mutual funds costs

Costs are the biggest problem with mutual funds. These costs eat into your return,
and they are the main reason why the majority of funds end up with sub-par
performance.
What's even more disturbing is the way the fund industry hides costs through a layer
of financial complexity and jargon. Some critics of the industry say that mutual fund
companies get away with the fees they charge only because the average investor
does not understand what he/she is paying for.
Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (loads).

International Funds

An international fund (or foreign fund) invests only outside your home country.
Global funds invest anywhere around the world, including your home country.
It's tough to classify these funds as either more risky or safer. On the one hand they
tend to be more volatile and have unique country and/or political risks. But, on the
flip side, they can, as part of a well-balanced portfolio, actually reduce risk by
increasing diversification. Although the world's economies are becoming more inter-
related, it is likely that another economy somewhere is outperforming the economy
of your home country.

Balanced Funds

The objective of these funds is to provide a "balanced" mixture of safety, income,
and capital appreciation. The strategy of balanced funds is to invest in a combination
of fixed-income and equities. A typical balanced fund might have a weighting of 60%
equity and 40% fixed-income. The weighting might also be restricted to a specified
maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund. Objectives are similar to
those of a balanced fund, but these kinds of funds typically do not have to hold a
specified percentage of any asset class. The portfolio manager is therefore given
freedom to switch the ratio of asset classes as the economy moves through the
business cycle.

bond funds

Income funds are named appropriately: their purpose is to provide current income
on a steady basis. When referring to mutual funds, the terms "fixed-income,"
"bond," and "income" are synonymous. These terms denote funds that invest
primarily in government and corporate debt. While fund holdings may appreciate in
value, the primary objective of these funds is to provide a steady cash flow to
investors. As such, the audience for these funds consists of conservative investors
and retirees.
Bond funds are likely to pay higher returns than certificates of deposit and money
market investments, but bond funds aren't without risk. Because there are many
different types of bonds, bond funds can vary dramatically depending on where they
invest. For example, a fund specializing in high-yield junk bonds is much more risky
than a fund that invests in government securities; also, nearly all bond funds are
subject to interest rate risk, which means that if rates go up the value of the fund
goes down.

Different Types of mutual funds

No matter what type of investor you are there is bound to be a mutual fund that fits
your style. According to the last count there are over 10,000 mutual funds in North
America! That means there are more mutual funds than stocks.
It's important to understand that each mutual fund has different risks and rewards.
In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk--it's never possible to diversify away all risk. This is a fact for all investments. (You can learn more about this in our financial concepts tutorial.)
Each fund has a predetermined investment objective that tailors the fund's assets,
regions of investments, and investment strategies. At the fundamental level, there
are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while
equity funds that invest in fast-growing companies are known as growth funds,
equity funds that invest only in companies of the same sector or region are known as
specialty funds.
Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky.

Unit Investment Trusts

Unit Investment Trusts are pools of money invested in a portfolio that is fixed for the life of the fund. To form a unit investment trust, a sponsor, typically a brokerage firm buys a portfolio of securities which are deposited into a trust. It then sells to the public shares, or "units," in the trust, called redeemable trust certificates. All income and payments of principal from the portfolio are paid out by the fund‘s trustees (a bank or trust company) to the shareholders. Most unit trusts hold fixed-income securities and expire at their maturity, which may be as short as a few months if the trust invests in short-term securities like money market instruments, or as long as many years if the trust holds long-term assets like fixed-income securities. The fixed life of fixed-income securities makes them a good fit for fixed-life unit investment trusts. In fact, about 90% of all unit investment trusts are invested in fixed-income portfolios, and a bout 90% of fixed-income unit investment trusts are invested in tax-exempt debt.
There is little active management of a unit investment trust because once established, the portfolio composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to invest in relatively uniform types of assets; for example, one trust may invest in municipal bonds, another in corporate bonds. The uniformity of the portfolio is consistent with the lack of active management. The trusts provide investors a vehicle to purchase a pool of one particular type of asset, which can be included in an overall portfolio as desired. The lack of active management of the portfolio implies that management fees can be lower than those of managed funds.
Sponsors of unit investment trusts earn their profit by selling shares in the trust at a premium to the cost of acquiring the underlying assets. For example, a trust that has purchased $5 million of assets may sell 5000 shares to the public at a price of 1030 per share, which (assuming the trust has no liabilities) represents a 3% premium over the net asset value of the securities held by the trust. the 3% premium is the trustee‘s fee for establishing the trust.
Investors who wish to liquidate their holdings of a unit investment trust may sell the shares back to the trustee for net asset value. The trustees can either sell enough securities from the asset portfolio to obtain the cash necessary to pay the investor, or they may instead sell the shares to a new investor (again at a slight premium to net asset value

Types of investment companies

In the United States, investment companies are classified by the investment company act of 1940 as either unit investment trusts or managed investment companies. The portfolios of unit investment trusts are essentially fixed and thus are called "unmanaged." in contrast, managed companies are so named because securities in their investment portfolios continually are bought and sold: the portfolios are managed. Managed companies are further classified as either closed-end or open-end companies are what we commonly call mutual funds.

investments companies

Investments companies are financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or those assets. Pooling assets is the key idea behind investment companies. Each investor has claim to the portfolio established by the investment company in proportion to the amount invested. These companies thus provide a mechanism for small investors to ' team up" to obtain the benefits of large-scale investing.
Investment companies perform several important functions for their investors:
1- Record keeping and administration. Investment companies issue periodic status reports, keeping track of capital gains distributions, dividend, investments, and redemption, and they may reinvest dividend and interest income for shareholders.
2- diversification and divisibility. By pooling their money, investment companies enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot.
3- professional management. Many, but not all, investment companies have full-time staffs of security analysts and portfolio managers who attempt to achieve superior investment results for their investors.
4- lower transactions costs. Because they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees and commissions.
While all investment companies pool assets of individual investors, they also need to divide claims to those assets among investors. Investors buy shares in investment companies, and ownerships proportional to the number of shares purchased. The value of each share is called the net asset value, or NAV. net asset value equals assets minus liabilities expressed on per-share basis

Disadvantages of preferred stock

The two major disadvantages of preferred stock are the seniority of the holder's claims and its cost.
Seniority of the holders´ claims.
Since holders of preferred stock are given preference over common stock holders with respect to the distribution of earnings and assets, the presence of preferred stock in a sense jeopardizes common shareholder's returns. Adding preferred stock to the firm's capital structure creates additional claims prior to those of common stockholders. If the firm's after-tax earnings are quite variable, its ability to pay at least token dividends to common stockholder may be seriously impaired.
Cost.
The cost of preferred stock financing is generally higher than the cost of debt financing. This is because the payment of dividends to preferred stockholders is not guaranteed, whereas interest on bond is. Since preferred shareholders are willing to accept the added risk of purchasing preferred stock rather than long-term debt, they must be compensated with a higher return. Another factor causing the cost of preferred stock to be significantly greater than that of long-term debt is the fact that interest on long-term debt is tax-deductible, while preferred dividends must be paid from earnings after taxes.

Instruments of the money market

The key instruments of the money market include treasury bills, tax-anticipation bills, treasury notes, federal agency issues, negotiable certificates of deposit, commercial paper, banker's acceptances, money market mutual funds, and repurchase agreements. These marketable securities will be described in next topic. It is important for you to a general understanding of the key characteristics of these instruments. One characteristic common to all is liquidity. The annual rate of return, or yield, on these securities reflects directly the "tightness' or "looseness" of money. Difference in return between various instruments result from the different degrees of risk associated with the issuers. Although the list of securities given above is not all-inclusive, it does contain the key money market instruments available to the corporate purchaser. The only instrument actually issued by a nonfinancial corporate business is commercial paper.

Disadvantages of leasing

The commonly cited disadvantages of leasing include high interest costs, the lack of salvage value, the difficulty of making property improvements, and obsolesce considerations. Though not relevant in every case, they may bear importantly on the
lease-purchase decision in certain instances.
High interest cost. A lease does not have an explicit interest cost; rather, the lessor builds a return for itself into the lease payment. In many leases the implicit return to the lessor is quite high, so that the firm might be better off borrowing to purchase the asset.
Lack of salvage value. At the end of the term of lease agreement, the salvage value of assets, if any, is realized by the lessor. If assets are expected to appreciate over the life of a lease agreement, it may be wiser to purchase them, although various other factors must be considered in making this decision. Appreciation in the value of assets is especially likely when land or buildings, or both, are involved. If the lease contains a purchase option this disadvantage may not exist.
Difficulty of property improvements Under a lease, the lessee is generally prohibited from making improvements on the leased property without the approval of the lessor. If the property were owned, this difficulty would not arise. Related to this disadvantage is the fact that it is often hard to obtain financing for improvements on leased property since it is difficult for the lender to obtain a security interest in the improvements. On the other hand, the lessor may agree in the initial lease contract finance or make certain leasehold improvements specified by the lessee.
Obsolescence considerations. If a lessee leases (under financial lease) an asset that subsequently becomes obsolete, it still as to make lease payments over the remaining life of the lease. This is true even if it is unable to use the leased asset. In many instances, a lessee will continue to use obsolete assets since it must pay for them. This type of situation can weaken a firm's competitive position by raising (or failing to lower) production costs and therefore forcing the sale price of its products to be increased in order to earn a profit.

Advantages of leasing

The basic advantages commonly cited for leasing are the ability it gives the lessor to, in effect, depreciate land, its effects on financial ratios, its effect on the firm's liquidity, the ability it gives the firm to obtain 100 percent financing, the limited claims of lessors in the event of bankruptcy or reorganization, the fact that the firm may avoid assuming the risk of obsolescence, the lack of many restrictive covenants, and the flexibility provided. Each of these often cited advantages is described and critically evaluated below.
-Effective depreciation of land. Leasing allows the lessee to, in effect; depreciate land, which is prohibited under a purchase of land. Since the lessee who leases land is permitted to deduct the total lease payment as an expense for tax purposes, the effect is the same as it would be if he or she purchased the land and then depreciated it. The greater the amount of land included in a lease agreement, the more advantageous this factor becomes from the point of view of the lessee. However, this advantage is somewhat tempered by the fact that land generally has a savage value for its purchaser, which it does not for a lessee.
- Effects on financial ratios. Leasing, since it results in the receipt o services from an asset possibly without increasing the assets or liabilities on the firm's balance sheet, may result in misleading financial ratios. With the passage of FASB No.13, this advantage no longer applies to financial lease, although in the case o operating leases it remains a potential advantage. Of course, even in the case of operating leases, the American Institute of Certified Public Accounts requires disclosure of the lease in a footnote to the Firm's statements. Today, most analysts are aware of the significance of leasing for the firm's financial position and will not view the firm's financial statements strictly as presented; instead, they will make certain adjustments to these statements that will more accurately reflect the effect of any existing operating leases on the firm's financial position.
- Increased liquidity .The use of sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which can be used as working capital. A firm short of working capital or in a liquidity squeeze can sell an owned asset to a lessor ad lease the asset back for a specified number of years. Of course, this action binds the firm to making fixed payments over period years. The benefits of the increase in current liquidity are therefore tempered somewhat by added fixed financial payments incurred through the lease.
-100 percent financing; another advantage of leasing is that it provide 100 percent financing. Most loan agreements for purchase of fixed assets require the borrower to pay a portion of the purchase price as adown payment. As a result, the borrower receives only 90 to 95 percent of the purchase price of the asset. In the case of a lease, the lessee is not required to make any type of down payment; he or she must make only a series of periodic payments. in essence, a lease permits a firm to receive the use of an asset for a smaller initial out-of-pocket cost than borrowing. However, since large initial lease payments are often required in advance, it is possible to view the initial advance payment as type of down payment.
-Limited claims in the event of bankruptcy or reorganization; when a firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is three years of lease payments. If debt is used to purchase an asset, the creditors have a claim equal to the total amount of unpaid financing. Of course, in such a case an owned asset may have a salvage value that can be used to defray the firm's obligations to its creditors.
-Avoidance of the risk of obsolescence; in a lease arrangement, the firm may avoid assuming the risk of obsolescence if he lessor in setting the lease payments fails accurately to anticipate the obsolescence of assets. This is especially true in the case of operating leases, which generally have relatively short lives. However, most lessors are perceptive enough to require sufficient compensation in both the term and the amount of lease payments to protect themselves against obsolescence.
-Lack of many restrictive covenants; a lessee avoids many restrictive covenants that are normally included as part of a long-term loan. Requirements with respect to minimum working capital, subsequent financing, changes in management, and so on are not normally found in a lease agreement; the only restrictive covenant occasionally included in the lease relates to subsequent lease commitments. The general lack of restrictive covenants allows the lease much greater flexibility in its operations. This many be viewed as an important advantage by the lessee.
-Flexibility provided; In the case of low-cost assets that are infrequently acquired, leasing-especially operating leases-may provide the firm with needed financing flexibility. This flexibility is attributable to the fact that the firm does not have to arrange other financing for these assets and can somewhat conveniently obtain them through a lease, thereby preserving its funds-raising power for the acquisition of more costly assets. The firm also retains its ability to raise funds in economically preferred quantities at the right time, again helping to lower its overall capital costs. Flexibility is also provided in the sense that with a short-term operating lease the firm can buy time to shop around for an owned asset that may be more advantageous from the standpoint of long-run owners´ wealth maximization.

Leasing as a source of financing

Leasing is considered a source of financing provided by the lessor to the lessee. The lessee receives the service of a certain fixed asset for a specified period of time, while in exchange for the use of this asset the lessee commits itself to a fixed periodic payment. The only other way the lessee could obtain the services of the given asset would be to purchase it outright, and the out right purchase of the asset would require financing. Again, fixed-most likely periodic-payments would be required. The lessee might have sufficient funds to purchase the asset outright without borrowing, but the funds used would not be free, since there is an opportunity cost associated with the use of cash. It is the fixed-payment obligation for a set period that forces us to view the financial lease as a source of long-term financing. Although at this point the rationale for leasing may seem no different than that for borrowing when a cash purchase cannot be made, certain other considerations with respect to the lease-purchase decision do exist.

The Lease Contract

The key items in the lease contract normally include the term of the lease, provisions for its cancellation, lease payment amounts and dates, renewal features, purchase clause, maintenance and associated cost provisions, and other provision specified in the lease negotiation process. As we indicated in the preceding discussion, many provisions are optional. A lease can be cancelable or non-cancelable, but if cancellation is permitted the penalties must be clearly specified. The lease may be renewable. If it is, the renewal procedures and costs should be specified. The lease agreement may provide for the purchase of the leased assets during the contract period or at the termination of the lease. The cost and conditions of the purchase must be clearly specified. In the case of operating leases, it is likely tat maintenance costs, taxes, and insurance will be paid by the lessor. In the case of a financial lease these costs will generally be borne by the lessee. The bearer of these costs must be specified in the lease agreement.
The leased assets, the terms of the agreement, the lease payment, and the payment interval must be clearly specified in all lease agreements. The consequences of missing a payment or violating any other lease provisions must also be clearly stated in the contract. The consequences of violation of the agreement by the lessor must also be specified. Once the lease contract has been drawn up and agreed to by lessee and lessor, the notarized signatures of these parties bind them to the terms of the contract.

Legal requirements of leases

In order to prevent business firms from using leasing arrangements as a disguise for what is actually an installment loan, the internal revenue service code, Section1031, "Exchange of property Held for productive Use or investment," specifies certain conditions under which lease payments are tax-deductible. If a lease arrangement does not meet these basic requirements, the lease payments are not completely tax-deductible. In order to conform to the IRS Code, a leasing arrangement must meet the following requirements:
1- The terms of a lease must be less than 30 years. A lease with life greater than 30 years is considered a sale by the IRS.
2- The premium paid to the lessor must be " reasonable"- that is- equal to the premium being paid on leases of similar assets. a premium between 10 and 15 percent would currently (November,1981) be considered reasonable.
3- The renewal option payment must also be "reasonable." If an outsider is willing to pay a higher amount to obtain the lease, the lease cannot be renewed with the original lessee at a lower rate. This is an application of the "fair market value" concept, which is also applied to purchase options.
4- No preferential purchase option is permitted. the lessee can be given an opportunity to purchase the asset only at a price equal to or above any other offers received by the lessor.

Advantages and Disadvantages of Common Stock

Common stock has a number of disadvantage and disadvantages. Some of the factors to be reckoned with in considering common stock financing are discussed below.
Advantages. The basic advantages of common stock stem from the fact that it is a source of financing that places a minimum of constraints on the firm. Since dividends do not have to be paid on common stock and their nonpayment does not jeopardize the receipt of payment by other security holders, common stock financing is quite attractive. The fact that common stock has no maturity, thereby eliminating future repayment obligation, also enhances the desirability of common stock financing. Another advantage of common stock over other forms of long-term financing is its ability to increase the firm's borrowing power. The more common stock the firm sells, the larger the firm's equity base and therefore the more easily and cheaply long-term debt financing can be obtained.
Disadvantages. The disadvantages of common stock financing include the potential dilution of voting power and earnings. Only when rights are offered and exercised by their recipients can this be avoided. Of course, the dilution of voting power and earning resulting from new issues of common stock may go unnoticed by the small shareholder. Another disadvantage of common stock financing is it high cost. Normally, the most expensive form of long-term financing. This is because dividends are not tax-de-ductile and because common stock is a riskier security than either debt or preferred stock.

Charters and regulations of mutual savings banks

Mutual can be chartered by either the sates or the federal government. Moreover, state and federal governments also share responsibility for insuring their deposits. About 70 percent of all savings banks have their deposits insured by the Federal Deposit Insurance Corporation (up to $100,000); the remainders are covered by state insurance programs. Today, only 17 states permit the chartering of mutual within their borders, but these institutions are not bound by geography in raising funds or making loans and investment. Their mortgage-lending activities reach nationwide and occasionally even abroad to support the building of commercial and residential projects. The largest mutual savings bank in the United States is the Philadelphia savings fund society of Pennsylvania, which at year-end 1979 reported total deposited of almost $5.9 billion. Close behind was Bowery Savings Bank of New York City, with $4.7 billion in total deposits. Of the10 largest mutual in the United States, all but 3 are headquartered in the state of New York.

Number and distribution of mutual savings banks

The number of mutual operating today is small- less than 500. Moreover, the savings bank population has been on the decline through most of this century. For example, in 1990 there were 626 mutual operating in the United States, and the total number rose to a peak of 637 in 1910. Thereafter, a progressive decline set in until the number of savings banks totaled only 463 at year-end 1979.
Nevertheless, industry assets and deposit have grown quite rapidly. In 1950 total assets of all mutual stood at $22 billion, but at year-end 1980, industry assets had reached almost $172 billion. Of course, with declining numbers and rapidly expanding assets, the average size of mutual savings banks has grown tremendously and now exceeds $300 million in total assets. Thus, the average mutual savings bank is far larger than most credit unions, savings and loan associations, or even commercial banks. This increase in average size has aided mutual in offerings a greater variety of services and in keeping their operating costs low.
Mutual savings banks are not evenly distributed across the United States but rather are located primarily in New England and the Middle Atlantic States. For example, Massachusetts leads the list with 163 mutual operating as of year-end 1979, followed by New York with 112. other states which have mutual headquartered within their borders include Alaska, Connecticut, Delaware, Indiana, Maine, Maryland, Minnesota, New Hampshire, New jersey, Oregon, Pennsylvania, Rhode Island, Vermont, Washington, and Wisconsin.

How municipal bonds are marketed?

The selling of municipals is usually carried out through a syndicate of banks and securities dealers. These institutions underwrite municipals by purchasing them from the issuing unit of government and reselling the securities in the open market, hopefully at a higher price. Prices paid by the underwriting firms may be determined either by competitive bidding among several syndicates or by negotiation with a single securities dealer or syndicate. Competitive bidding normally is employed in the marketing of general obligation (GO) bonds, while revenue bonds more frequently are placed through negotiation.
In competitive bidding, syndicates interested in a particular bond issue will estimate its potential reoffer price in the open market and their desired underwriting commission. Each syndicate wants to bid a price high enough to win the bid, but low enough so that the securities can later be sold in the open market at a price sufficient to protect the group's commission. That is,
Bid price+ underwriting commission= market reoffer price
The winning bid carries the lowest net interest cost (NIC) to the issuing unit of government. The NIC is simply the sum of all interest payments that will be owed on the new issues of municipal bonds is a treacherous business. Prices, interest rates, and market demand for municipals all change rapidly, often without warning. In fact, the tax-exempt securities market is one of the most volatile of all financial markets. This is due in part to the dominant role of commercial banks, whose demand for municipals fluctuates with their net earnings and loan demand. Legal interest-rate ceilings, which prohibit some local governments from borrowing when market rates climb above those ceilings, also play a significant role in the volatility of municipal trading. These combined factors render the tax-exempt market highly sensitive to the business cycle, monetary policy, inflation, and a host of other economic and financial factors. The spectre of high interest rates often forces the postponement of hundreds of millions of dollars of new issues, while the onset of lower rates may unleash a flood of new security offerings.
There is trend today away from competitive bidding and toward negotiated sales of new state and local bonds, due partly to the treacherous character of the tax-exempt market. For example, during 1978 an estimated 53 percent of bonds issued in the market for long-term municipals were negotiated, compared with only 15 percent a dozen years before. This trend has aroused some concern among financial analysis because competitive bidding should result in the lowest net interest cost, reducing the burden on local taxpayers. A recent study sponsored by the Municipal Finance Officers Association (MFOA) concluded that taxpayers have borne some added interest burden as a result of the recent emphasis upon negotiated, rather than combative, sale.
This problem is especially severe in certain states. For example, the AFOA-sponsored study found that in Pennsylvania, where competitive bidding is not required by law, about 95 percent of all bonds sold by local governments were handled through negotiation with a single underwriter group. It was estimated that Pennsylvania local governments paid approximately $14 million in excess interest costs on bond sales totaling about $360 million. On the other side of the coin, underwriting firms argue that they provide extra services to borrowing governments during the negotiation process-services not generally available through competitive bidding. These include preparing legal offering statements, scheduling the sale of new securities, helping to secure desirable credit ratings, and contacting potential buyers.

Operational Problems in Offering Credit Cards

Banks and other companies offering credit cards must solve several significant operational problems. First, the break-even point in card operations appears to be relatively high, placing pressure on credit card companies to sign up enough merchants to accept the cards and enough individuals to use them. The two problems are, of course, interrelated. Merchants are willing to accept a card only if they believe there will be sufficient customers using it to make the program worthwhile. Similarly, individuals are willing to make use of their cards only if a large number of merchants will accept them in payment for goods and services. One problem that has plagued credit-card operations for many years is losses due to customer fraud. Recent estimates by the Federal Reserve System find that fraud losses represent 15 to 20 percent of total card charge-offs for most plans.
During the late 1960s some U.S. banks tried to overcome the card-acceptance barrier by mass mailing of unsolicited cards, resulting in large-scale credit and fraud losses. Fearing that the safety and soundness of the banking system might be jeopardized and public confidence in banks shaken, Congress Passed the Consumer Credit Protection act, which prohibits unsolicited mailing of credit cards. Moreover, once the card-issuing company has been notified, the customer is no longer liable for any unauthorized use of his or her card. Prior to notification, the cardholder can only be held responsible for a maximum of $50 in unauthorized charges per card. Moreover, the customer cannot be held liable for unauthorized use of his or her credit card if the card was not requested or used, if it carries a means of identifying the authorized user (such as a signature or photograph), or if the customer was not notified of the $50 maximum liability. In addition, card issuers must provide the customer with a means of notifying them in case of card loss or theft.
Federal legislation has done much to enhance public acceptance of credit cards. Most cards are issued to customers today only after a careful analysis of their credit standing. That is why cardholders frequently are able to use their cards as a credit reference to aid in the cashing of checks or to obtain other forms of credit. Most merchants know that charge-card holders tend to have higher incomes and better payment record than the general population.
The most profitable credit-card accounts from the point of view of the issuing companies are those with high balances which are not paid off immediately (I.e., those held by installment users). However, less than half the sales volume experienced by most card programs winds up as carry-over balances subject to finance charges. Most card users are convenience users, who pay off their credit purchases within the normal billing cycle. Banks have found that they cannot make significant profits on their credit card operations when over half their cardholders are only convenience users. Moreover, cards users with the highest incomes and best repayment records typically economize on their cash balances and delay payment as long as possible, which further reduces the earnings from card operations. However, the performance of credit-card programs does improve with experience. Card companies become more skillful at identifying profitable groups of customers and at minimizing fraud and bad-debt losses. In addition, credit card programs bring in customers who may purchase other financial services from the same institution, such as installment loans and savings plans.

The determinants of consumer borrowing

Consumers represent one of the largest groups of borrowers in the financial system. Yet individual consumers differ widely in their use of credit and their attitudes toward borrowing money. What factors appear to influence the volume of borrowing carried out by households? Gross income is a common standard in this instance. For younger borrowers, without substantial assets to serve as collect for a loan, a cosigner may be sought whose assets and financial standing represent more adequate security. The duration of employment of the borrower is often a cortical factor, and many institutions will deny a loan request if the customer has been employed at his or her present job for less than a year.
The past payment record of a customer usually is the key indicator of character and the likelihood that the loan will be repaid in timely fashion. Many lenders refuse to make loans to those consumers who evidence "pyramiding of debt"-that is, borrowing from one financial institution to pay another. Evidence of sloppy money handling, such as unusually large balances carried on charge accounts or a heavy burden of installment payments, is regarded as a negative factor in the loan decision. Loan officers are particularly alert to evidence of a lack of credit integrity as reflected in frequent late payments or actual default on past loans. The character of the borrower is the single-most-important issue in the decision to grant or deny a consumer loan. Regardless of the strength of the borrower's financial position, if the customer lacks the willingness to repay his or her debt, then the lender has made a bad loan.
Most lenders feel that those who own valuable property such as land, buildings, or marketable securities are more reliable than those who do not own such property, especially if the property itself is pledged to secure the loan. For example, homeowners are usually considered to be better risks than those who rent. Moreover, borrowers´ chances of getting a loan usually are better if they do other business (such as maintain a deposit) with the lending institution. If more than one member of the family works, this is often viewed as a more-favorable factor than if the family depends upon one breadwinner who may become ill, die, or simply lose his or her job. Having a telephone at home is another positive factor in evaluating a loan application, since the telephone gives the lender an inexpensive way to contact the borrower. One way to lower the cost of a loan is for the consumer to pledge a bank deposit, marketable securities, or other liquid assets behind the loan. The disadvantage here is that such a pledge "ties up" the asset pledged as security until the loan is repaid.

Fair Housing and Home Mortgage Disclosure Acts

Two other important antidiscrimination laws are the Fair Housing Act, which forbids discrimination in lending for the purchase or renovation of residential property, and the Home Mortgage Discloser Act (HMDA). The latter requires financial institutions to disclose to the public the amount and location of their home mortgage and home improvement loans. HMDA was designed to eliminate "redlining," in which some lenders would mark out areas of a community as unsuitable for mortgage loans because of low income, high crime rates, or other negative factors. Not only was the low supposed to increase home mortgage loans to low- and moderate-income neighborhoods, but it was also intended to encourage the public to divert its funds away from those institutions practicing redlining. Unfortunately, this law reveals information about the supply of mortgage credit but not the demand. Also, nondeposit mortgage lenders are exempted from its provisions even though they are often significant factors in the local real estate market.
Both HMDA and the Fair Housing Act require nondiscriminatory advertising by lenders. No longer can a consumer lending institution direct its advertisements solely to high-income neighborhoods to the exclusion of other potential customers. When loans to purchase, construct, improve, repair, or maintain a dwelling are advertised, the lender must state that such loans will be made without regard to race, color, religion, sex, or national origin. On written advertising, an "equal housing" symbol must be attached. Clearly, then, in advertising the availability of credit, in accepting and evaluating loan applications, and in the actual granting of credit, the principles of civil rights and nondiscrimination apply. Lenders are free to choose who will receive credit, but that decision must be made within the framework of the nation's social goals.

Equal Credit Opportunity Act

The Equal Credit Opportunity Act of 1974 forbids discrimination against credit applicants on the basis of age, sex, marital statues, race, color, religion, national origin receipt of public assistance or good-faith exercise of rights under the federal consumer credit protection laws. Major beneficiaries of this law are women, who no longer can be denied credit solely on the basis of their sex, age, family plans, or the fact that they are not wage earners. Women may receive credit under their own signature, based on their own personal credit record and earnings, without having the husband's joint signature. Credit applications must be notified of the approval or denial of their loan request within 30 days of filling a completed application. The reasons for denial of a loan application must be set forth in writing, and the lender may not request information on the borrower's race, color, religion, national origin, or sex, except in the case of residential mortgage loans.

Community Reinvestment Act

one of the most important and controversial pieces of financial legislation in recent years is the Community Reinvestment Act, singed into law by President Jimmy Carter on October12,1977. Under its terms financial institutions are required to make an " affirmative effort" to meet the credit needs of low- and middle-income customers, including households, small businesses, farms, and ranches. Moreover, the regulatory authorities are required to consider the performance of lending institution in meeting these community credit needs when processing applications for merges, new branch offices, corporate charters, and holding company acquisitions by these same lending institutions.
Each commercial and savings banks must define its own local "trade territory" and describe the services that it offers or is planning to offer in that local area. Once a year each institution must prepare an updated map which delineates the trade territory served, without deliberately excluding low- or moderate-income neighborhoods. The lending institution's board of directors must adopt a CRA Statement, which specifies that lender's trade territory and lists the principal types of credit offered in that territory. A notice must be posted in the lobby, alerting customers to their rights and where the institution's CRA Statement may be found. Customers are entitled to make written comments concerning the lender's performance in meeting local credit needs. These comments must be retained on the premises for at least two years and be available for public inspection. The basic purpose of the Community Reinvestment Act is to avoid "gerrymandering" out low-income neighborhoods and other areas that the lender may consider undesirable.

Recent Trends in Original Maturities of Bonds

There is a trend today toward shorter original maturities for corporate bonds due to inflation, rapid changes in technology, and heavy borrowing demands from other sectors of the economy. During the 1950s and 60s corporations usually found a ready market for 20-to 30-year bonds. Such long-term debt contracts were extremely desirable from the borrowing company's standpoint because they locked in relatively low interest costs for many years and made financial planning much simpler. Today, with inflation and other factors frequently sending market interest rates soaring to records levels, bonds and notes with 3- to 15-year maturities are becoming commonplace.
Some financial analysts expect to see a substantial number of corporate bonds issued in the future whose interest rates are indexed to commodity prices (especially silver and gold) or to the price of energy. These commodity-indexed bonds are designed to provide the investor a hedge against inflation and, as result, carry substantially lower coupon rates than conventional bonds. Another recent innovation is the issuance of zero-coupon bonds which carry no fixed rate of return but offer the investor the prospect of significant capital gains. Those bonds still issued with fixed interest rates may carry "openers" which call for periodic adjustments in the principal amount of the loan as interest rates change. In brief, the trend in corporate bonds today is toward shorter maturities and more flexible rate of return for the investor.

Special drawing rights

Several nations peg their currency's exchange rate to a basket of currencies assembled by the international monetary fund, known as the special drawing right (SDR). The SDR is an official international monetary reserve unit designed to settle international claims arising from transactions between the IMF, governments of member nations, central banks, and various international agencies. SDRs are really "book entries" on the ledgers of the IMF and are sometimes referred to as "paper gold" periodically, that organization will issue new SDRs and credit them to the international reserve accounts of member nations. To spend its SDRs, a nation simply requests the IMF to transfer some amount of SDRs from its own reserve account to the reserve account of another nation, usually one whose currency is widely accepted in the international markets. In return, the country asking for the transfer gets deposit balances denominated in the currency of the nation receiving the SDRs. These deposit balances may then be used to make international payments.
The value of SDRs today is based upon a basket of currencies representing the five IMF member nations with the largest volume of exports during the 1975-79 periods. These five countries are the United Stated, The Federal Republic of Germany, France, Japan, and the United Kingdom. In determining the current value of SDRs the currency of each of these five nations is weighted according to the value of their exports and currency holdings. In 1981 the weights applied to these five currencies in the SDR basket were: U.S. dollars, 42 percent; German marks, 19 percent: French francs, 13 percent; Japanese yen, 13 percent; and British pound sterling, 13 percent. Countries that peg their currency's value to the value of SDR basket include Burma, Guinea, Kenya, Vietnam, Zaire, and Zambia.

State banking commissions

The regulatory powers of the federal banking agencies overlap with those of the state banking agencies, which rule upon charter applications in their respective states and regularly examine all state-chartered banks. The states also have rules prescribing the minimum amount of equity capital for individual banks and frequently place interest-rate ceilings on deposits and loans. Many states in recent years have imposed restrictions on the growth and formation of bank holding companies, requiring state approval before a holding company may be formed or, once formed, before it can acquire additional authorities, consider the new bank's prospects for earnings, the convenience and needs of the public in the area to be served, and the potential for damage to existing financial institutions if a new charter is granted.
One of the areas in which state banking law currently is supreme is that concerning branch banking. Since the McFadden Act of 1927, the federal government has allowed the states to determine whether commercial banks operating within their borders will be permitted to establish any branch offices and, if so, under what circumstances. Today, 15 states forbid full-services branch offices. These so-called unit-banking states are situated mainly in the Midwest and south and include taxes, Kansas, Nebraska, and Colorado. However, as we saw earlier, there is a definite trend toward greater use of branching and holding company activity in most pats of the United States. Recent examples include Florida, which until 1978 was a unit-banking state and now permits limited branching on a countywide basis. The state of New York converted to statewide branching in 1976 following an experiment with limited branching in designated regions. Most experts predict that in future years branch banking in one form or another will spread across the United States as needs for larger banking organizations and new financial services increase.

Federal deposit insurance corporations

Federal Deposit Insurance Corporations insures deposits of U.S. commercial banks which meet its regulations; the coverage provides up to $100,000 per depositor. Roughly 98 percent of all U.S. banks are insured, and approximately 62 percent of all commercial bank deposits are covered by the FDIC's insurance program. Each participating bank is assessed annually an amount equal to about 1\10 of 1 percent of its eligible deposits to build and maintain a national insurance fund.
One of the most important functions of the FDIC is to act as a check on the state banking commissions, because few banks today-even those with state charters-will open their doors without FDIC insurance. The FDIC reviews the adequacy of capital, earnings prospects, the character of management, and the public convenience and needs aspects of each application before granting deposit insurance. This agency is also charged with examining insured banks that are not members of the Federal Reserve System, and it must approve applications for branches, changes in location, or mergers involving federally insured banks. The FDIC is empowered to close a bank will be merged with or absorbed by a healthy one; FDIC often purchases some of the bankrupt institution's weaker assets to support such a merger.

The roles played by life insurance companies in the mortgage market

Life insurance companies make substantial investments in commercial as well as residential mortgage properties. Commercial mortgages make up more than 60 percent of mortgage obligations held by life insurance companies, with residential units accounting for between a third and a quarter of their mortgage total. These companies will search national and international markets for good mortgage investments instead of focusing upon only one or a few local areas.
In the past, life companies strongly preferred government-guaranteed mortgages. In recent years, however, the higher yields available on conventional mortgages have caused some shift of emphasis toward these more risky loans. Despite the greater flexibility of conventional home mortgages, life insurance companies have been gradually reducing their holdings of home mortgages and emphasizing commercial and apartment mortgages. Commercial and apartment loans often carry "equity kickers," which permit the lender to receive a portion of project earnings as well as a guaranteed interest rate.
At the end of 1980 life insurance companies held about 9 percent of total mortgages loans outstanding in the United States. This market share placed them third among private mortgage lenders, behind savings and loan associations and commercial banks. This high ranking is due in part to the fact that life insurers are the largest institutional holder of farm mortgages; stand second only to commercial banks in mortgage loans for commercial properties, and rank second to savings and loans in apartment loans. However, in making loans to finance one-to-four-family residential dwellings, life companies rank a distant fourth among all private lenders. For example, at year-end 1980 they held only $18 billion in one-to-four-family residential loans, compared to $65 billion for mutual savings banks, more than $160 billion reported by commercial banks, and nearly $420 billion held savings and loan associations.

Residential versus nonresidential mortgage loans

The mortgage market can be dividend into two major segments: (1) residential, which encompasses all loans secured by single-family homes and other dwelling units; (2) nonresidential, which includes loans against business and farm properties. Which of these two sectors is the most important? Loans to finance the building and purchase of homes, apartments, and other residential units dominate the American mortgage market. In 1980 residential mortgage loans on one-to-four-family properties and multifamily structures represented three fourths of all mortgage loans outstanding. Mortgages on commercial and farm properties accounted for the remaining one fourth of all mortgages issued.
In recent years the residential portion of the market has grown faster than nonresidential mortgages. The most-dramatic growth occurred in loans on one-to-four family properties, which rose from 61 percent of total mortgage debt outstanding in 1975 to 66 percent in 1980.this category of mortgages is dominated by singe-family home loans, which increased significantly due to the rapid growth of new family formations and the effects of inflation.
The 1970a also ushered in a speculative investment boom in the building of condominiums, duplexes, triplexes, and smaller residential structures by wealthy investors. Much of this speculative construction activity has been aimed at the rental housing market, designed especially to appeal to college students and low-to middle-income families. Unlike owner-occupied residences, rental properties can be depreciated so that both mortgage-loan costs and annual depreciation expenses are legitimate income tax deductions for investors in such properties. While one-to-four-family residential mortgages were capturing a larger share of the total market, both multifamily (apartment) and commercial mortgage loans were declining in relative importance.
Because residential mortgages dominate the market, it should not be surprising that households are the leading mortgage borrower. The next-largest group of borrowers-nonfinancial corporations- is a distant second. Moreover, the share of the market represented by household has risen in recent years due to an upward surge in the demand for housing, while other mortgage borrowers have declined in relative importance.

Reserve requirements and excess reserve

Money creation by banks is made possible because the public readily accepts claim on bank deposits (mainly checks) in payment for goods and services. In addition, the law requires individual banks to hold only a fraction of the amount of deposits received from the public in cash or near-cash reserve, thus freeing up a majority of incoming funds for the making of loans and the purchasing of securities. We need to look more closely at these so-called reserve requirements bank must meet, since they play a key role in the money-creation process.
Under current federal law, banks and other depository institutions must hold reserves in cash or in deposit form behind their transaction accounts and time and savings deposits. These reserve requirements are linked to the size of the depository institution and require that a specified percentage of all incoming deposits must be placed either in an account at the Federal Reserve Bank in the region or as cash in the bank's vault. Vault cash and deposits at the Fed constitute a bank's holdings of legal reserves- those assets acceptable for meeting reserve requirements behind the public's deposits. In 1980, following passage of the depository institutions deregulation and Monetary Control Act, all deposit-type financial institutions (including commercial banks, mutual savings banks, savings and loan associations, and credit unions) were required to hold legal reserves equal to 3 percent of that portion of their transaction accounts (principally checking and NOW accounts) below $25 million and 12 percent for that portion over $25 million.
Each bank's legal reserve may be divided into two categories- required reserves and excess reserves. Required reserves are equal to the legal reserve requirement ratio times the volume of deposits subject to reserve requirements. For example, if a bank holds $20 million in checking and other transaction accounts and $30 million in savings deposits and the law requires it to hold 3 percent of its transaction accounts and 3 percent of its savings deposits in legal reserve , then required reserves for this bank are $20 million ×3%+$30 million×3 %,or $1.5 million.
Excess reserve equal the difference between the total legal reserves actually held by a bank and the amount of its required reserves. For example, if a bank is required to hold legal reserves equal to $1.5 million but finds on a given date that it has $500,000 in cash on the premises and $1.5 million on deposit with the Federal Reserve Bank in its region, this bank clearly holds $500,000 in excess reserves. Since legal reserve assets earn little or no interest income, most commercial banks try to keep their holdings of excess reserve as close to zero as possible. Indeed, the larger banks frequently run deficits in their required reserve position and must borrow additional legal reserves from other banks or attract more funds from their customers to cover the deficit.

Pension fund assets

The particular assets held as investment by pension funds depend heavily upon whether the fund is government controlled or private. Private funds emphasize investments in corporate stock, which represented about three fifths of their assets at year-end 1979. Corporate bonds ranked a distant second, accounting for almost one fourth of all financial investments. With few liquidity needs, private pensions held relatively small amounts of cash, time deposits, or government securities.
Corporate stock is far less important in the portfolios of government pension funds. State and local government pension programs held almost $44 billion in corporate stock at year-end 1979, which represented about one quarter of their financial assets. However, stock investments were far outweighed by corporate bonds, which amounted to $86 billion-close to half the assets of public pensions.
Under the pressure of strict regulations and more-frequent benefit claims, public plans hold a larger proportion of cash and liquid government securities than do private plans. For example, investments in U.S. Treasury and federal agency securities, demand deposits, and currency represented a full 20 percent of total financial investments at year-end 1979. Government pensions also place moderate amounts of funds in state and local government securities-often IOUs issued by their own governmental unit.

The money market versus the capital market

The pool of funds represented by the financial markets may be divided into different segments, depending upon the characteristics of financial claims being traded and the needs of different groups. One of the most important divisions in the financial system is between the money market and the capital market.
The money market is designed for the making short-term loans where individuals and institutions with temporary surpluses of funds meet borrowers who have temporary cash shortages. By convention, a security evidencing a loan which matures within one year or less is considered to be a money market instrument. One of the principal functions of the money market is to finance the working-capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.
In contrast, the capital market is designed to finance long-term investments. Trading of funds in the capital market makes possible the construction of factories, office buildings, highways, bridges, schools, homes, and apartments. Financial instruments traded in the capital market have original maturities of more than one year.
Who are principal suppliers and demanders funds in the money market and the capital market? In the money market commercial banks are the most important institutional lender to both business firms and governments.
Nonfinancial business corporations with temporary cash surpluses also provide substantial short-term funds to commercial banks, securities dealers, and other corporations in the money market. Finance companies supply large amounts of working capital to major corporate borrowers, as do money market mutual funds which specialize in short-term, high-grade government and corporate securities.
On the demand-for-funds side the largest borrower in the American money market is the U.S Treasury, which borrowers several billion dollars weekly. The largest and best-known U.S. corporations are also active borrowers in the money market through their offerings of short-term notes. Major securities dealers require huge amounts of borrowed funds daily to carry billions of dollars in securities held in their trading portfolio to meet customer demand. Finally, the Federal Reserve System, which is charged by Congress with responsibility for regulating the flow of money and credit in U.S. financial system, operates on both sides of the money market. Through its open market operations the Fed both buys and sells securities to maintain credit conditions at levels deemed satisfactory to meet the nation's economic goals. Due to the large size and strong financial standing of these well-known money market borrowers and lenders, money market credit instrument are considered to be highly-quality, "near money" IOUs.
The principal suppliers and demanders of funds in the capital market are more varied than in the money market. An institution must be large and well known with an excellent credit rating to gain access to the money market. The capital market for long-term funds, in contrast, encompasses both well-established and lesser-known individuals and institutions. Families and individuals, for example, tap the capital market when they borrow to finance a new home or new automobile. State and local governments rely upon the capital market for funds to build schools, highways, and public buildings and to provide essential services to the public. The U.S. Treasury draws upon the capital market in issuing new notes and bonds to pay for federal government programs. The most important borrowers in the nation's capital market are businesses of all sizes, which issue bonds, notes, and other long-term IOUs to cover the purchase of equipment and the construction of new plants and other facilities.
Ranged against these many borrowers in the capital market are financial institutions which supply the bulk of long-term funds. Prominent here are life and property-casualty insurance companies, pension funds, savings and loan associations, mutual savings banks, finance companies, and commercial banks. Each of these institutions tends to specialize in a few different kinds of loans consistent with it own cash-flow needs and regulatory restrictions.
For example, life insurance companies are major buyers of corporate bonds and commercial mortgages. Property-casualty insurers stay heavily invested in state and local government (municipal) bonds, corporate stock, and corporate bonds. Pension funds are major buyers of both corporate equities and bonds, while savings and loan associations are principally home mortgage lenders. Mutual savings banks emphasize investments in mortgages and corporate bonds. Finance companies and commercial banks provide large amounts of capital funds to both individuals and businesses through direct loans and financing. Commercial banks are probably the most diversified of all lenders in the capital market since they provide long-term funds to all major groups in the economy.

Open versus negotiated markets

Another distinction within the financial system which is sometimes useful is that between open markets and negotiated markets. For example, some corporate bonds are sold in the open market to the highest bidder and bought and sold any number of times before they mature. In contrast, in the negotiated market for corporate bonds, securities generally are sold to one or a few buyers under private contract and held maturity.
An individual who goes to his or her local banker to secure a loan for a new car enters the negotiated market for auto loan. However, a broker instructed to buy a few shares of GM stock will attempt to fill the order by contacting a seller in the open market. Most state and local government securities are sold in the open market. But a growing number are sold under a privately negotiated "treaty" with one or a few buyers. In the market for corporate stocks there are over-the-counter (OTC) sales and the major stock exchanges, which represent the open market. Operating at the same time, however, is the negotiated market for stock, in which a corporation may sell its entire equity issue to a large insurance company or pension funds.

Preferred stock

The other major form of stock issued today is preferred stock. Each share of preferred carries a stated annual dividend expressed as a percent of the stock's par value. For example, if preferred shares carry a $100 par value with an 8 percent dividend rate, then each preferred shareholder is entitled to dividends of $8 per year on each share owned, provided the company declares a dividend. Common stockholders would receive whatever dividends remain after the preferred shareholders receive their stated annual dividend.
Preferred stock occupies the middle group between debt and equity securities, including advantages and disadvantages of both forms of raising long-term funds. Preferred stockholders have a prior claim over the firm's assets and earnings relative to the claim of common stockholders. However, bondholders and other creditors of the firm must be paid before either preferred or common stockholders receive anything. Unlike creditors of the firm, preferred stockholders cannot press for bankruptcy proceedings against a company which fails to pay them dividends. Nevertheless, preferred stock is part of a firm's equity capital and strengthens a firm's net worth account allowing is to issue more debt in the future. It also is a more flexible financing arrangement than debt since dividends may be passed if earnings are inadequate or uncertain and there is no fixed maturity date.
Generally, preferred stockholders have no voice or vote in the selection of management unless the corporation "passes" dividends (i.e., fails to pay dividends at the agreed-upon time). A frequent provision in corporate charters gives preferred stockholders the right to elect some members of the board of directors if dividends are passed for a full year. Dividends on proffered stock, like those paid on common stock are not a tax-deductible expense. This makes preferred shares nearly twice as expensive to issue as debt for companies in the top-earning bracket. However, IRS regulations specify that 85 percent of the dividends on preferred stock received by a corporate investor are not taxable. This tax-exemption feature makes preferred stock especially attractive to companies seeking to acquire ownership shares in other firms and sometimes allows preferred stock to be issued at a lower net interest cost than debt securities. In fact, corporations themselves are the principal buyers of preferred stock issues.
Most preferred stock is cumulative, which means that the passing of dividends results in an arrearage which must be paid in full before the common stockholders receive anything. A few preferred shares are participating, allowing the holder to share in the residual earnings normally accruing entirely to the common stockholders. To illustrate how the participating feature might work, assume that an investor holds 8-percents participating preferred stock with a $100 par value. After the issuing company's board of director's votes to pay preferred shareholders their stated annual dividend of $8 per share, the board also declares a $20-a-share common stock dividend. If the formula for dividend participation calls for common and preferred shareholders to share equally in any net earnings, then each preferred shares will earn an additional $12 to bring its total dividend to $20 per share as well. Not all participating formulas are this generous, however, and most preferred issues are nonparticipating since the participation feature is detrimental to the interests of the common stockholders.
Most corporations plan to retire their preferred stock, even though it carries no stated maturity. In fact, the bulk of preferred shares issued today have call provisions. When interest rates decline, the issuing company may exercise the call privilege at the price (which usually includes a premium over par) stated in the formal agreement between the firm and its shareholders. A few preferred issues are convertible into shares of common stock at the investor's option. The company retires all converted proffered shares and may force conversion by simply exercising the stock's call privilege. New preferred issues today are often accompanied by a sinking fund provision whereby funds are gradually accumulated and set aside for eventual retirement of preferred shares. A trustee is appointed (usually a bank trust department) who collects sinking fund payments from the company and periodically calls in preferred shares or occasionally purchases them in the open market. While sinking fund provisions allow the issuing firm to sell preferred stock with lower dividend rates, payments into the fund drain earnings and reduce dividend payments flowing to common stockholders.
From the standpoint of the investor, preferred stock represents an intermediate investment between bonds and common stock. Preferred shares often provide more income than bonds but also carry greater risk. Preferred shares prices fluctuate more widely than bond prices for the same change in interest rates. Compared to common stock, preferred shares generally provide less total income (considering both capital gains and dividend income) but are, in turn, less risky. They appeal to the investor who is looking for a favorable, but moderate rate of return.
Among major corporations preferred stock experienced a resurgence of interest during the 1970s due to high debt financing cost, the greater flexibility of preferred stock financing over bonds, and pressure on many firms (especially public utilities) to rebuild their equity positions. The numbers of issues of preferred stock listed on the New York stock exchange reached a low of 373 in 1965 and then rose to record highs during the 1970s. Many of these new preferred stock issues proved to be extremely popular with investors because of their high dividend yields, which, in several recent periods, have averaged about twice as large as the dividends yield on listed common stock.

Common stock

The most important from of corporate stock is common stock. Like all forms of equity, common stock represents a residual claim against the assets of the issuing firm, entitling the owner to a share in the net earnings of the firm when it is profitable and to a share in the net market value (after all debts are paid) of the company's assets if it is liquidated. By owning common stock the investor is subject to the full risks of ownership, which means that the business may fail or its earnings may fall risks of ownership, which means that the business may fail or its earning may fall to unacceptable levels, however, the risks of equity ownership are limited since the stockholder is liable only for the amount of his or her investment of funds.
If a corporation with out standing shares of common stock is liquidated, the debts of the firm must be paid first from any assets available. The preferred stockholders then receive their contractual share of any remaining funds. The residual, whatever is left, accrues to common stockholders on a pro rate basis. Unlike many debt securities, common stock is generally a registered instrument with the holder's name recorded on the issuing company's books.
The volume of stock that a corporation may issue is limited by the terms of its charter of incorporation. Additional shares beyond those authorized by the company's charter may be issued only by amending the charter with the approval of the current stockholders. Some companies have issued large numbers of corporate shares, reflecting not only their need for large amounts of equity capital, but also a desire to broaden their ownership base across millions of shareholders. For example, American Telephone and Telegraph (AT&T) have more than 700 million shares of common stock listed on the New York stock exchange. International business machines (IBM) lists more than 580 million shares.
The par value of common sock is an arbitrarily assigned value printed on each stock certificate. Par is usually set low relative to the stock's current market value. In fact, today some stock is issued without any par value. Originally, par value supposed to represent the owners´ original investment per share in the firm. The only real significant of par today is that the firm cannot pay any dividends to stockholders which would reduce the company ´s net worth per share below the par value of its stock . In addition, in the event of liquidation or bankruptcy, the common stockholders may be liable under some circumstances to creditors of the firm for the difference between par value and the subscription price of the stock.
Common stockholders are granted a number of rights when they buy a share of equity in a business corporation stock. Stock ownership permits them to elect the company's board of directors which, in turn, chooses the firm's officers responsible for day-to-day management of the company. Most companies grant a preemptive right when stock is purchased (unless specifically denied by the firm's charter ) which gives the individual shareholder the right to purchase any new voting stock, convertible bonds, or preferred stock issued by the firm in order to maintain his pro rate share of ownership. For example, if a stockholder holds 5 percent of all shares outstanding and 500 new shares are issued, this stockholder has the right to subscribe to 25 new shares.
While most common stock grants each shareholder one vote per share, nonvoting common is also issued occasionally. Some companies issue class a common which as voting rights and class B common which has a prior claim on earnings but no voting power. Te major stock exchanges do not encourage publicly held firms to issue classified common stock, but classified shares are used extensively by privately held firms.
A right granted to all common stockholders is the right of access to the minutes of stockholder meetings and to lists of existing shareholders. This gives the stockholders some power to reorganize the company if existing management or the board of directors is performing poorly. Common stockholders may vote on all matters which affect the firm's property as a whole, such as a merger, liquidation, or the issuance of additional equity shares. This vote may be cast in person or by revocable proxy (which is a temporary assignment of voting power and an instruction on how to vote) granted to a trustee.

The channels through which central banks work

Later on, we will examine in some detail how the Federal Reserve System affects domestic and international economic conditions. It is useful at this point, however, to give a brief overview of the channels through which modern central banks influence conditions in the economy and financial system. Central bank policy affects the economy as a whole by making:
1-Changes in the cost and availability of credit to businesses, consumers, and governments.
2-Changes in the volume and rate of growth of the nation's money supply.
3-Changes in the wealth of investors as reflected in the market value of their security holdings.
The central bank has a number of policy tools at its command which it can use to influence interest rates, the prices of securities, and the level and growth of reserve in the banking system. In the United States the principal policy tools used by the central bank are open market operations, changes in required reserves held by depository institutions, and changes in the discount rate on central bank loans. In turn, changes in interest rates, security prices, and bank reserves influence the cost and availability of credit. If borrowers find that credit is less available and more expensive to obtain, they are likely to restrain their borrowing and reduce spending for both capital and consumer goods. This results in a slowing in the economy's rate of growth and perhaps a reduction in inflationary pressures. Second, if the central bank can reduce the rate of growth of the nation's money supply, this policy will eventually slow the growth of income and production in the economy due to a reduction in the demand for goads and services. Finally, if the central bank raises interest rates and therefore lowers security prices, this will tend to reduce the market value of the public's holdings of stocks, bonds, and other securities. The result is a decline in the value of investors´ wealth, altering borrowings and spending plans and ultimately influencing employment, prices, and the economy's rate of growth.

The goals and channels of central banking

Central banking is goal oriented. Since World War II the United States and several other industrialized nations have accepted the premise that government is responsible to its citizens for maintaining high levels of employment, combating inflation, and supporting sustained economic growth. This is a relatively new idea since, in earlier periods, governments were assigned a much smaller role in the economic system and much less was expected of them by their citizens. It was felt that "automatic" mechanisms operated within t economy to provide stability and high employment in the long run. One of the bitter lessons of the Great Depression of the 1930s was that these mechanisms can break down and that innovative and skillfully managed government policies may be needed to restore the economy's stability and growth.
Central banking in the United States and in most other nations is directed toward four major goals:
1- Full employment of resources.
2- Reasonable stability in the general price level of all goods and services.
3- Sustained economic growth.
4- A stable balance of payments positions for the nation vis-à-vis the rest of the world.
Through its influence over interest rates and the growth of the nation's money supply, the central bank is able to influence the economy's progress toward each of these goals. Achievement of all these goals simultaneously as proven to be exceedingly difficult, however, as the recent track record of the economy demonstrates. One reason is that the goals often conflict. Pursuit of price stability and an improved balances of payments position, for example, may require higher interest rates and restricted credit availability- policies which tend to increase unemployment and slow investment spending and growth. Central bank policy making is a matter of accepting trade-off (compromises) among multiple goals. For example, the central bank can pursue policies leading to lower rate of inflation and a stronger dollar but probably at the price of some additional unemployment and slower economic growth in the short run.
Central banking in most Western nations, including the United States, operates principally through the marketplace. Modern central banks operate as a balance wheel in promoting and stabilizing the flow of savings from surplus-spending units to deficit-spending units. They try to assure a smooth and orderly flow of funds through the money and capital markets so that adequate financing is available for worthwhile investment projects. This means, among other things, avoiding panic in the market due to sudden shortages of available credit or sharp declines in security prices. However, most of the actions taken by the central bank to promote a smooth flow of funds are carried out through the marketplace rather than by government order. For example, the central bank may encourage interest rates to rise in order to reduce borrowing and spending and combat inflation, but it does not usually allocate credit to particular borrowers. The private sector, working through demand and supply forces in the marketplace, is left to make its own decisions about how much borrowing and spending will take place at the current level of interest rates and who is to receive credit.

The role of central banks in the economy

Control of the money supply
Central banks, including the Federal Reserve System, perform several important functions in a modern economy. The first and most important of their functions is control of the nation's money supply.
What is money? Money is anything which serves as a medium of exchange in the purchase of goods and services. Money as another important function, however-serving as a store of value, for money is a financial asset that may be used to store purchasing power until it is needed by the owner. If we define money exclusively as a medium of exchange , then the sum of all currency and coin held by the public plus the value of all publicly held checking accounts and other deposits against which drafts may be issued (such as NOW accounts) would constitute the nation's money supply. If we define money as a store of value, on the other hand, then time and savings accounts at commercial banks and other nonbank financial intermediaries, such as credit unions and savings banks, would also be considered important components of the money supply. However we define money, the power to regulate its quantity and value was delegated by Congress early in this century to the Federal Reserve System. The Fed has become, not only the principal source of currency and coin (pocket money) used by public, but also the principal government agency responsible for stabilizing the value of the dollar and protecting its integrity in the international financial markets. Why is control of the nation's money supply so important? One reason is that changes in the money supply are closely linked to the changes in economic activity. A number of studies in recent years have found a statistically significant relationship between current and lagged changes in the money supply and movements in the nation's gross national product (GNP). The essential implication of these studies is that, if the central bank carefully controls the rate of growth of money, then it can influence the growth rate of the economy as a whole.
Another important reason for controlling the money supply is that, in the absence of effective controls, money in the form of paper notes or bank deposits could expand virtually without limit. The marginal cost of creating additional units of money is close to zero. Therefore, the banking system, the government, or both are capable of increasing the money supply well beyond the economy's capacity to produce goods and services. Because this action would bring on severe inflation, disrupt the nation's payments mechanism, and eventually bring business activity to a halt, it is not surprising that modern governments have come to rely so heavily upon centrals banks as guardians of the quantity and value of their currencies. The Federal Reserve System operates almost daily in the financial markets in an attempt to control domestic price inflation in order to protect the purchasing power of the dollar at home, while occasionally intervening in foreign currency markets to protect the dollar abroad.
Stabilizing the money and capital markets
A second function of central banking is stabilization of the money and capital markets. The financial system must transmit savings to those who require funds for investment so that the economy can grow. If the system of money and capital markets is to work efficiently, however, the public must have confidence in financial institutions and be willing to commit its savings to tem. If the financial markets are unruly, with extremely volatile fluctuations in interest rates and security prices, or if financial institutions are prone to frequent collapse, the public´ confidence in the financial system might well be lost. The flow of capital funds would dry up, resulting in a drastic slowing in the nation's rate of economic growth and a rise in unemployment. All central banks play a vital role in fostering the mature development of financial markets and in ensuring a stable flow of funds through those markets.
Pursuing this objective, the Federal Reserve System will, from time to time, provide funds to major securities dealers when they have difficulty financing their portfolios so that buyers and sellers may easily acquire or sell securities. When interest rates rise or fall more rapidly than seems consistent with the nation's economic goals, the Fed will again intervene in the financial markets. The central bank may changes the rates it charges banks on direct loans or engage in securities trading in an attempt to moderate rate movements.
Lender of last resort
Another essential function of central banks is to serve as a lender of last resort. This means providing liquid funds to those financial institutions in need, especially when alternative sources of funds have dried up. For example, the Federal Reserve through its discount window will provide funds to selected deposit-type financial institutions, upon their request, to cover short-term cash deficiencies. As we will soon see, before the Fed was created, one of the weaknesses in the early financial system of the United States was the absence of a lender of last resort to aid to aid financial institutions squeezed by severe liquidity pressures.
Maintaining the payments mechanism
Finally, central banks have a role to play in maintaining and improving a nation´ payments mechanism. This involves the clearing checks, providing an adequate supply of currency and coin, and preserving confidence in the value of the fundamental monetary unit. A smoothly functioning and efficient payments mechanism is vital for carrying on business and commerce. If checks cannot be cleared in timely fashion or the public cannot get the currency and coin that it needs to carry out transactions, business activity will be severely curtailed. The result might well be large-scale unemployment and a decline in both capital investment and the nation's rate of economic growth.

Types of Hedging In The Financial Futures Market

There are basically three types of hedges used in the financial futures market today: (1) the long hedge, (2) the short hedge, and (3) the cross hedge. Cross hedges, as we will see, may be either long or short. Each types of hedge meets the unique trading needs of a particular group of investors. All three types have become increasingly popular as interest rates and security prices have become more volatile in recent years.
The long (or buying) Hedge
A long hedge involves the purchase of futures contracts today, before the investor must buy the actual securities desired at a later date. The purpose of the long hedge is to guarantee ("lock in") a desired yield in case interest rates decline before securities are actually purchased in the cash market.
As an example of a typical long-hedge transaction, suppose that a commercial bank, Life Insurance Company, pension funds, or other institutional investor anticipates receiving $ 1 million 90 days from today. Assume that today is April 1 and the funds are expected on July 2. The current yield to maturity on securities the investor hopes to purchase in July is 12.26 percent. We might imagine that these securities are long-term U.S. Treasury bonds, which appeal to this investor because of their high liquidity and zero default risk. Suppose, however, that interest rates are expected to decline over the next three months due to a recession. If the investor waits until the $1 million in cash is available 90 days from now, the yield on Treasury bonds may well be lower than 12.26 percent. Is there a way to lock in the yield available now even though funds will not be available for another three months?
Yes, if a suitable long hedge can be negotiated with another investor or trader. In this case the investor can purchase ("go long") 10 September Treasury bond futures contracts at their current market price. (Recall that Treasury bond futures are sold in $100,000 denominations.) Cash payment on these contracts will not be due until September. Suppose their price currently is 68-10, or $68,312.50 on a $100,000 face-value contract. Assume too that, as expected, bond prices rise and interest rates fall. At some later point the investor may be able sell the bond futures contracts at a profit, since prices on these contracts tend to rise along with rising bond prices in the cash market. Selling the bond futures contracts at a profit will help this investor offset the lower yields on Treasury bonds that will prevail in the cash market once the 1 million actually becomes available on July 2.
We note that on July 2 the investor goes into the spot market and buys $1 million in 8 percent, 20-year U.S. Treasury bonds at a price of 82-13. At the same time, the investor sells 10 September Treasury bonds futures contracts at 80-07. Due to higher bond prices (lower yields) in July, the investor loses $139,687.50, because the market price of treasury bonds has risen from 68-14 to 82-13. This represents an opportunity loss because the $1 million in investable funds was not available in April when interest rates were high and bond prices low. However, this loss is at least partially offset by a given in the futures market of $119,062.50, because the 10 September bond futures purchased on April 1st were sold at a profit on July 2. Over this period, bond futures contracts rose in price from 68-10 to 80-07. In effect, the investor will pay only $705,000 for treasury bonds bought in the cash market on July2. The market price of these bonds will be $824,062.50 (or 82-13) per bond, but the investor's net cost is lower by $119,062.25 due to a gain in the futures market.
The short (or selling) hedge
A financial device of growing popularity is the short hedge. This hedge involves the immediate sale of financial futures contracts until the actual securities must be sold in the cash market at some later point. Short hedges are especially useful to investors who may hold a large portfolio of securities which they plan to sell in the future but, in the meantime, must be protected against the risk of declining security prices. We examine a typical situation where a securities dealer might employ the short hedge.
Suppose the dealer holds $1 million in U.S. Treasury bonds, carrying an 8¾percent coupon and a maturity of 20 years. The current price of these bonds is 94-26 (or $948.125 per $1,000 par value), which amounts to a yield of 9.25 percent. However, the dealer is concerned because higher interest rates appear to be in the offing. Any upward climb in rates would bring about lower bond prices and therefore reduce the value of the dealer's portfolio. A possible remedy in this case is simply to sell bond futures contracts in order to counteract the anticipated decline in bond prices. For example, suppose the dealer decides to sell 10 Treasury bond futures contracts at 86-28, and 30 days later is able to sell $1 million of 20-year, 8¾ percent Treasury bonds at a price of 86-16 for yield of 10.29 percent. At the same time the dealer goes into the futures market and buys 10 Treasury bond futures contracts at 79-26 to offset the previous forward sale of bond futures.
The financial consequences of these combined trades in the spot and futures markets are offsetting. The dealer as lost $83,125 in the cash market due to the price decline in the bonds held. However, a gain of about $70,625 (fewer fees, commissions, and any tax liability) has resulted from the gain in the futures price. This dealer has helped to insulate the value of the portfolio from the risk of price fluctuations through a short hedge.
Cross hedging
Another approach to minimizing risk is the cross hedge- a combined transaction between the spot market and the futures market using different types of securities in each market. This device rests upon the assumption that the prices of most financial instruments tend to move in the same direction and by the same direction and by roughly the same proportion. Because this is only approximately true is any real-world situation, cross hedging does not usually result in forming a perfect hedge. Profits or losses in the cash market will not exactly offset losses or profits in the futures market. Nevertheless, if the investor's goal is to minimum risk, cross hedging is often preferable to a completely unhedged position.
As an example, consider the case of a commercial bank which holds good-quality corporate bonds carrying a face value of $5 million with an average maturity of 20 years. The bank's portfolio manager anticipates a rise in interest rates, which will reduce the value of the corporate bonds. Unfortunately, there is no futures market for corporate bonds, and therefore the portfolio manager cannot construct a prefect hedge involving these securities. However, futures contracts can be negotiated in U.S. Treasury bonds or even in Ginnie Mae passthroughs , providing either a long or a short hedge to offset the risk of a decline in the value of the corporate bonds.
To illustrate how such a cross-hedge transaction might take place, suppose that on January 2 the market value of the bank's corporate bonds is $3,673,437.50. This means that each $1,000 par value bond currently carries a market price of $734.6875 (or 73-15 on a $100 basis).the portfolio manager decides to 50 sell Treasury bond futures contracts at 81-20 (or $816.25 per $1,000 face value). About two and half months later, on March 14, interest rates have risen significantly. The value of each corporate bond has fallen to 64-13 (or $644.0625 per $1000 bond). At this point the Bank's portfolio manager decides to sell the bonds, receiving $3,220,312.50 from the buyer. This represents a loss on the bonds of $453,125.00. At the same time, however, the portfolio manager buys back 50 U.S. Treasury bond futures contracts at 69-20. The result is a gain from futures trading of 600,000. In this particular transaction the gain from futures trading more than offsets the loss in the cash market. Of course, this example of a cross hedge and the preceding example of long and short hedges are simplified considerably to make the fundamental principal of futures trading easier to understand. In the real world the placing and removal of hedges is an exercise requiring detailed study of the futures market and, in most cases, a substantial amount of trading experience.

Social consequences of the futures market

Not all observers agree that the futures market results in a net gain for society by helping financial institutions reduce risk and use scare resources more efficiently. Some analysts believe that the futures markets are largely speculative and not really geared for the hedging of risks per se. they see these markets as aimed principally at providing wealthy investors with a speculative outlet for their funds, and resulting in unnecessary risks due to excessive speculation. Some have argued that the futures markets increase the price volatility of those securities whose contracts are actively traded. If this is true, it would tend to make the impact of government economic policy, aimed at promoting high employment and low inflation, more difficult to predict. There is evidence from the commodities field that trading in futures tends to smooth out seasonal fluctuations, but only limited evidence exists to date as to the overall impact on the securities markets of contracts trading.
Certainly the more existence of the futures market and its continuing growth creates additional problems for regulatory authorities, especially those concerned with the regulation of financial institutions. Another market must be supervised and additional regulations prepared to cover new forms of risk and new fiduciary relationships. Some observers have expressed the fear that the futures markets substitute "gambling" with securities for "investing" in securities. If this view correct, it suggests a withdrawal of some risk-taking activity from the traditional securities markets and a redirection of this activity towards the futures market. To the extent that risk taking by securities investors is curtailed, this limits the flow of funds into venture capital and decreases the aggregate volume of investment in the economy. Other things equal, the economy's rate of growth is reduced.
On balance, the financial futures market probably has resulted in a modest net benefit to the financial system and to the economy. Those who support the development of this market have certainly overdramatized its positive features, alleging, for example, that interest rates tend to be lower and less volatile with a well-functioning futures market. There is little evidence that this is, in fact, the case. Regardless, it seems clear that the futures market has separated the risk of changing security prices and interest rates from the lending of funds, at least for those institutions actively participating in this market. The risk of price and yield changes is transferred to investors quite willing to assume such risks. The futures market has helped to reduce search costs and expand the flow of information on market opportunities for those who seek risk reduction through hedging. In this sense, the market tends to promote greater efficiency in the use of scare financial resources. Moreover, this developing institution has tended to unify many local markets into a national forward market, overcoming geographic and institutional rigities which tend to separate one market from another.
It should not be forgotten that futures trading is not without its own special risks. While the risk of price and yield fluctuations is reduced through negotiating a futures contract, the investor faces the risk of changing interest rates and security prices between the futures and spot markets. It is rare that gains and losses from simultaneous trading in spot and futures markets will exactly offset each other, resulting in a perfect hedge. Moreover, there are substantial brokerage fees for executing futures contracts, and required minimum deposits for margin accounts. To the extent that the futures market encourages speculation, does not fully offset all prices and interest-rates risks, and is characterized by substantial transactions costs, its net benefits to society will remain both limited and a subject of continuing controversy and close regulatory security.

Traders Active in The Future Market

A wide of financial institutions and individuals are active in futures trading today. The principal traders in financial futures are individuals and commodity pools. Commodity pools are like mutual funds, offering shares to the individual investor who regularly purchases futures contracts. Commodity pools offer the advantage of diversifying risk by trading in many contracts with varied maturities; in addition, they are professionally managed. the majority of commodity pools try to limit losses to the investor‘s original investment. Liquidating investor holdings rather than issuing margin calls. Combined, individuals and commodity pools held close to half of total open contract positions in 1979, and their share as been growing over time.
Firms and individual traders representing the future industry run a close second to individual investors and commodity pools, with open positions ranging from a fifth to about 35 percent of contracts outstanding, depending on the instrument being traded. many of these industry personal speculate on interest-rate movements or arbitrage between spot and futures markets, purchasing one contract and selling another in the expectation that interest rates on purchased contracts will decline more than (or rise less than) rates on contract sold. Alternatively, futures firms and industry traders will buy or sell futures contracts simultaneously with a sell or buy move in the spot market.
Financial institutions also play a prominent role in future trading, led by securities dealers, commercial banks, mortgages bankers, and savings and loans associations. Securities dealers appear to be less interested in risk reduction through hedging and more interested in profitable traders arising from correctly guessing the future course of interest rates and contract prices. Savings and loan associations and mortgage bankers, not surprisingly, are most involved in futures trading of GNMA mortgage-backed instruments. Rapid increases in long-term mortgage rates and volatile swings in the demand for new housing over the past two decades have brought substantial risk to the mortgage lending business. Under pressure from rising interest costs and deposit withdrawals, many savings and loan associations today have been forced to deeply discount and sell their old, low-yielding mortgage loans in the secondary market in order to raise funds. Losses incurred in the sale of old mortgages can be at least partially offset by trades executed in GNMA futures contracts. For their part, mortgages bankers frequently sell GNMA futures to hedge against interest-rate changes that may occur between the time mortgage loans are taken into their portfolios and the time they are sold in package to other investors.
The participation of savings and loan associations in futures trading was been a substantial boost in July 1981. The federal home loan bank broad (FHLBB), the industry ´s chief regulator, loosened the old rules, which limited the total volume of futures contracts an S&L could have outstanding at any one time to no more than the association's net worth position (normally about 5 percent of total assets). The new rules permit a savings and loan to hedge all of its assets if it so chooses. Trading may be carried out in any securities which a savings associations is legally entitled to hold. Many savings and loans sell GNMA futures to hedge the fixed-rate mortgages they hold on single-family homes. However, the new rules for futures trading set by the FHLBB allow savings associations to hedge on both the asset and liability side of the balance sheet and especially to offset the rapidly rising cost of deposits and nondeposit borrowings.
Participation by commercial banks in futures trading has been quite limited to date. Banks accounted for no more than 4 percent of all positions in the three most-active futures markets, according to a survey taken in March 1979. the survey, conducted by the Commodity Futures Trading Commission, found that only 24 banks held open positions in Treasury bill futures and only 14 carried positions in bond futures at that time. One major factor limiting commercial bank participation in the futures market is uncertainly over the attitude of the regulatory authorities, especially the Federal Reserve System and the Comptroller of the Currency. Another problem centers on the required accounting treatment of gains and losses from futures trading. Losses must be recognized immediately for tax purposes, while gains can be deferred. The result is volatile fluctuations in reported income for those banks active in futures trading. However, it is anticipated that bank participation in the futures market will expand significantly as the regulatory community becomes more comfortable with the hedging concept.