121, 1223 basis 97105 behavioural finance 11421 booms and crashes 10810, 11721 bubbles 10810, 11920 capital markets 11721 crashes 10810, 11721 dot.com boom/bust 110, 11920 failure of arbitrage 11617 forecasting 99101 growth strategies 1058 heuristics 11516 implications 1058 informational efficiency 97114 insider trading 1023 market rationality 1045 mis-pricing 11516, 11821 momentum 118, 120 operational efficiency 978 optimal forecast 99101 pricing 1035, 11016, 11822 principal-agent investment 11819, 120

rationality 11819, 120 science-based theory 118 semi-strong efficiency 101, 1048, 11213, 1212 shares 1068 strong efficiency 101, 1045, 107, 11314 testing 11214 unified theory of finance 118 weak efficiency 101, 11012 yields 1035 elasticity of bond prices 528, 614 electronic data sources 68, 6970 EMH see efficient market hypothesis empirical testing 18 EMU see European Monetary Union endogenous money supplies 35 end users financial systems 57 foreign exchange markets 137, 157 enforcement costs 9 equity company shares 67, 87, 8990 efficient market hypothesis 1058 ERM see Exchange Rate Mechanism EU see European Union euro-dollar exchange rates 155 Euronet exchange 87, 88 European Central Bank (ECB) 7, 35, 156, 18993 European Financial Common Market 213 European Monetary Union (EMU) 170, 1815 European options 134 European Union (EU) regulations 21215 euros 18791 evidence interpretations, foreign exchange markets 1547 Exchange Rate Mechanism (ERM), exchange rate systems 183, 185 exchange rates 16993 adjustable peg system 175, 1767, 1912 anchor currency 171 arbitrage 1579 asymmetric shock 184, 189 Bretton Woods 17580, 1913 Bretton Woods II 17780, 1913 central banks 1715 currency board 186

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currency regimes 1867 currency unions 1802, 18793 depreciation 1712 determination 14657 dollarisation 186 European Monetary Union 170, 1815 exchange rate targeting 1856 fixed exchange rates 17080 flexibility 184 floating exchange rates 17080 Government intervention 1713 interest rates 17387, 189, 1913 International Monetary Fund 1756, 190 monetary policy 1723, 187 monetary unions 1812, 18793 optimal currency area 1812, 1912 other currency systems 18591 seignorage 186 shocks 184, 186, 18990 symmetric economic shock 18990 targeting 1856 theory 1703 Triffin dilemma/paradox 177, 1912 variability 1614 see also foreign exchange markets exchange-traded products 1324 expectations, foreign exchange markets 14950 expectations hypothesis 546 expected returns 816 externalities, regulation 199201 failure of arbitrage 11617 fair game 106 fallibility 114 FDIC see Federal Deposit Insurance Company Federal Deposit Insurance Company (FDIC) 209 Federal Reserve 35 financial crisis of 2008 187 Financial Industry Regulation Authority (FINRA) 21011 financial institutions 23 financial intermediaries 67 financial markets and financial systems 35, 1012 financial regulation 194222

see also regulation Financial Services Act (1986) 211 Financial Services Authority (FSA) 211, 217, 219 financial systems 122 borrowing 57, 914 characteristics 29 costs 910, 1718 economic growth 1320, 21 end users 57 financial institutions 23 financial markets 35, 1012 lending 57, 914 liquidity 10, 1112 real economy 1320, 21 regulation 79, 17, 20 risk 810, 1112, 20 secondary markets 1012, 20, 21 FINRA see Financial Industry Regulation Authority Fisher hypothesis 149 fixed exchange rates advantages 17080 central banks 1745 gold standard 1735 in practice 17380 theory 1703 fixed interest securities 4264 bonds 4264 characteristics 423 coupons 423, 479, 63, 64 interest rates 446, 5060, 624 pricing 4458, 623 returns 446, 502 uses 423 yields 446, 502, 54, 568, 634 flexibility, exchange rates 184 floating exchange rates advantages 17080 Bretton Woods II 17780 theory 1703 floating rate notes (FRN) 42 fluctuations in foreign exchange markets 14568 forecasting 99101 foreign exchange markets 12737, 13844 American options 134 arbitrage 1301, 138, 142, 1579, 164, 165 at the money options 135 call options 1347, 141

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Canadian dollar 1624 capital account 14950 central banks 138, 157 cross rates 128, 142 data 1258 derivatives 12844 discounting 12930 end users 137, 157 European options 134 evidence interpretations 1547 exchange rate arbitrage 1579 exchange rate determination 14657 exchange rate variability 1614 exchange-traded products 1324 expectations 14950 fluctuations 14568 forward rates 12837 forwards 125, 12837, 139, 1423, 164, 1668 futures 1324, 13940, 1423 hedging 13841, 161, 164, 165 inflation 1478, 155 influencing factors 14568 instruments 12444 interest rate parity condition 131, 159 interest rates 14950, 155, 159, 164 in the money options 1356 long positions 141, 164, 165 loonie Canadian dollar 1624 margins 1334 market makers 137, 157 moral hazard 1434 options 132, 1347, 139, 1423 out of the money options 1356 overshooting 1503, 155 premia 12930, 137 pricing 12737 profits 1589 purchasing power parity 1478, 1501 put options 1347 random walks 153 risk 13843, 145, 1614, 1668 riskless arbitrage 1301 speculation 157, 15960, 164, 1656 spot markets 164, 1668 spot rates 125, 1278, 129, 139 spread 127

testing 1556 transaction data 1258 using derivatives 13741 yen 13941 see also exchange rates forex markets see foreign exchange markets forwards 125, 12837, 139, 1423, 164, 1668 fractional reserve ratios 35 free markets 17580 FRN see floating rate notes FSA see Financial Services Authority FTSE-100 index 701, 109 functions of money markets 2340 fundamental analysis 728, 801 futures 1324, 13940, 1423 gaps 125 GATT see General Agreement on Tariff and Trade GDP see Gross Domestic Product GEMMS see Gilt Edge Market Makers General Agreement on Tariff and Trade (GATT) 176 Germany 1834 gilt bonds 323, 378 Gilt Edge Market Makers (GEMMS) 58 Glass-Steagall Act (1933) 209 globalisation and regulation 21520, 2212 gold quotas 176 gold standard 1735 goods markets 1523 Gordon's growth model 73, 75, 94 Governing Council 35 Government exchange rate systems 1713 foreign exchange markets 162 regulation 20812 government bonds financial system end users 6 fixed interest securities 46 market users 59 pricing yield instruments 323, 378 Gramm-Leach-Bliley Act (1999) 209 Greece 456, 1878, 190 Gross Domestic Product (GDP) 215 growth efficient market hypothesis 1058 market efficiency 1314

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pricing company shares 73, 75, 94 half-coupons 62, 63 head and shoulders patterns 80 hedging 13841, 161, 164, 165 heuristics 11516 IAS see International Accounting Standards IFRS see International Financial Reporting Standards illiquidity 10 IMF see International Monetary Fund India 177 indirect quotations 127 industry-specific studies 162 industry stability 213, 2201 inflation exchange rate systems 187 fixed interest securities 63 foreign exchange markets 1478, 155 money markets 39, 40 information abuse 218 informational efficiency 1516, 97114 initial maturity 24 in the money options 1356 insider trading 1023, 198 insolvency 110 instruments foreign exchange markets 12444 money markets 2434, 3740 interbank deposits 2832 interest elasticity 528 interest rates bonds 446, 5060, 624 company shares 82, 913 duration 578 exchange rate systems 17387, 189, 1913 fixed interest securities 446, 5060, 624 foreign exchange markets 131, 140, 14950, 155, 159, 164 money market instruments 245, 28, 3740 parity condition 131, 159 risk and duration 578 term structure 528 interest yields 502 intermediaries 67 International Accounting Standards (IAS) 216
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International Financial Reporting Standards (IFRS) 216 international Fisher hypothesis 149 internationalisation 21516, 2212 International Monetary Fund (IMF) 1756, 190, 216 interstate transfers 1889, 190 intrinsic value 135 investment 1314, 1720 Ireland 18991 Japan 39, 40, 13941 jurisdictions and financial regulation 194222 labour markets 1523 Lamfalussy process 21315 lending 57, 914, 58 liberalisation Bretton Woods 176, 17780 regulation 213, 215 LIBOR see London Interbank Offer Rate liquidity 10, 1112, 54 Lisbon Strategy 213 loans 323 London Equity Market 87 London Interbank Offer Rate (LIBOR) 29, 36, 378 London Stock Exchange 59 long positions 141, 164, 165 long-term markets 4, 20 loonie Canadian dollar 1624 losses 141 margins 1334 market abuse 214, 21720 market capitalisation 88, 91, 92 Market Conduct team 219 market efficiency 1316, 20, 21 market failure 195201, 21720 market makers bond market users 58 company share trading 867 cost reduction 11 foreign exchange markets 137, 157 market optimism 208 market rationality 1045 market regulation see regulation market risk 825 market rumours 21819 markets cost reduction 1011

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liquidity 1112 risk 1112 market segmentation 567 Markets in Financial Instruments Directive (MiFID) 214 Market Watch 30 219 master agreements 216 maturity bonds 51, 612, 65 financial systems 4 money market instruments 24 yields 51, 612 membership of exchanges 201 mergers and acquisitions 211, 21718, 21920 MFI see monetary financial institutions MiFID see Markets in Financial Instruments Directive mis-pricing 11516, 11821 momentum, efficient market hypothesis 118, 120 monetary financial institutions (MFI) 3 monetary policy 1723, 187 Monetary Policy Committee (MPC) 35, 367 monetary unions 1812, 18793 money markets 2340 Bank of Japan 39, 40 capital markets 24, 38, 39 characteristics of instruments 245 financial systems 4 functions 2340 instruments 2434, 3740 operations 2340 pricing of instruments 2534, 3740 users 348 uses of instruments 245 moral hazard 1434, 196, 1978 moving averages 79 MPC see Monetary Policy Committee myopia and financial regulation 2001 NASDAQ market 88 National Association of Securities Dealers (NASD) 211 need for financial regulation 195205 New York Stock Exchange (NYSE) 87, 88 Nice Treaty 213 nominal convergence 185 NYSE see New York Stock Exchange

obligations 134 OCA see optimal currency area Open Market Committee 35 operational efficiency 1314, 978 operations, money markets 2340 optimal currency area (OCA) 1812, 1912 optimal forecast 99101 options 132, 1347, 139, 1423 order-driven markets 87 ordinary company shares 67 out of the money options 1356 over the counter transactions 29 overshooting 1503, 155 Panel on Takeovers and Mergers 211 PD see Prospectus Directive peg systems 175, 1767, 1912 period to maturity 65 policy rates 378 portfolios 823, 878, 91, 93 PPP see purchasing power parity preferred shares 67, 68 premia 12930, 137 price/earnings ratios 69, 756, 91, 92 price elasticity 528, 614 prices/pricing bonds 323, 378, 4458, 615 company shares 6881, 8990 discount instruments 245, 278, 38, 39 efficient market hypothesis 1035, 11016, 11822 fixed interest securities 4458, 623 foreign exchange markets 12737 money market instruments 2534, 3740 yield instruments 245, 2833, 3740 primary currency 127 primary markets bond market users 589 company share trading 87 financial systems 10 pricing money market instruments 334 principal-agent investment 11819, 120 printed data sources 689 profits 1589, 21820 Prospectus Directive (PD) 214 purchasing power parity (PPP) 1478, 1501
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put options 1347 quotations 127 quote-driven markets 87, 924 random walks 153 rate of interest see interest rates rate of return 73, 816, 903 rationality 11819, 120 real economy 1320, 21 recessions 63 redemption yields 51 regulation 199201, 21520 acquisitions 211, 21718, 21920 asymmetric information 7, 1968 Bretton Woods 17580, 1913 capital adequacy rules 2028, 221 capital ratio 2025, 221 derivatives 2028, 221 economic theories 2015, 2212 European Union 21215 financial markets 194222 financial systems 79, 17, 20 globalisation 21520, 2212 Government 20812 internationalisation 21516, 2212 Lamfalussy process 21315 liberalisation 213, 215 market abuse 214, 21720 market failure 195201, 21720 mergers and acquisitions 211, 21718, 21920 need for 195205 regulatory capture 202, 211 risk 1968, 21617 rumour issues 21820 self-regulation issues 208, 211, 2202 taxes 2025 United Kingdom 21112 United States of America 20811 relative purchasing power parity 1478 repo deals 323, 37, 39, 40 representiveness, efficient market hypothesis 116 repurchase agreements 323, 37, 39, 40 reputational issues 778 reserves/reserve ratios 35 residual maturity 24, 42 resource allocation 1516 returns company shares 73, 816, 905

economic development 1720 fixed interest securities 446, 502 pricing money market instruments 2630 Revived Bretton Woods 17780, 1913 risk asymmetric information 1968 company shares 816 contagion 89 financial systems 810, 1112, 20 foreign exchange markets 13844, 145, 1614, 1668 free bonds 52 free interest rates 91 markets 1112 premium 43 regulation 1968, 21617 risk-adjusted assets 2025 riskless arbitrage 1301 rumour issues 21820 Sarbanes-Oxley Act (2002) 210 science-based, unified theory of finance 118 SEA see Single European Act (SEA) search costs 9, 1011 SE Asian economies 17780 SEC see Securities and Exchange Commission secondary currency 127 secondary markets bond market users 589 company share trading 87, 889 financial systems 1012, 20, 21 liquidity and risk 1112 pricing money market instruments 334 Securities and Exchange Commission (SEC) 20911 Securities and Investment Board (SIB) 211 securitised loans 323 security 1516, 98105 seignorage 186 self-regulation issues 208, 211, 2202 semi-strong efficiency 101, 1048, 11213, 1212 sensitivity of bond prices 65 shareholders 6695 shares economic development 1720 efficient market hypothesis 1068

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market efficiency 1516, 20, 21 regulatory authorities 89 see also company shares shocks 184, 186, 18990 short selling 218 short-term markets 4, 20 SIB see Securities and Investment Board simple yield to maturity 51, 612 Single European Act (SEA) (1986) 213 South Sea Bubble 1089 sovereign debt 456 sovereign risk 163 Spain 18991 specific risk 823 speculation/speculators 138, 157, 159 60, 164, 1656 spot markets 164, 1668 spot rates 125, 1278, 129, 139 spot transactions 125 spreads bonds 18991 cost reduction 11 foreign exchange markets 127 standard deviation 812 Sterling-Dollar exchange rate 154 stock exchanges 59, 87 stock markets 1112, 8691 strikes 76 strips 42 strong efficiency 101, 1045, 107, 11314 Subprime Crisis 187 subsidisation 2012 supply and demand bond market users 5960 company shares 8990 pricing money market instruments 334 swaps 125 Swiss National Bank/Swiss Franc 163, 164 symmetric economic shock 18990 takeovers 1056, 211 taxes, regulation 2025 TD see Transparency Directive technical analysis 72, 7881 technological changes and globalisation 21516, 2212 term structure, interest rates 528 testing economic development 18

efficient market hypothesis 11214 foreign exchange markets 1556 theory economic theory in regulation 2015, 2212 exchange rate systems 1703 unified theory of finance 118 three-point foreign exchange arbitrage 1589, 164, 165 time value 135 trading bond markets 5862 company shares 8691, 924 foreign exchange markets 126 transaction costs 910 transaction data 1258 transaction risk 138, 161 translation risk 138, 161 Transparency Directive (TD) 21415 Treasury 6.25 2010 46 treasury bills 2630, 334, 3740 Triffin dilemma/paradox 177, 1912 two-point arbitrage 1589 UK see United Kingdom ultimate borrowers/lenders 57, 58 unified theory of finance 118 United Kingdom (UK) bond market users 59 money markets 2630, 334, 35, 3740 pricing money market instruments 2630, 334, 3740 regulation 21112 treasury bills 2630, 334, 3740 United States of America (USA) Bretton Woods 17580, 1913 exchange rate systems 171, 17483, 188, 1913 money markets 35 regulation 20811 unlimited losses 141 USA see United States of America users/uses bond markets 5862 fixed interest securities 423 foreign exchange derivatives 13741 money markets 348 vanilla bonds 423 variance in company shares 812

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weak efficiency 101, 11012 weighted averages 53, 93 Werner Committee 183 World Bank 176, 216 World Trade Organisation 176 yen 39, 40, 13941 yields bonds 323, 378, 446, 502, 54, 568, 634 efficient market hypothesis 1035 fixed interest securities 446, 502, 54, 568, 634 money market instruments 245, 2833, 3740 yield to maturity 51, 612 zero coupon bonds 42

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