MIDLANDS STATE UNIVERSITY

DEPARTMENT OF ACCOUNTING SCIENCES

MODULE: FINANCIAL MARKETS AND REGULATION (FDB103)

COURSE OUTLINE

Aims of the Module

The aim of the course is to provide students with a thorough understanding of the operations
of financial markets and market finance. Practical aspects of financial markets where initially
short term and long term capital is raised or investment of assets and how the financial assets
are exchanged or traded are dealt with. This course thus should appeal to those interested in
equity research and fund management.

Objectives of the Module:

By the end of the module, students should be able to;

• describe the financial markets framework and the components that make up the
framework.
• classify financial markets into their respective classes.
• Identify various money market instruments based on their unique characteristics
• Identify various capital market instruments based on their unique characteristics
• Carry out computations for financial securities quoted on a yield basis
• Carry out computations for financial securities quoted on a discount basis
• Differentiate between forward, futures and option derivative contracts
• Carry out computations for European style options
• Close out a futures positions before delivery
• Arrange a futures or swap position given a certain market scenario
• Articulate the building blocks of financial regulation
• Link the theoretical aspects of regulation to the regulatory aspects pertaining to the
local financial sector
• Determine the contribution of corporate governance aspects to bank collapses in
Zimbabwe.
• Evaluate the strength of the Basel 2 framework as a regulatory tool
• Investigate the feasibility of applying the Basel 2 framework in developing markets

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 • Establish the major factors behind financial crises in global financial markets

Course Grading/Assessment

The grading of this course will be based on two assignments, class presentation, one in class
test and one examination at the end of the semester. The weighting of the final grade is
shown below:

Assignments (one assignment, class presentation and one test) 30%

Final examination 70%

COURSE OUTLNE

UNIT ONE : FINANCIAL MARKETS FRAMEWORK

• The Financial System

• Financial Assets

• Role of the Financial System

UNIT TWO: MONEY MARKET INSTRUMENTS

• Treasury Bills

• Bankers’ acceptances

• Negotiable Certificates of Deposits

• Commercial paper

• Repurchase agreements

• Call accounts

• Interbank loans and deposits

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UNIT THREE: CAPITAL MARKET SECURITIES

• Term loans

• Bonds

• Equities

UNIT FOUR: SECURITIES ANALYSIS

• Money market securities

✓ Securities quoted on a yield basis

✓ Securities quoted on a discount basis

• Capital markets

✓ Bonds

UNIT FIVE: Derivatives markets

✓ Forwards and futures

✓ Options

✓ swaps

UNIT SIX: REGULATION OF FINANCIAL MARKETS

• Forms of regulation

• Objectives of regulation

• Principles of regulation

• The Basel Framework

RECOMMENDED READING

1. Mishkin S F (2ND Edition) The Economics of Money, Banking and Financial Markets

2. Beiem, D O and Calmiris C W (2001), Emerging Financial Markets

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 3. Bodie Z, Kane A, Marcus A J (1999), Essentials of Investments 4th Edition

4. Fabozzie F J, Foundations of financial markets and institutions

5. Fabozzie F J and Fabozzie T D (1989), Bond Markets, Analysis and Strategies

6. Thomas W A (1998), The securities Market

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UNIT ONE: FINANCIAL MARKETS FRAMEWORK

A financial system is a system that allows the transfer of money between savers and
borrowers. A financial system is the term used to comprehend the set of arrangements
covering the borrowing and lending of funds and the transfer of ownership of financial
claims. A financial system is the set of markets and other institutions used for financial
contracting and the exchange of financial assets and risks.

It includes the money market, capital market, foreign exchange markets, the derivatives
markets (financial markets), financial intermediaries (such as banks and insurance
companies), financial services firms such as advisory firms and the regulatory bodies that
govern all of these institutions.

Financial Assets

An asset broadly speaking, is any possession that has value in an exchange. Assets can be
classified as tangible or intangible. A tangible asset is one whose value depends on particular
physical properties – examples are buildings, land or machinery. Intangible assets, by
contrast, represent legal claims to some future benefit. Their value bears no relation to the
form , physical or otherwise, in which claims are recorded.

Financial assets are intangible assets. For financial assets, the typical benefit or value is a
claim to future cash. The entity that has agreed to make future cash payments is called the
issuer of the financial asset; the owner of the financial asset is referred to as the investor.
Examples of financial assets are as follows;

• A loan by Kingdom (investor) to an individual (issuer/borrower) to purchase a car.

• A Treasury bill issued by the RBZ

• A bond issued by by Econet Wireless

• A share of common stock issued by RIOZIM

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The Role/Function of the Financial System

The users of the system are people, firms and other organisations who wish to make use of
the facilities offered by a financial system. The facilities offered may be summarised as

• Intermediation between surplus and deficit units;

• Financial services such as insurance and pensions

• A payments system

• Portfolio adjustment facilities

Notice that while different parts of the system may specialise in each of these functions, they
all have one thing in common: they all have the effect of channelling funds from those who
have a surplus (to their current spending plans) to those who have a deficit. Similarly ,
insurance companies and pension funds have a primary purpose which is to offer people a
means of managing the risk of some major adverse event. However, the contributions made
by the policyholders create a fund which is usually invested in a wide range of securities.
This purchase of securities involves a flow of funds (directly or indirectly) to those who
issued the securities as a means of raising funds. Portfolio adjustment facilities have to
provide wealth-holders with a quick, cheap and reliable way of buying and selling a wide
variety of financial assets. When wealth-holders buy financial assets they are lending (again
directly or indirectly ) to those who issued the assets. In developed economies, incomes are
generally so high that there are many people who wish to lend and the state of technology is
such that real investment cam only be undertaken by borrowing funds to finance its
installations. Faced with a desire to lend or to borrow, the end users of financial systems
have a choice between three broad approaches namely; direct lending, the use of organised
markets and use of financial intermediaries. When a lender deals through an intermediary, he
acquires an assets typically a bank deposit or claims on an insurance fund which cannot be
traded but can only be returned to the intermediary. Similarly intermediaries create
liabilities, typically in the form of loans for borrowers. These too are non-marketable. If the
borrower wishes to end the loan, it must be repaid to the intermediary.

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THE STRUCTURE OF FINANCIAL MARKETS

Financial markets are the places where financial instruments are bought and sold. They are a
central component of the economy, relaying and reacting to information quickly, allocating
resources and determining price. In doing so, financial markets enable both firms and
individuals to find financing for their activities.

What is a market?

A market in general terms refers to any arrangement that allows buyers and sellers to come
together and trade. This can take a physical shape like Zimbabwe Stock Exchange or buyer
and seller are brought together by means of electronic technology e.g the money market.

Financial Market

A financial market is a market where financial assets are exchanged or traded. These are
financial instruments or securities.

It is a market where initially short term and long term capital is raised. Those with excess
money lend to those who have insufficient funds for their needs.

Financial markets can be classified in a number of ways as follows;

Organised Exchanges, Over The Counter Markets and Electronic Networks

Organised Exchanges or centralised exchanges are physical market places where the agents
of buyers and sellers operate through the auction process. Examples of organised exchange
include the Zimbabwe Stock Exchange, Johannesburg Stock Exchange, New York stock
Exchange etc. A financial market however, does not necessarily need to have a physical
location. Shares, bonds and money market instruments can be traded over the counter using a
system of computer screens and telephones. Over the Counter markets are best thought of as
networks of dealers connected together electronically. The dealers buy and sell various
securities both for themselves and for their customers. On OTC markets, the advantages are
that customers can see the orders, orders are executed quickly, costs are low and trading is 24
hours a day. There are also Electronic Communication Networks where buyers and sellers

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are brought together for electronic execution without the use of a broker and dealer. The
NASDAQ is an example of an electronic communication network.

Debt, Equity and Derivative Markets

A useful way to think of the structure of financial markets is to distinguish between markets
where debt and equity are traded and those where derivative instruments are traded. Debt
markets are the markets for loans, mortgages and bonds. The instruments that allow for the
transfer of resources from lenders to borrowers and at the same time give investors a store of
value for their wealth. Equity markets are the markets for stocks. Equities such as common
stock are claims to share in the net income and the assets of a business. The main
disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is
a residual claimant; that is the corporation must pay all its debt holders before it pays its
equity holders. The advantage of holding equities is that equity holders benefit directly from
any increases in the corporation’s profitability or asset value because equities confer
ownership rights on the equity holders. Debt holders do not share in this benefit because their
dollar payments are fixed. Derivative markets are the markets where investors where
investors trade instruments such as futures and options which are designed primarily to
transfer risk. Derivative securities are financial contracts whose values are derived from the
values of underlying assets such as debt and equity securities. Many derivative securities
enable investors to engage in speculation and risk management. In debt and equity markets,
actual claims are bought and sold for immediate cash payment while in derivative markets
investors make agreements that are settled later.

Continuous and Call markets

Most markets operate on a continuous basis during opening hours, implying that trading can
take place at any time that the markets are open. Examples here are the markets for shares,
bonds and money market instruments. However, some markets trade at specific times during
opening hours. Such markets are known as call markets because the securities are called for
trading. There has to be sufficient time between calls to allow offers to buy and sell securities
to accumulate and so make trading worthwhile.

Money and Capital Markets

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Markets can also be classified according to the maturity of the securities traded in them. A
major distinction is usually drawn between money markets and capital markets. Money
markets deal in securities with less than one year to maturity, whereas capital markets deal in
securities with more thn one year maturity. Examples of money market instruments are
treasury bills , commercial paper, bankers’ acceptances and negotiable certificates of deposit.
Examples of capital market instruments are bonds with more than a year to maturity and
shares.

Primary and Secondary Markets

An important decision can also be drawn between primary and secondary markets. The
primary market is the new issues market. When an investment bank brings a new company
to flotation, its shares are issued on the primary market (as an initial public offer). If this
company subsequently decides to gear up by issuing bonds, these are also floated on the
primary market. Similarly, if a company decides to expand using either equity finance or
bond finance, the additional shares or bonds are floated on the primary market (known as a
secondary public offer). The important point about the primary market is that the initial price
of the security is set rather than determined by the market, unless the security is issued
through a tender offer or by auction.

The secondary market is the market in which existing securities are subsequently traded.
There two main reasons why individuals transact in the secondary market: information
motivated reasons and liquidity motivated reasons. Information-motivated investors believe
that they have superior information about a particular security than other market participants.
This information leads them to believe that the security is currently underpriced, and
investors with access to such information will want to buy the security. On the other hand, if
the information consists of bad news, the security will be currently overpriced and such
investors will want to sell their holdings of the security. Liquidity motivated investors, on the
other hand, transact in the secondary market because they are currently in a position of either
excess or insufficient liquidity. Investors with surplus cash holdings will buy securities
whereas investors with insufficient cash will sell securities. The prices of securities in the
secondary market are determined by the market makers in those securities

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UNIT TWO: MONEY MARKET INSTRUMENTS

Money market securities are debt securities with a maturity of one year or less. They are
issued in the primary market through a telecommunications network by the treasury,
corporations and financial intermediaries that wish to obtain short term financing. The
government treasury issues money markets securities and uses the proceeds to finance the
budget deficit. Financial institutions issue money market securities and bundle the proceeds
to make loans to households or corporations. Thus the funds are channelled to support
household purchases such as cars and homes and to support corporate investment in buildings
and machinery. Money markets allow households, corporations, and the government to
increase their expenditures and therefore finance economic growth. Since money market
securities have a short term maturity and can typically be sold in the secondary market, they
provide liquidity to investors.

TREASURY BILLS

These are short term debt instruments used by the government to obtain funds and are issued
by the central bank. They are fully guaranteed, very liquid and are backed by the full faith
and credit of the government. These instruments do not pay regular interest payments but
instead are sold at a discount. This means they are sold for an amount that is less than what
the government promises to pay at maturity and the difference between the purchase price
and the face value is the return from the treasury bill. The greater the discount at the time of
purchase the higher the return earned by the investor.

Negotiable Certificates of Deposit

Certificates of deposit are debt instruments sold by banks and other depository institutions. A
CD pays the depositor a specified amount of interest during the term of the certificates, plus
the purchase price of the CD at maturity. CDs can be resold in the secondary market which
makes them very liquid. The original purchaser need not hold the CD to maturity or pay a
substantial penalty for early withdrawal if he she needs to liquidate the CD, instead the

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person can sell the CD in the secondary market at a price that will depend on the market
interest rate effective when it is sold.

Commercial Paper

This is a form of direct short-term finance by large credit worthy companies. Commercial
paper is a promise to pay back a higher specified amount at a designated time in the
immediate future say 30 days. By issuing commercial paper, a corporation avoids the process
of applying for a loan and instead engages in direct finance. To engage in direct finance
effectively, the issuing company must be large and creditworthy enough to find someone
wiling to accept its commercial paper which is sold with the aid of brokers. Commercial
paper is sold at a discount. The secondary market for commercial paper is rather weak and as
a result it is held to maturity.

Bankers’ Acceptances

A banker’s acceptance is a letter of credit (a bank’s promise to pay on a specified date) that
has been stamped “accepted” . In simple terms a BA is a vehicle (instrument) to facilitate
commercial trade transactions. The instrument is called a BA because a bank accepts the
ultimate responsibility to repay a loan to its holder. The use of BAs to finance commercial
trade transactions is called acceptance financing. The party issuing a banker’s acceptance
pays a fee to the bank for its guarantee.

Repurchase Agreements

A repurchase agreement is an agreement by two parties in which the borrower sells and
agrees to pay back a financial instrument such as a government bond or treasury bill.
Suppose a bank needs short term cash today, the bank can sell some treasury bills to a firm
with the agreement that the bank will repurchase the treasury bills in 30 days at a higher
price. In effect this repurchase agreement is a short loan in which the treasury bills serve as
collateral.

Call accounts

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These are accounts where funds are repayable on demand or on call. The accounts are the
appropriate vehicle for very short term surpluses. The interest rate is lower than any other
market securities. This call interest rate is negotiated on a daily basis.

Interbank loans and deposits

For very short term requirements, banks may enter the interbank market within the overall
money market and borrow funds from other banks. Similarly, a bank in surplus would invest
funds on the inter bank market and be in a position to withdraw them on demand. The rate of
interest on such deposits is determined by the period of deposit.

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UNIT THREE : CAPITAL MARKET SECURITIES

Capital Market Instruments

The capital market encompasses instruments of maturities of more than one year. The capital
market includes both debt and equity instruments with the latter having no maturity date. The
government is an important player in this market through issues of government bonds.

Long term debt instruments

1. Term loans –A term loan is a contract under which a borrower agrees to make a series
of interest and principal payments on specific dates to the lender. Term loans are
usually negotiated between the borrowing firm and the lender (generally a bank,
insurance company or pension fund). Term loans maturities vary from 2 years to 30
years but most are for periods in the 3 to 15 year range. These loans have three
advantages over public offerings a)speed b)flexibility c)low issuance costs. Apart
from minimal documentation the key provisions of a term loan can be worked out
much more than those of public issue. Flexibility is another facet that a term loan has.
For instance if a bond issue is held by many different bondholders, it is virtually
impossible to obtain permission to alter the terms of the agreement even though new
economic conditions may make such changes desirable. With a term loan, the
borrower can just sit down with the lender and work out mutually agreeable
modifications to the contract. The interest rate on a term loan can either be fixed for
the life of the loan or be variable. If a fixed rate is used it is set close to the rate on
bonds of equivalent maturity and risk. If the rate is variable it will usually be set at a
certain number of % points over the prime rate, the commercial paper or the treasury
bill rate.

2. Bonds - a bond is a long term contract under which the borrower agrees to make
payments of interest and principal on specific dates to the holder of the bond.
Traditionally bonds have been issued with maturities of between 20 and 30 years but
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 shorter maturities of between 7-10 years are now being used to an increased extent.
Although bonds are similar to term loans, a bond issue is actually advertised, offered
to the public and sold to many different investors. With bonds the interest is generally
fixed although in recent years there has been an increase in the use of various types of
floating rate bonds. There are many different types of bonds the most important of
which are

a) Mortgage bonds- a mortage bond grants the bond holders a lien against the
pledged assets, that is a legal right to sell the mortgaged property to satisfy unpaid
obligations to the bondholders

b) Debenture bonds-these are debt securities not secured by a specific pledge of

property, but that does not mean the offer no claim on property to issuers or on
their earnings. Debenture bond holders have the claim of general creditors on all
assets of the issuer not pledged specifically to secure other debt.

c) Subordinated debenture bonds- these ones rank after secured debt, after debenture
bonds and often after some general creditors in their claim on assets and earnings.
The type of security issued determines the cost of the company. For a given
company mortgage bonds will cost less than debenture bonds which will cost less
than subordinated debenture bonds.

d) Guaranteed bonds- these are obligations guaranteed by another entity. The safety
of a guaranteed bond depends upon the guarantor’s financial capability as well as
the financial capability of the issuer. The terms may call for the guarantor to
guarantee the payment of the interest and/or payment of the principal.

e) Junk bonds- this is a bond which is high yield, high risk bond issued to finance a
leveraged buy out or a merger or to finance a troubled company.

f) Zero-coupon-bonds – these bonds pay no interest but are offered at a substantial

discount below their par values and hence provide capital appreciation rather than
current cash income.

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 g) Income bonds – these bonds pay interest only when the interest is earned. These
securities cannot bankrupt the issuing company but from the an investor’s view
point they are riskier than regular bonds.

h) Convertible bonds- these are securities that are convertible into other securities
such as ordinary shares, preference shares etc at a fixed price and at the option of
the bond holder. Basically convertibles provide investors with a chance for
capital gains in exchange for a lower coupon rate while the issuing company gets
the advantage of that lower rate. Bonds issued with warrants are similar to
convertibles. Warrants are options which permit the holder to buy stock for a
stated price thereby providing capital gain if the price of the stock rises.

Specific debt contract features

Bond indentures

An indenture is a legal document that spells out the rights and obligations of both the
bondholders and the issuing company. A trustee usually a bank officer is assigned to
represent the bondholders and to make sure that the terms of the indenture are carried out.
The indenture is a lengthy and legal document which may be difficult to understand for many
bondholders. These problems are solved by the bringing in of a corporate trustee as a
representative of the interests of the bondholders. A trustee acts in a fiduciary capacity for
the investors who own the bond issue. The indenture may cover such issues as the restrictive
covenants that cover such points as the conditions under which the issuer can pay off the
bonds prior to maturity, the level at which the issuer’s times-interest –earned ratio must be
maintained if the company is to sell additional bonds and restrictions against the payment of
dividends when earnings do not meet certain specifications. Note that the trustee is
responsible both for trying to make sure that the covenants are not violated and for taking
appropriate action if they are.

Provisions of paying off bonds

Most corporate issues have a call provision allowing the issuer an option to buy back all or
part of the issue prior to the stated date. Some issues specify that the issuer must retire a
predetermined amount of the issue periodically.

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Call and refund provision

Most banks contain a call provision which gives the issuing company the right to call the
bonds for redemption. The call provision generally states that the company must pay
bondholders an amount greater than the par value for the bond when it is called. Normally
when the call privileged is exercised, the security issuer will pay the investor the call price
which equals the security’s face value plus a call penalty. In the case of a bond, one year’s
worth a coupon income is often the minimum call penalty required.

Sinking Fund

A sinking fund is a provision that facilitates the orderly retirement of a bond issue (or in some
cases preference shares). The SF provision requires the company to retire a portion of the
bond issue each year. On rare occasions the company may be required to deposit money with
a trustee who invests the funds and then uses the accumulated funds to retire the bonds when
they mature. Normally the sf is used to buy back a certain % of the issue each year. Failure
to meet a SF requirement causes the bond issue to be thrown into default which may force the
company into bankruptcy.

Risk Associated with Bonds

Bonds have their own sources of risk just as ordinary shares and other securities. Bond
holders are promised a stream of interest payments and repayments of the principal or par
value but these are subject to several sources of risk in actually realising such returns. The
specific risks facing bondholders are (1) interest rate risk (2) inflation risk (3) default risk (4)
maturity risk (5) call risk (6) liquidity risk

Interest Rate Risk

A major risk facing bondholders or investors in bonds is changing interest rates which
thereby change the price of the bonds. When price of a bond is going up interest rates will be
going down and vice versa. Prices of outstanding bonds must change inversely with changes
in current market interest rates. As a general rule when the market interest rates decline
(rise), prices of bonds outstanding rise (fall).

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Inflation risk

Fixed income securities by definition promise specified payments at specified periods. As

the payments in $ terms is fixed , the value of the payment in real terms declines as the price
level rises. This risk of the real return being less than the nominal dollar return is called the
inflation risk.

Default Risk

Corporate bonds and municipal bonds are subject to default risk, that is failure to pay the
specified interest payments or repay the principal at the time specified in the indenture.
Bonds carry strict obligations and the failure to make a specified payment as called fir is a
serious event. By and large government bonds are risk free because they are issued with a
full guarantee of the treasury.

Maturity Risk

Refers to the fact that the further into the future an investor goes in purchasing a long term
security the more risk there is in an investment. The environment 30 years from now when
some long term bonds mature can scarcely be envisioned today thus investing for the long
term involves substantial risk and bond investors wish to be compensated for this risk with an
additional premium lending long term than short term.

Call Risk

As explained earlier, corporate bonds are issued with an option to call them back at a time
that represents lower cost to the issuer of the bonds. Issuers have the option of redeeming a
bond before the maturity date. Bonds will not be called unless it is to the issuer’s advantage.

Liquidity Risk

Concerned with the secondary market where a security is traded. A security is liquid if it can
be sold easily and quickly with small price concessions.

SHARES

There are several types of shares that can be issued by a firm as specified in the memorandum
and articles of association. The most important type is ordinary shares . Ordinary
shareholders have voting privileges, the right to receive dividends and subscription privileges
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in the event of new shares being issued. A common stock represents a share ownership in a
corporation. It is a security that is a claim on the earnings and assets of the corporation. The
two most important characteristics of common stock as an investment are its residual claim
and its limited liability features.
Residual claim means stockholders are the last in line of all those who have a claim on the
assets and income of the corporation. In a liquidation of the firm’s assets, the shareholders
have claim to what is left after paying all other claimants, such as the tax authorities,
employees, suppliers, bondholders, and other creditors. In a going concern, shareholders have
claim to the part of operating income left after interest and income taxes have been paid.
Management either can pay this residual as cash dividends to shareholders or reinvest it in the
business to increase the value of the shares.
Limited liability means that the most shareholders can lose in event of the failure of the
corporation is their original investment. Shareholders are not like owners of unincorporated
businesses, whose creditors can lay claim to the personal assets of the owner—such as
houses, cars, and furniture. In the event of the firm’s bankruptcy, corporate stockholders at
worst have worthless stock. They are not personally liable for the firm’s obligations: Their
liability is limited.

Issuing stock and selling it to the public is a way for corporations to raise funds to finance
their activities. The stock market is also an important factor in business investment decisions,
because the price of shares affects the amount of funds that can be raised by selling newly
issued stock to finance investment spending. A higher price for a firm’s shares means that it
can raise a larger amount of funds, which it can use to buy production facilities and
equipment.

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UNIT FOUR: SECURITIES ANALYSIS

Security Valuation

Security valuation is the art of determining the value of securities. In simple basic terms ,
value is the factor which equates the forces of supply and demand. Valuation of securities
mainly involves finding the intrinsic value of securities and is calculated by discounting the
future stream of a security by the required rate of return of that security.

Debentures/bonds

A bond is a security that is issued by a firm when it borrows long term funds. The
promissory note provides evidence of the borrowing and the terms and conditions of the
borrowing.

Face or par value

The face or par value of the bond is the principal amount that has been borrowed by the
company. Usually the amount is in multiples of $100 or $1000. The firm does not
necessarily receive the face value of the bond issue. The face value is however important in
determining the amount of annual interest and also usually the amount repaid at maturity.
The par value is not the price of the bond. A bond’s price will fluctuate over the life of the
bond is response to a number of variables. When a bond trades at a price above the face
value, it is said to be selling at a premium. When a bond sells at below face value, it is said
to be selling at a discount.

Coupon Rate

Debentures usually pay annual, semi annual or quarterly interest o investors. The interest
paid by the company is called a coupon payment. Most bonds have a fixed coupon rate but
some companies may issue floating rate bonds based on the short term treasury bill rate.

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Maturity date

Bonds are long term promissory notes and are issued for 20-40 years. Firms sometimes issue
shorter term bonds where such features such as convertibility to common stock are included.

Yield

Yield is a figure that shows the return you get on a bond. The yield is the rate of interest that
is required by investors in order for them to invest in those bonds. While the coupon rate
usually remains the same throughout the life of the debenture, the yield will change, with
changes in interest rates in the economy and in the creditworthiness of the firm. The simplest
version of yield is calculated using the formula yield=coupon amount/price. When you buy
a bond at par, yield is equal to the interest rate. When price changes so does the yield.

The Valuation Instruments quoted on a Discount Basis

Treasury bills are attractive to investors because they are backed by the federal government
and therefore are virtually free of credit risk. Another attractive feature of T-Bills is their
liquidity, which is due to their short term maturity and secondary market. Existing T-Bills
can be can be sold in the secondary market through government securities dealers, who profit
by purchasing the bills at a slightly lower price than the price at which they sell them.

Depository institutions commonly invest in T.Bills so that they can retain a portion of their
funds in assets that can easily be liquidated if they suddenly need to accommodate deposi
withdrawals. Other financial institutions also invest in T Bills in the event that they need
cash because cash outflows exceed cash inflows. Individuals with substantial savings invest
in T Bills for liquidity purposes. Many individuals indirectly invest in T Bills by investing in
money market funds which in turn purchase large amounts of T Bills. Corporations invest in
T Bills so that they have easy access to funding if they incur sudden unanticipated expenses.

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Pricing Treasury Bills

The price that an investor will pay for a T Bill with a particular maturity is dependent on the
investor’s required rate of return on the T Bill. That price is determined as the present value
of the future cash flows to be received. Since the T Bill does not generate interest payments,
the value of a T Bill is the present value of the par value. Thus, because T Bills do not pay
interest investors are willing to pay a price for a one year T Bill that ensures that the amount
they receive a year later will generate their desired return.

If investors require a 7% annualised return on a one year T Bill with a $10 000 par value, the
price that they are willing to pay is

P = $10 000/1.07

=?

If the investors require a higher return, they will discount the $10 000 at that higher rate of
return, which will result in a lower price that they are willing to pay today. You can verify
this by estimating the price based on a required return of a 8% and then on a required return
of 9%.

Treasury Bill Auction

The primary T Bill market is an auction. At the auctions, investors have the option of
bidding competitively or non competitively. The treasury has a specified amount of funds that
it plans to borrow, which dictates the amount of T Bill bids that it will accept for that
maturity. Investors who wish to ensure that their bids will be accepted can use non
competitive bids. After accounting for non competitive bids, the Treasury accepts the highest
competitive bids first and works it way down until it has generated the amount of funds from
competitive bids that it needs. Any bids below that cut off point are not accepted.The
treasury. The treasury applies the lowest accepted bid price to all competitive bids that are
accepted and to all non competitive bids. Thus, the price paid by competitive and non
competitive bidders reflects the lowest price of the competitive bids. Competitive bids are
still submitted because many bidders want to purchase more T Bills than the maximum that
can be purchased on a non competitive basis.
21
Calculating the Yield

As explained earlier, T Bills do not offer coupon payments but are sold at a discount from par
value. Their yield is influenced by the difference between the selling price and the purchase
price. If an investor purchases a newly issued T Bill and holds it until maturity, the return is
based on the difference the price for which the bill was sold in the secondary market and the
purchase price. If the T Bill is sold prior to maturity, the return is based on the difference
between the price for which the bill was sold in the secondary market and the purchase price.
The annualised yield from investing in a T Bill (YT)can be determined as

YT = (SP-PP)/PP * 365/n

Where SP = Selling Price

PP = Purchase price

n = number of days on the investment (holding period)

An investor purchases a T Bill with a (182 day) maturity and $10 000 par value for $9 600. If
this T Bill is held to maturity, calculate its yield.

If the T Bill is sold prior to maturity, the selling price and therefore the yield are dependent
on market conditions at the time of the sale. Suppose the investor plans to sell the T Bill after
120 days and forecasts a selling price of $9820 at that time. The expected annualised yield
based on this forecast is

YT = ($9820 – 9600)/9600 * 365/120 = ?

The higher the forecasted selling price, the higher the expected annualised yield.

Calculating the Treasury Bill Discount

22
The Treasury Bill discount represents the percent discount of the purchase price from par
value and is computed as follows;

T Bill discount = (Par – PP)/Par *360/n

Note that a 360 day year is used to compute the T Bill discount

Using the information from the previous example, calculate the T Bill discount.

For a newly issued T Bill that is held to maturity, the T Bill yield will always be higher than
the discount. The difference occurs because the purchase price is the denominator of the
yield equation, and the par value will always exceed the purchase price of a newly issued T
Bill .in addition the formula uses a 365 day year versus a 360 day year for the discount
computation.

Calculating the yield on Commercial Paper

Like T Bills, commercial paper is sold at a discount from par value. The nominal return
investors who retain the paper until maturity is the difference between the price paid for the
paper and the par value. Thus, the yield received by a commercial paper investor can be
determined in a manner similar to the T Bill yield although a 360 day year is usually used.

If an investor purchases a 30 day commercial paper with a par value of $ 1000000 for a price
of $990 000, the yield(Ycp) is

Ycp= (Par – PP)/PP *360/n

= ?

The Valuation of Coupon bonds and other interest bearing debt instruments

Unlike discount bonds, some debt instruments such as coupon bonds issued by both the
government and corporations provide regular interest payments in addition to paying their
face value at maturity. The face value of a coupon bond is similar to that of a discount bond
and a TB. It specifies the amount that will be paid when the bond matures. In addition
however, the face value of the bond indirectly determines how much the investor will receive
in interest payments each year up to and including the bond’s maturity date. In particular a

23
coupon bond specifies a coupon rate of interest. This coupon rate determines the % of the
face value that will be paid each year as interest. Consider a corporate bond with a face value
of $1000 and a coupon rate of 5%. If this bond matures in 20 years, the owner of the bond
will receive 20 coupon payments of 0,05x1000=$50 each. This annual payment of $50 is in
effect on interest payment to the owner of the bond. In addition to these coupon payments,
the bond pays the owner the face value of $1000 at the end of 20 yrs.

Valuing Coupon Bonds

The price of a coupon bond reflects the present value of all future payments the bondholder
receives. A coupon bond that pays its face (F) in T years also generates a coupon payment
(c) at the end of each year until maturity. If the market interest rate is i, the price of a coupon
(PCB) will be

PCB = c/(1+i)1+c/(1+i)2 +c/(1+i)3+....................+ (c+F)/(1+i)T

Notice that at the end of year T, when the bond matures, the owner receives a coupon
payment plus the face value of the bond. Suppose a coupon bond pays $100 each year for
two years, plus the face value of $1000 at the end of the second year. In this case, the owner
will receive $100 at the end of the first year and $1100 at the end of the second year ($100 in
interest, plus the payment of the face value). Given an 8% interest rate, calculate the price of
the coupon bond.

Clean and Dirty Bond Prices

In the bond markets, the price that is quoted is the clean price. This is the price disregarding
accrued interest. However, the price that is actually paid for the bond in the market is the
dirty price (also called the gross price or the full price), which is the clean price plus the net
accrued interest. In other words, the net accrued interest must be added to the quoted price to
get the total price. Accrued interest compensates the seller of the bond for giving up all of
the next coupon payment even though he will have held the bond for part of the period since
the last coupon payment. Between the coupon payment date and the next ex dividend date,
the bond is traded cum dividend, so that the buyer gets the next coupon payment. The seller
is compensated for not receiving the next coupon payment by receiving accrued interest
instead.

24
Yield Measures on Bonds

Bonds are traded on the basis of their prices, but because of the complicated patterns of cash
flows that different bonds can have, they are usually not compared in terms of prices, instead
they are generally compared in terms of yields. There are many different types of yield
measure as follows;

Current yield

The simplest measure of the yield of a bond is the current yield (running yield, income yield).
This is defined as

rc= d/P

where: rc=current yield

P=clean price

Given that the clean price of the bond is $95.30 and the coupon is $8.75, calculate the current
yield.

The current yield is used to estimate the cost of or profit from holding a bond. For example,
if other short term interest rates are higher than the current yield, the bond is said to involve a
running cost. The main problem with the current yield is that it does not take into account
capital gains or losses resulting from the differences between the current price of the bond
and its maturity value.

Simple yield to maturity

The simple yield to maturity (rms) attempts to rectify the shortcomings of the current yield
measure by taking into account capital gains or losses. The assumption made is that the
capital gain or loss occurs evenly over the remaining life of the bond. The resulting formula
is :

25
 rms = (d/P) + (100-P)/T.P

where, rms = simple yield to maturity to maturity;

P= clean price

T=number of years to maturity

For the bond just discussed, and assuming T = 9 years, calculate the simple yield
to maturity:

The main problem with the simple yield to maturity is that it does not take into account
compound interest. As the dividends paid they can be reinvested, and hence interest can be
earned. This increases the overall return from holding the bond.

Yield to Maturity

Other Securities quoted on a yield basis

The most important examples of money market securities that are quoted on a yield basis are
money market deposits and negotiable certificates of deposit. Such instruments are always
issued at par.

Money market deposits

Money market deposits are fixed interest fixed term deposits of up to one year with banks or
discount houses. The deposits can be for the following terms , 1 wk or 1,2,3,4,5,6,9 or 12
months. They are not negotiable so cannot be liquidated before maturity. The interest rates
on the deposits are fixed for the term. The interest and capital are paid in one lump sum on
the maturity day. Therefore the amount of interest due at the end of the period is calculated
according to the formula for simple interest.

R=M.d.(N/365)

Where

R = amount of interest

M= face or par value of deposit

26
d = int rate on deposit (as a proportion)

N= Number of days between deposit and maturity

The maturity value of the deposit (F) is therefore

F = M+R

Example 1

A money market deposit is opened on 15 January and matures on 15 February, calculate the
proceeds to the depositor.

M= $1000

d = 9,25% (1 month annualised)

N = 31 days

Negotiable Certificates of Deposit

NCDs are receipts from banks for deposits that have been made with them. The deposits
themselves carry a fixed interest rate related to LIBID and have a fixed term to maturity, so
cannot be withdrawn before maturity. But the certicates or receipts on these deposits can be
traded in a secondary market i.e they are negotiable.

The interest on a fixed rate CD is calculated as above , where d is called the coupon rate on
the CD. However d does not necessarily represent the yield on the CD, because the price of
the CD is not fixed since the CD is traded in a secondary market. If the current market price
of the CD including accrued interest is P and the current yield is r, we can calculate the yield
given the price using

r = {M/P . [1+d(Nim/365) ] – 1} . (365/Nsm)

or the price given the yield using

P= M. [1+d(Nim/365)] / [1+r (Nsm/365)]

=F/[1+r(Nsm/365)]

27
Where M= Face value of the CD

F = Maturity value of the CD

Nim= no of days between the issue and maturity

Nsm = no of days between settlement and maturity

Nis = no of days between issue and settlement

Example

$1m CD issued at par on 15 April with a coupon of 10% with 91 days to maturity (matures
on 15 July)

M=P=$1 000 000 d=10% (3 month annualised)

Nim=Nsm=91days

The initial yield is

r=?

Example

$1m CD issued at par with a coupon of 8% with 91 days to maturity, but currently priced at
$1 005 000 with 61 days remaining

M=$1 000 000 P=1 005 000 d=8% (3 mnth annualised) Nim= 91 days Nsm=61 days.

The current yield is

r=?

Example

$1m CD issued at par wit a coupon of 8% with 91days maturity, currently yielding 9% with
61 days remaining.

28
M= $1 000 000, r=9% Nim=91 days, Nsm = 61 days

The current price is

P=$1 000 000, r=9% , Nim=91 days , Nsm = 61 days

The current price is

P= ?

29
UNIT FIVE: DERIVATIVE MARKETS

A derivative is any financial contract whose value is derived from the value of another
underlying asset. The most commonly transacted derivatives are futures, options and swaps.
Derivatives can be used to manage financial risk by allowing one party to the transaction to
transfer the risk to the other party. Derivatives markets have existed for a long time, but the
markets for financial derivatives only developed in the 1970s with the development of the
Options Pricing Theory by the US academics Black, Scholes and Merton.

Forward Contracts

A forward contract is an agreement between two counterparties that fixes the terms of an
exchange that will take place between them at some future date. The contract specifies: what
is being exchanged (eg cash for a good, cash for a service, a good for a good etc), the price at
which the exchange takes place and the date or range of dates in the future at which the
exchange takes place. In other words, a forward contract locks in the price today of an
exchange that will take place at some future date. A forward contract is therefore a contract
for forward delivery rather than a contract for immediate or spot or cash delivery and
generally no money is exchanged between the counterparties until delivery.

Forward contracts have the advantage of being tailor made to meet the requirements of the
two counterparties in terms of both the size of the transaction and the date of forward
delivery. However, one disadvantage of a forward contract is that it cannot be cancelled
without the agreement of both counterparties. Similarly, the obligations of one counterparty
under the contract cannot generally be transferred to a third party. In short, the forward
contract is neither very liquid nor very marketable. Another disadvantage is that there is no
guarantee that one counterparty will not default and fail to deliver his obligations under the
contract.

30
Option Contracts

An option gives the holder the right but not the obligation to buy or sell an underlying
security at a fixed price, the exercise or strike price on or before a specific date (the maturity
date or expiry date). This right is given by the issuer or writer of the option. A call option
gives the right to buy the security, while a put option gives the right to sell the security. In
order to give effect to the right to buy or sell, the option has to be exercised only on the
expiry date, whereas an American option can be exercised at any time before the expiry date.
In return for the insurance offered by the option, a price (ie option premium) has to be paid.

Financial options include share options, currency options and interest rate options.

A person can buy an option and becomes the option holder. The terms ‘option buyer’ and
‘option holder’ effectively mean the same thing. The purchase price of an option is called the
option premium.

An option buyer purchases the option from a seller. The seller receives the premium for
selling the option. When a new option is created and sold, we may say that the option is
written. The terms ‘option seller’ and ‘option writer’ effectively mean the same thing

Exercise price and strike price

An option gives its holder the right either to buy or to sell the underlying item at a price that
is fixed by the option agreement. For example, a person might hold a call option on 2000
shares in ABC plc at a price of 500 cents per share. This would give the holder the right but
not the obligation to buy 2000 shares in the company at a price of 500 cents. The fixed
purchase price for a call option and the fixed selling price or strike rate for the option.

Every option has an expiry date, after which the rights of the option holder lapse.

American and European style options

A company share option might give its holder, an employee in the company the right to buy a
quantity of shares at any time between an earliest and a latest specified future date.

a) Exercising the right to buy/sell at strike price

b) Not exercising this right and allowing the option to lapse.

31
It is this element of choice for the option holder that is the big distinction between options
and futures or forward contracts.

The option seller or option writer does not have any choice. If the option holder exercises the
option, the option seller must comply with the terms of the option agreement. And either buy
the underlying item (call option) or sell the underlying item (put option) at the strike price.

When is an option exercised?

An option will only be exercised if it is in the option holder’s interest interest. In other
words, an option will only be exercised if the strike price for the option is more favourable to
the option holder than the current market price for the underlying item.

The Intrinsic Value of the Option Price

Intrinsic value – the intrinsic value of an option is the economic value of the option if it is
exercised immediately, except that if there is no positive economic value that will result from
exercising immediately then the intrinsic value is zero.

The intrinsic value of a call option, is the difference between the current price of the
underlying asset and the strike price if positive eg if the strike price of a call option is $100
and the current asset price is $105 the intrinsic value is $5 ie an option buyer exercising the
option and simultaneously selling the underlying asset would realise $105 from the sale of the
asset, which would be covered by acquiring the asset from the option writer for $100 thereby
netting a $5.

When an option has intrinsic value it is said to be ‘in the money’. When the strike price of a
call option exceeds the current asset price the call option is said to be out of the money; it has
no intrinsic value. An option for which the strike price is equal to the current price is said to
be at the money. Both at the money and out of the money options have an intrinsic value of
zero because it is not profitable to exercise the option. Our call option with a strike price of
$100 would be

1. In the money when the current asset price is greater than $100

2. Out of the money when the current asset is less than $100

3. At the money when the current asset price =$100

32
Examples

You hold the following European style options at expiry date.

a) A put option on 6000 shares in Lock PLC with an exercise price of 545
cents. The current market price of the shares is 510 cents.

b) A call option of 10 000 shares in ECONET with an exercise price of

378 cents. The current market price of the share is 330 cents.

c) A call option on 500 000 euros in exchange for the dollar at an

exchange rate of 1 euro = US $0,9000 when the current exchange is
$0,9500.

d) A put option on 250 000 in exchange for the dollar at a strike rate of 1
pound = US $1,4500 when the current exchange rate is $1,4100.

e) A call option on a notional currency, giving you the right to borrow a

quantity of funds for six months at a strike rate (LIBOR) of 5%, when
the current six months LIBOR is 5,6%.

The Gain or Loss on exercising an option

Options can be described as a ‘zero sum’ transaction, because the combined profits of the
option writer and the option buyer must always be zero. If the option buyer makes a gain, the
option writer must lose an equal amount. Similarly, if the option writer makes a gain, the
option buyer must make a loss of an equal amount.

There are two elements in the calculation of the gain or loss to the option holder and the
option writer. These are:

i. The option premium: this is the income for the option writer and a cost for the option
buyer.

33
 ii. The gain for the option buyer and the loss for the option writer when (and if) the
option is exercised.

Example:

An investor holds a call option on 2000 shares in RIOZIM at a strike price of 460 cents. The
option premium is 25 cents. Calculate the gain or loss for the option buyer and the option
writer if the share price at the expiry date for the option is:

a. 445 cents

b. 476 cents

c. 500 cents

Futures Contracts

A futures contract can be defined as a standardised contract covering the sale or purchase at a
set future date of a set quantity of a commodity, financial investment or cash. A financial
future is a futures contract which is based on a financial instrument, rather than a physical
commodity. There are financial futures for interest rates, currencies, stock market indices
and some individual company’s shares. A currency future is a futures contract to buy or sell
one currency in exchange for another.

Futures contracts are standardised agreements to exchange specific types of goods in specific
amounts and at specific future delivery or maturity dates. Eg there might be only four
contracts traded per year with four delivery months: March, June, September and December.
This means that the details of the contracts are not negotiable as with forward contracts. The
big advantage of having a standardised contract is that it an be exchanged between
counterparties very easily. Futures contracts eliminate the problems of illiquidity and credit
risk associated with forward contracts by introducing a clearing house, a system of marking
to market and margin payments and a system of price limits.

The clearing house guarantees fulfilment of all contracts by intervening in all transactions
and becoming the formal counterparty to every transaction. The only credit risk is therefore
34
with the clearing house. It is also possible to unwind a futures contract at any time by
performing a reversing trade, so futures contracts are generally extremely liquid.

Standard Quantities

For each futures contract, there is a standard quantity of the underlying item, such as a
notional portfolio of shares, 100 tonnes of wheat, 62 500 pounds in exchange for US dollars ,
US $100 000 of notional US treasury bonds, Euro currency futures are traded with a standard
contract size of 125 000 euros etc. Someone wishing to sell futures on US1 Million of
notional US Treasuries would need to sell 10 contracts.

The standardisation of contract sizes means that amounts required must be rounded to the
nearest whole number of contracts. For example a requirement to buy 950 000 euros must be
dealt with on the futures by buying 8 contracts (950 000 euros/125 000 euros per
contract=7.6 contracts, which is 8 contracts to the nearest whole number).

Closing Out a Position Before Delivery

Futures are traded for a specific settlement/ delivery date. However, instead of waiting until
settlement to conclude the transaction, someone holding a position in futures can close the
position at any time up to settlement date. On closing the position, there will be an overall
gain/loss on the futures transactions.

a) Someone who has bought futures contracts is said to be long in the futures or
to hold a long position. A long position can be closed by selling an equal
number of the contracts for the same settlement date. For example, someone
who has purchased 100 September sterling LIBOR futures can close the
position by selling 100 September sterling LIBOR futures at any time before
settlement date in September.

b) Someone who has sold futures contracts is said to be short in the futures or to
hold a short position. (it is possible to sell futures contracts without having
anything to sell because settlement does not take place until a later date). A
short position can be closed by purchasing an equal number of the contracts
for the same settlement date.

Example: Closing Out

35
 On International Monetary Exchange on 1 July the price of euro-US Dollar
futures with a September settlement date is 0.8600 (ie 1 euro= $0.8600). By
31 July the price of these futures has moved to $0.8800. Your company buys
8 euro futures contracts on 1 July and sells 8 euros futures contracts on 31
July. What gain/loss has been made.

Solution:

Closing out of futures contracts is used both by hedgers and speculators. In the above
example, a speculator with no particular interest in euros could have made a profit by buying
futures contracts on 1 July and selling them on 31 July. Likewise a company which actually
needed to buy one million euros on 31 July could have hedged by using the same technique.

Currency Futures

Suppose that a company decides to hedge a currency transaction exposure using

futures , the first questions to be asked are:

I. Should the futures contracts be bought or sold

II. How many contracts

III. Which settlement date

Most currency futures transactions are made on the Chicago Merchantile Exchange,
where all currency futures are for a currency against the US Dollar. Currency futures
on the CME are priced in terms of dollars and cents per one unit of the other currency.
The basic rules apply as follows.

a) If you need to buy a currency on a future date with US dollars, take the following
action.

Step 1. Buy the appropriate currency futures contracts now.

Step 2 Close out by selling the same number of futures contracts on the date
that you buy the actual currency.
36
Futures market NOW..................................................................................LATER

ACTION: Buy Futures Sell Futures

Foreign Currency NOW......................................................................................LATER

ACTION: Do nothing yet Buy the currency

b) If you need to sell a currency on a future date for US$, take the following steps.

Step 1. Sell the appropriate currency futures contracts now

Step 2. Close out by buying the same number of futures contracts on the date that
you sell the actual currency.

Example:

A US company will receive a dividend of 3 million Swiss Francs in 70 days’ time

and will convert this currency into US Dollars. What action should it take on the
futures market to hedge currency risk?

Solution:

Example:

On 1 July the spot exchange for the euro against the dollar (euro/$) is 0.8465.
Euro September futures are trading at a price of 0.8460.

Your company needs to buy one million euros with US dollars on 31 July.
You are happy with the July 1 exchange rate but are afraid that the euro might
strengthen over the next month. You decide to lock into today’s exchange rate
by buying 8 euro September at $0.8460. If the euro strengthens on the spot
market, you will be able to sell the futures contracts at a profit which will
offset the increase in the spot price of the euros.

Required:

37
 Illustrate the effect of using the futures hedge if by 31 July the , the spot
exchange rate has strengthened to euro/$0.8589 and the September futures
price moves to 0.8584.

Solution

SWAPS

A swap is a contract in which two parties agree to exchange payments on different terms, for
example one paying interest at a fixed rate and the other paying interest at a floating rate, or
one paying interest in one currency and the other paying interest in a second currency.

Interest Rate Swaps

An interest rate swap is an agreement between two parties to exchange a stream of interest
payments at agreed time intervals over an agreed period of time. Focus will be on a ‘generic’
interest rate swap. In this type of swap;

a) One party pays the other interest on a notional loan at a fixed interest rate, and

b) The other party pays interest on the same notional loan amount, but at a floating rate
of interest.

For example, one month might agree to pay interest on a notional loan of 10 million pounds
at a fixed rate of 7.5% per annum, and the other might agree to pay in exchange interest on a
notional loan of 10 million pounds at the 6 month LIBOR rate. The LIBOR rate will change
for each interest period.

Using Interest Rate Swaps

Interest rate swaps have several potential uses for a non bank company.

a) To manage the mix of fixed and floating rate interest in the company’s debt mix.
They can be used to switch fixed rate borrowing to effective floating rate borrowing
or from floating rate borrowing to effective fixed rate borrowing.

b) To obtain fixed rate borrowing commitments when the company cannot obtain debt
finance at a fixed rate. Many companies are too small to issue fixed rate bonds, and
38
 banks are generally unwilling to lend at fixed rates of interest for longer than one to
two years. If a company wants to take on fixed interest commitments, rather than
floating rate commitments, it can:

I. Borrow at a floating rate, and

II. Arrange a coupon swap to switch from floating rate to fixed rate borrowing.

Another borrower in contrast , may have a very high credit rating and be able to
borrow long term in the open market at a relatively low fixed interest rate. However,
the highly rated borrower (which is often a large bank) may desire a more flexible
short term loan if the interest rate can be made low enough. These two borrowers can
simply agree to swap interest payments , tapping the best features of each other’s
borrowings.

c) Possibly to borrow at a cheaper fixed rate than borrowing directly at a fixed rate.
Using swaps to reduce borrowing costs is known as credit arbitrage.

Features of a generic interest rate swap are as follows.

a) The notional loan principal is a constant amount for the full term of the swap.

b) The swap involves an exchange of a fixed interest rate for a floating rate of interest.
This type of swap is called a coupon swap.

c) The fixed rate of interest remains the same for the full term of the swap

d) The floating rate is an agreed benchmark rate of interest , such as the three month or
six month sterling LIBOR rate.

The two parties to a swap are often referred to as the ‘swap counterparties’. When the
interest payments dates for the counterparties coincide, there will just be a net payment of
interest. For example, suppose one party is paying fixed interest at 6% and the other is
paying interest at the LIBOR rate, on a notional principal of $5 000 000.

a) If the LIBOR rate for an interest period is 6.7%, there will be a net payment of
interest from the payer of the floating rate to the payer of the fixed rate. The payment

39
 will be for interest at 0.7% per annum for the period (6.7%-6%) on principal of $5
million.

b) If the LIBOR rate for an interest period is 4.8%, there will be a net payment of
interest from the payer of the fixed rate to the payer of the floating rate. The payment
will be for interest at 1.2% per annum for the period (6%-4.8%) on the principal of $5
million.

An interest rate swap is on a notional loan, not an actual loan. It is a contract on interest
rates, and the only payments exchanged are payments of interest. The principal amount of
the loans is not exchanged. Each party to the swap must still pay off its own debt.

Example;

A company arranges a two year swap with a bank. The bank agrees to pay a fixed rate of
5.9% per annum on notional principal of $5 million in exchange for receiving interest at
the six month LIBOR rate. Interest payments are exchanged every six month.

Suppose the LIBOR rates for each six month period are as follows:

a) Months 1-6,Year 1: 5.5%

b) Months 7-12, Year 1: 5.75%

c) Months 1-6, Year 2: 6,1%

d) Months 7-12, Year 2: 6.45%

Determine the exchange of payments every six months.

40
UNIT SIX: REGULATION OF FINANCIAL MARKETS

Banking regulation may be defined as the formulation and issuance whether under banking
law or administration measures of rules for the conduct of banking business.

Financial markets play a prominent role in many economies and governments around the
world have long deemed it necessary to regulate certain aspects of these markets.

The standard explanation for governmental regulation of a market is that the market left to
itself will not produce its particular goods and services in an efficient manner and at the
lowest possible cost. Efficiency and low cost production are hallmarks of a perfectly
competitive market.

The regulatory structure in the US is largely the result of financial crisis that have occurred at
various times. Most regulatory mechanisms are the products of the stock market crush of
1929 and the great depression of the 1930s. The same situation applies to the Zimbabwe
scenario where the Central Bank has stepped up the regulatory regime following the financial
crisis of 2004.

The Principles of Regulation

The regulatory framework for financial institutions has four main components:

Regulatory Objectives (the reasons why these institutions require regulation and what the
community expects regulation to achieve. Regulations are fundamentally rules of behaviour.
Financial regulations are rules that govern commercial behaviour in the financial system.
Commercial rules are needed to reconcile the conflicting interests of participants in the
commercial system. The financial sector however is often singled out as special and
subjected to a level and form of regulation that goes well beyond that of other sectors of the
commercial system the reason for this lies in the fundamental importance of finance to the
efficient working of the economy. Financial regulation attempts to establish a legal and
ethical framework within which commerce can flourish to the mutual benefit of all involved.
Viewed in this way, regulation is fundamentally about promotion of economic efficiency.

41
Regulatory Structure (the structure of agencies that carry the delegated regulatory
responsibilities of the community ). In principle there are two different models of regulatory
structure ie one based on institutions and the other based on regulatory functions. The former
involves the establishment of separate agencies to regulate different institutional groups,
while the latter involves the establishment of separate agencies to regulate different sources
of market failure (competition, market conduct, asymmetric information and systemic
instability). Under this structure, each regulator regulates a single function, regardless of the
institution involved, thus for example, the competition regulator is responsible for
competition issues for banks, insurance companies and securities dealers etc.

Regulatory Backing (the political, legal and financial backing to enable regulators to carry
out their duties effectively). Regulatory effectiveness refers to how well and how cost
effectively the regulator of a particular intermediary group or financial product meets its
objective of counteracting market failure. True regulatory effectiveness requires that the cost
of eliminating the market failure is not greater than the cost of the market failure itself.
Effectiveness ultimately coes down to two issues: the backing or support available to the
regulator (the effectiveness of the political,legal and financial backing in enabling a regulator
to carry out its duties ) and regulatory implementation (the effectiveness of the tools and
techniques employed by the regulator).

Regulatory implementation (the instruments , tools and techniques that regulatory agencies
use to achieve their objectives) and these include Preconditions for entry in the form of
licensing which is the most basic from of entry restriction, ownership restrictions which are a
form of entry requirement. Many countries for example restrict the issue of banking licences
to institutions that do not hold other financial service licenses. They also include the
imposition of minimum capital requirements. Capital adequacy requirements are intended to
absorb unexpected losses incurred by financial institutions.

Regulation of Commercial Banks

Commercial Banks are regulated in each country where they operate. The purpose of
regulating the commercial banks is to ensure that the financial sector is stable and is
operating in harmony with the economic objective of a state or a country. Banks are also
regulated to ensure that deposits are protected. In some countries deposits are protected by a
requirement that a bank insures all deposits. In the United States, the Federal Deposited
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Insurance Corporation (FDIC) ensures that banks in the United States insure all the deposits.
In Zimbabwe we have the Deposit Protection Board. This protects the deposits in case a
bank fails.

Banks are closely watched because of their power to create money in the form of readily
spendable deposits by making loans and investments. Banks and their closest competitors are
also regulated because they provide individuals and businesses with loans that support
consumption and investment spending. Regulatory authorities argue that the public has a
keen interest in an adequate supply of credit flowing from the financial system.

Forms of Regulation

Disclosure Regulation

-requires issuers of securities to make public a large amount of financial information to actual
and potential investors. The standard justification for disclosure rules is that the managers of
the issuing firms have more information about the financial health and future of the firm than
investors who own or are considering the purchase of the firm’s securities and this is referred
to as ‘asymetric information’. This means investors and managers have uneven possession of
information. Also the problem is said to be one of ‘agency’ in the sense that the firm’s
managers who act as agents for investors may act in their own interest to the disadvantage of
those investors.

Financial Activity Regulation

-consists of rules about traders of securities and trading on financial markets. A prime
example of this form of regulation is the set of rules against trading by insiders who are
corporate officers and others in positions to know more about a firm’s prospects than the
general investing public.

Regulation of Financial Institutions

-it is that form of government monitoring that restricts these institutions’ activities in the vital
areas of lending, borrowing and funding.

Regulation of Foreign Participants

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It is that form of government activity that limits the roles foreign firms can have on domestic
markets and their ownership or control of financial institutions.

Many countries regulate participation by foreign firms in domestic financial securities

markets. As have many countries, USA has been extensively reviewing and changing its
policies regarding its foreign firms activities in the US financial markets.

WHY REGULATION

Failure of one financial institution has ripple effects which adversely affect other participants
in the banking system which easily lead to the collapse of the entire banking sector and
consequently the national financial system.

The problems witnessed in the financial services markets, some of which manifested
themselves in corporate collapses and failures, have been attributed largely to weaknesses in
the legal and regulatory framework. These weaknesses resulted in inadequate monitoring and
supervision of financial institutions, ineffective enforcement of laws and regulations,
inadequate powers t prosecute financial firms for violations and so on.

Other problems emanated from failure of the regulatory system to tighten rules in respect of
financial institutions that; curb market manipulation by market players, improve disclosure of
material operational information to regulators and investors and improve management of
risks associated with fraud.

The lessons that were learnt from these experiences is that, if financial institutions are left
unregulated, they are prone to bouts of instability which can easily cause the entire financial
services and markets to collapse.

The failure and collapse of financial institutions, particularly banks have revealed , on one
hand , serious lapses in corporate governance practices and on the other , limitations inself
regulating instruments of companies operating in the financial sector .

Limitations of Regulation

The majority of central banks have some sort of regulations meant to regulate the banking
industry. However, there are some central banks whose regulations are not sufficient to bring
the stability of the financial sector. Those that have sufficient regulations have problems of

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enforcing those regulations, in other words there is the problem of supervision. Those that
fail to supervise their commercial banks site reasons of manpower and financial resources.
Both supervision and adequate regulations protect the customers of a bank.

Methods that can be employed by Central Banks in Supervising Commercial Banks

There are various methods available to central banks as follows:

Routine Check

Under routine check, the central bank’s staff goes to inspect commercial banks. The central
bank has a calendar that highlights when it will be visiting a particular commercial bank.
Commercial banks know exactly when the central bank officials will be visiting them and the
program is prearranged.

Supervision By Appointment

Supervision by appointment is similar to routine inspection. Their similarities arise because

the commercial banks are informed before the officials of a central bank arrive. The
difference between routine check and supervision by appointment is that an appointment can
be made any time.

Spot Unannounced Checks

This is the most effective method available to central banks. Here commercial banks are not
aware of the exact day or time when they can anticipate unannounced visits from the central
bank officials and as such may always try to conform to the regulations and practices which
are in force. They may find it difficult to engage in activities that are contrary to their license
requirement because unannounced checks can take place anytime.

Submission of Returns on Compliance

Under this method, central banks are supposed to regularly give feed back on how they are
handling certain issues in writing without the central bank staff physically visiting
commercial banks.

The BASEL Framework

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The globalisation of the banking industry led to a great increase in international interbank
lending and increased dramatically the possibility that the collapse of a bank in one country
could cause serious losses for banks in other countries. Regulators became strongly aware of
this danger with the collapse in 1974 of both the Franklin National Bank in New York and
the Herstatt Bank in Germany. At the same time there was increasing worry over tha
gravitation of banks to the least regulated national jurisdictions with resulting competition in
regulatory laxity between financial centres. One outcome of these concerns was the setting
up of a standing committee of bank supervisors under the auspices of the Bank for
International Settlements (BIS). The committee comprised representatives of the 11 Group
of ten countries and of Luxenbourg. (USA, UK, Japan, Germany, France, Italy, Canada,
Netherlands, Belgium, Sweden and Switzerland). This committee is known as the Basel
Committee. It sought to link together the different regulatory regimes in different in order to
ensure that all banks were supervised according certain broad principles.

The initial concern of the committee was to establish guidelines for the division of
responsibilities among the national supervisory authorities and this led to the signing of the
Basel Concordat in December 1975 by the central bank governors of the group of ten. This
distinguished between ‘host’ and ‘parent’ authorities and between branches and subsidiaries
of foreign banks. Under the concordat, the supervision of foreign banking establishments
was to be the joint responsibility of parent and host authorities.

The original agreement was revised in 1988 to come up with the Basel Minimum capital
adequacy guidelines for international banks. The Basel agreement initially distinguished
between two types of capital:

Tier 1 capital (core capital)- consists principally of shareholders’ equity, disclosed reserves
and the current year’s retained profits, which were readily available to cushion losses - these
must be verified by the bank's auditors.

Tier II capital (supplementary capital) comprises funds available but not fully owned or
controlled by the institution such as general provisions that the bank has set aside against
unidentified future losses and medium or long term subordinated debt issued by the bank.

A third type of capital Tier III was later defined and it consists of

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Subordinated debt of at least two years’ maturity and accumulated profit arising from the
trading book ie securities and investment activities

The basel committee proposed a lower limit of 8 per cent for the ratio of total capital to risk
adjusted assets.

Basel II came into effect at the end of 2006. The new capital framework consists of three
pillars:

1.Minimum capital requirements, developing and expanding on the standardised rules set
forth in the 1988 accord.

2.A supervisory review of an institution’s capital adequacy and internal assessment process
and

3.the effective use of market discipline to strengthen disclosure and encourage safe and sound
banking practices. The new capital accord has been designed to improve the extent to which
regulatory capital requirements reflect underlying risks and to address specifically the
financial innovation that has occurred in recent years.9

The Basel II capital accord framework is based on three integrated pillars:

1.Pillar 1:the capital adequacy minimum requirements

2.Pillar 2:the supervisory review of capital adequacy

3.Pillar 3:the market discipline, incorporating disclosure and transparency requirements

Pillar 1: Incorporates three risk components: credit risk, operational risk and market risk.

Credit risk relates to the underlying counterparty to a balance sheet asset or an off balance
sheet transaction. If an asset is secured by eligible collateral or certain forms of guarantee, it
is risk weighted according to the risk weight appropriate to the counterparty to that collateral
or guarantee.

Operational Risk Component

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In recent years banks have gained a greater understanding and awareness of operational risks
that may result in the loss of business functions. The Bank for International Settlements
categorises operational risk as :

-internal and external fraud

-employment practices and business practices

-clients, products and business practices

-damage to physical assets

-business disruption and business failures

-execution, delivery and process management

The categorisation of operational risk is very wide ranging and indicates that all aspects of an
organisation’s day yo day business activities are exposed to operational risk.

Market Risk Component

Defined as the risk of losses resulting from movements in market prices. Commercial banks
that operate in the foreign exchange, interest rate, equity or commodities markets may be
exposed to potentially large swings in market prices and significant consequential losses.
Potential losses may arise from general market price movements and, in the case of interest
rate and equity instruments, from price movements specific to particular issuers

Pillar 2- Supervisory Review of Capital Adequacy

The Basel Committee on Banking Supervision advises that the supervisory review process is
intended to :

1.Ensure that banks have sufficient capital to support all the risk exposures in their business

2.Encourage banks to develop and use improved risk management policies and practices in
identifying, measuring and managing risk exposures

Banks have a responsibility to ensure that they hold adequate capital to support tha overall
risks of the organisation beyond the core mini minimum requirements determined in pillar 1.
A bank’s supervisors are expected to evaluate how well the bank is actually assessing its

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capital needs relative to its level of risk. The supervisory review process establishes a forum
for dialogue between commercial banks and their supervisors. Supervisors are expected to
intervene when capital assessment by a bank is seen as inadequate for its risk profile. While
capital adequacy is a key foundation in the support of sound risk management, it should not
be seen as the sole determinant. Pillar 2 encourages additional good risk management
practice, such as:

-developing risk management policies and procedures, including education and training

-applying internal responsibilities, delegations and exposure limits

-increasing provisions and reserves

-strengthening internal control and reporting procedures

Therefore, the pillar 2 supervisory review process seeks to encourage banks to better
understand and account for

-risks that are not fully captured in pillar 1 such as credit concentration risk

-those factors that are not taken into account by pillar 1 for example interest rate risk in the
banking book, business risk and strategic risk

-factors external to the bank, such as the effects of a changing business cycle

An essential component of the pillar 2 supervisory review process is the assessment by the
supervisor, of compliance by the banks with the minimum standards and disclosure
requirements attached to the capital accord. Supervisors are responsible for ensuring that
these requirements are being met.

Pillar 3: Market Discipline

Market disclosure forms the third pillar in the Basel II capital accord. The purpose of pillar is
to encourage market discipline by developing a set of disclosure requirements that allow
market participants to assess important information relating to the capital adequacy of an
institution. The key word associated with pillar 3 is transparency, whereby the objective is to
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make banks’risk exposure, risk management and capital adequacy positions more transparent
or apparent such that market discipline can reinforce the regulatory process.

The Basel Committee on banking supervision recommends that a range of qualitative and
quantitative disclosure reports be prepared that relate to the principal parts of pillar 1 and
pillar 2. Within the context of the basel II capital accord, these will include reports on:

-the scope of the application of the capital accord within an organisation

-the capital structure of the institution

-the methodologies, approaches and assessment of capital adequacy by the institution

-the determination of all aspects of credit risk exposures

-the application of credit risk mitigation

-the determination of equity risk within the banking book

-the impact of securitisation of assets

-the determination of market risk exposures

-the measurement of operational risk

-the assessment of interest rate risk within the banking book.

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