Monday, August 31, 2009

Borrowers and Lenders in the Money Market

Who are the principal lenders of funds in the money market? And, who are the principal borrowers? These questions are difficult to answer since the same institutions frequently operate on both sides of the market. For example, a large commercial bank operating in the New York money market, such as Chase Manhattan or manufactures Hanover, will be borrowing short-term funds aggressively in the market through CDs, federal funds, and Eurodollars while simultaneously lending short-term funds to corporations who have temporary cash shortages. Frequently, large nonfinancial corporations borrow millions of dollars on a single day only to come back into the money market later in the week as a lender of funds due to a sudden upsurge in cash receipts. Institutions which typically play both sides of the money market include commercial banks, major nonfinancial corporations, state and local units of government, finance companies, and savings banks. Even the nation‘s central bank, the Federal Reserve System, may be an aggressive supplier of funds to the money market on one day and reserve itself the day following, demanding funds through the sale of securities in the open market. One institution which is virtually always on the demand side of the market, however, is the U.S Treasury, which borrows billions of dollars every week through the issuance of Treasury bills.

The Goals of Money Market Investors

investors in the money market seek mainly safety and liquidity plus the opportunity to earn some interest income. this is because funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future to meet tax obligations, cover wage and salary costs, pay stockholder dividends, and so on. for this reason money market investors are especially sensitive to risk.
the strong aversion to risk among money market investors is especially evident when there is even a hint of trouble concerning the financial condition of a major money market borrower. for example, when the huge Penn central transportation company collapsed in 1970 and defaulted on its short-term commercial notes, the commercial paper market virtually ground to a halt because many investors refused to buy even the notes offered by top-grade companies. Similarly,in 1974 when Franklin National Bank of New York, holding nearly $4 billion in assets, closed its doors, the rates on short-term certificates of deposit (CDs) issued by other big New York banks surged upward due to fears on the part of money market investors that all large-bank CDs had become more risky.

Characteristics of the money market

The money market, like all financial markets, provides a channel for the exchange of financial assets for money. However, it differs from other parts of the financial system in its emphasis upon loans to meet purely short-term cash needs. The money market is the mechanism trough which holders of temporary cash surplus meet holders of temporary cash deficits. it is designed, on the one hand, to meet the short-run cash requirements of corporations, financial institutions, and governments, providing a mechanism for granting loans as short as overnight and as long as one year to maturity. At the same time, the money market provides an investment outlet for those spending units (also principally corporations, financial institutions, and governments) who hold surplus cash for short periods of time and wish to earn at least some return on temporarily idle funds. The essential function of the money market, of course, is to bring these two group into contact with each other in order to make borrowing and lending possible.

Riding the Yield Curve

Some active security investors, especially dealers in U.S. Government Securities, have learned to "ride" the yield curve for profit, if the curve is positively sloped, with a slope steep enough to offset transactions costs from buying and selling securities, the investor may gain by timely portfolio switching.
for example, if a securities dealer purchases U.S. Treasury bills six months from maturity, holds them for three months, converts the bills into cash, and buys new six-month bills, he or she can profit in two ways from a positively sloped yield curve. Because the yield is lower on three-month than on six-month bills, the dealer experiences a capital gain on the sale. Second, the purchase of new six-month bills replaces a lower-yielding security with a higher-yielding one at a lower price. Riding
The yield curve can be risky, however, since yield curves are constantly changing their shape. If the curve gets flatter or turns down, a potential gain can be turned into a realized loss. Experience and good judgment are indispensable in using the yield curve for investment decision making.

Use of the yield curve to indicate trade-offs between maturity and yield

Still another use of the yield curve is to indicate the current trade-off between maturity and yield confronting the investor. If the investor wishes to alter the maturity of a portfolio, the yield curve indicates what gain or loss in rate of return may be expected for each change in the portfolio‘s average maturity.
with an upward-sloping yield curve,for example, an investor may be able to increase a bond portfolio‘s expected annual yield from 9 percent to 11 percent by extending the portfolio‘s average maturity from six to eight years. however, the prices of longer-term bonds are more volatile, creating greater risk of capital loss. moreover, longer-term securities tend to be less liquid and less marketable than shorter-term securities. therefore, the investor must weigh the gain in yield from extending the maturity of his or her portfolio against added price, liquidity, and marketability risk. because yield curves tend to flatten out for the longest maturities, the investor bent on lengthening the average maturity of a portfolio eventually discovers that gains in yield get smaller and smaller for each additional unit of maturity. At some point along the yield curve it clearly does not pay to further extend the maturity of a portfolio.

Uses of the yield curve for detecting overpriced and under-priced securities

Yield curves can be used as an aid to investors in deciding which securities are temporarily overpriced or underpriced. This use of the curve derives from the fact that, in equilibrium, the yields on all securities of comparable risk should come to rest along the yield curve at their appropriate maturity levels. In an efficiently functioning market, however, any deviations of individual securities from the yield curve will be short-lived; so the investor must move quickly upon spotting a security whose yield lies temporarily above or blew the curve.
if a security‘s rate of return lies above the yield curve, this sends a signal to investors that that particular security is temporarily underpriced relative to other securities of the maturity. Other things equal, this is a buy signal which some investors will take advantage of, driving the price of the purchased security upward and its yield back down toward the yield curve. on the other hand, if a security‘s rate of return is temporarily below the yield curve, this indicates a temporarily overpriced financial instrument, because its yield is below that of securities bearing the same maturity. Some investors holding this security will sell it, pushing its price down and its yield back up toward the curve.

Convertible securities

Another factor which affects relative rates of returns on different securities is convertibility. Convertible securities consist of special issues of corporate bonds or preferred stock which entitle the holder to exchange these securities for a specific number of shares of the issuing firm‘s common stock. Convertible are frequently called " hybrid securities" because they offer the investor the prospect of both stable income in the form of interest or dividends plus capital gains on common stock, once conversion takes place. The timing of a conversion is purely at the option of the investor; however, the contract agreed to at time of purchase specifies the terms under which conversion may take place. An issuing firm often can "force" conversion of its securities by bringing about a rise in the price of its common stock, because conversion is most likely to occur in a rising market. Conversion is a one-way transaction-once convertibles are exchanged for common stock there is no way back for the investor.
Investors generally pay a premium for convertible securities over nonconvertible securities in the form of a higher price and reduced yield. Thus, convertibles will carry a lower rate of return than other securities of comparable quality and maturity issued by the same company. This occurs because the investor in convertibles is granted a hedge against future risk. If security prices fall, the investor still earns a fixed rate of return in the form of interest income from a convertible bond or dividend income from each share of convertible preferred stock. On the other hand, if stock prices rise, the investor can exercise the conversion option and share in any capital gains earned on the company‘s common stock.

Sunday, August 30, 2009

Advantage and disadvantage of the call privilege

Clearly, the call privilege is an advantage to the security issuer because it grants him greater financial flexibility and the potential for reducing future interest costs. On the other hand, the call privilege is a distinct disadvantage to the security buyer, who may suffer a decline in the expected holding-period yield if the security is, in fact, called. The issuer will call in a security if the market rate of interest falls far enough so that the savings from issuing a new security at lower interest rates more than offset the call penalty plus flotation costs of a new security issue. This means, however, that an investor who is paid off will be forced to reinvest the call price in lower-yielding securities.
Another disadvantage for the investor is that call privileges limit the potential increase in a security‘s market price. In general, the market price of a security will not rise significantly above its call price, even when interest rates fall. The reason is that the issuer can call in a security at the call price, presenting the investor with a loss equal to the difference between the prevailing market price and the call price. Thus, callable securities have a more-limited potential for capital gains than non-callable securities.

the call privilege

nearly all corporation bonds and mortgages and some U.S. government bonds issued in today‘s financial markets carry call privilege. this provision of the bond contract, or indenture, permits the borrower to retire all or a portion of bond issue by buying back the securities in advance of their maturity. Bondholders usually are informed of a call through a notice in a newspaper of general circulation, while holders of record of registered bonds are notified directly. Normally, when the call privilege is exercised, the security issuer will pay the investor the call price, which equals the securities‘ face value plus a call penalty. the size of the call penalty is set forth in the indenture (contract) and generally varies with the number of years remaining to maturity. in case of a bond, one year‘s worth of coupon income is often the minimum call penalty required.

Recent changes in the character of the finance company industry.

The structure of the finance industry has changed markedly in recent years. As in the case of credit union, savings and loans, and savings banks, the number f finance companies have been trending downward, although the average size of such companies has grown considerably. A survey by the Federal Reserve board revealed that in 1960 there were more than 6,400 finance companies operating in the United States, but by 1980 only about 2,000 independent companies could be found. A modest rise in the number of new firms occurred during the 1970s, however, as bank holding companies centered around some of the nation‘s largest banks organized new finance company subsidiaries.
this long-term downtrend in the industry‘s population reflects a number of powerful economic forces at work. Rising cost pressures, the broadening of markets, the need to innovate, and intensified competition from other financial institutions have encouraged finance companies to strive for lager size and greater efficiency. Many smaller companies have sold out to larger conglomerates as high interest rates squeezed earnings. Despite their declining numbers, however, finance companies rank among the fastest-growing financial intermediaries in the United States and continue to be a potent force in the markets for business and consumer credit.

open-end and closed-end investment companies

There are two basic kinds of investment companies. Open-end companies-often called mutual funds-will buy back (redeem) their shares any time the customer wishes and sell open shares in any quantity demanded. Thus, the amount of their outstanding shares changes continually in response to public demand. The price of each open-end company share is equal to the net asset value of the fund-i.e., the difference between the value of its assets and its liabilities divided by the volume of shares issued.
Open-end companies may be either load or no-load funds. Load funds, which are in the majority, offer their shares to the public at net asset value plus a commission to brokers marketing all the shares. No-load funds sell their shares purely at net asset value. The investor must contact the no-load company himself, however. Whether load or no load, open-end investment companies are heavily invested in common stocks, with corporate bonds running a distant second.
Closed-end investment companies sell only a specific number of ownership shares. An investor wanting to acquire closed-end shares must find another investor who wishes to sell. The investment company does not take part in the transaction. In addition to selling equity shares, closed-end companies issue a variety of debt and equity securities to raise funds, including preferred stock, regular and convertible bonds, and stock warrants. In contrast, open-end companies rely almost exclusively on the sale of equity shares to the public to raise the funds they require

Goals and Earnings of Investment Companies

Investment companies adopt many different goal. Growth funds are interested primarily in long-term capital appreciation and tend to invest mainly in common stocks offering strong growth potential. income funds stress current income in their portfolio choices rater than growth of capital, and they typically purchase stocks and bonds paying high dividends and interest. balanced funds attempt to bridge the gap between growth and income, acquiring bonds, preferred stock,and common stock which offer both capital gain (growth) and adequate current income. On average, balanced funds place about two thirds of their resources in stocks and about one third in bonds.
the majority of investment companies give priority to growth in capital over current income due to the tax advantages of capital gains to their investors. However, the industry‘s growth in recent years has centered primarily in funds which stress current income. Prominent examples include bond funds, money market funds, and option income funds (which issue option against a portfolio of common stocks). while most investment companies hold a highly diversified portfolio of securities, a few specialize in stocks or bonds from a single industry or sector (such as precious metals or oil and natural gas).
It is not at all clear that investment companies hold a significant advantage over other investors in seeking out the highest returns available in the financial marketplace. Moreover, there is evidence that these companies may roll over their portfolios too rapidly, which runs up the cost of managing the fund and reduces net earnings. Less-frequent trading activity on the part of investment companies might well result in greater long-run benefits for the saver.Research evidence has been mounting for a number of years that security markets are highly efficient. overvaluation or undervaluation of securities is, at most, a temporary phenomenon. In this kind of environment it is doubtful that investment companies are of significant benefit to the large investor, though they may indeed aid the small investor in reducing information and transactions costs and opening up investment opportunities not otherwise available.

Tax status of the industry

investment companies have a highly favorable tax situation. provided they conform to certain rules to qualify as an investment company, they do not pay federal taxes on income generated by their security holdings. however, no less than half their resources must be devoted to securities and cash assets. Investment companies must maintain a highly diversified portfolio-a maximum of one quarter of their total resources can be devoted to securities issued by any single firm. Only a small portion of their net income (no more than 10 percent) can be retained in the business. the rest must be distributed to the shareholders.

regulation of investment companies

Investment companies are heavily regulated at the federal level through such laws as the investment company act and the investment Advisers act, both passed by congress in 1940. Registration of investment company securities and periodic reports to the Securities and Exchange Commission (SEC) are mandatory. policies for investing funds are determined by the investment company‘s shareholders, who also elect at least two thirds of the company‘s directors. The portfolio held by an investment company is managed by a separate management company or investment advisory service, which levies a substantial fee for its services. the management fee is typically a percentage of the fund‘s performance. Any contractual arrangements between the investment advisory service and the investment company must be approved by the latter‘s stockholders and must come up for renewal or revision every two years. Most investment advisory services are provided by either life insurance firms or securities specialists.

Different Finance Companies for Different Purposes(3)

Commercial finance companies, as their name implies, focus principally on extending credit to business firms. Most of these companies provide "account receivable financing" or "factoring" services to small or medium-sized manufacturers and wholesalers. with accounts receivable financing, the commercial finance company may extent credit against the borrower‘s receivables in the form of a direct cash loan. Alternatively, a factoring arrangement may be used in which the finance company acquires the borrowing firm‘s credit accounts at an appropriate discount rate to cover the risk of loss. most commercial finance companies today do not confine their credit-granting activities to the financing of receivables but also make loans secured by business inventories, machinery, and other fixed assets. In addition, they offer lease financing for the purchase of capital equipment and rolling stock (such as airplanes and railroad cars) and make short-term unsecured cash loans.
We should not over-dramatize the differences between these three types of finance companies. The larger companies are active in all three areas. In addition, most finance companies today are extremely diversified in their credit-granting activities, offering a wide range of installment and working-capital loans, leasing plans, and long-term credit to support capital investment..

Different Finance Companies for Different Purposes(2)

Sales finance companies make indirect loans to consumers by purchasing installment paper from dealers selling automobiles and other durables. Many of these firms are "captive" finance companies controlled by a dealer or manufacturer. their principal function is to promote sales of the sponsoring firm‘s goods and services providing by credit. Companies having finance affiliates include General Electric, Motorola, Sears, wards, and International Harvester. Generally, sales, finance companies will specify in advance to retail dealers the terms (i.e., maturities, minimum down payments, and finance charges) of installment contracts they are willing to accept. Frequently they will give the retail dealers a supply of contract forms which the dealers will fill out when the sale is made. The contract is then sold immediately to the finance company.

Different Finance Companies for Different Purposes(1)

also finance companies, also known as small-loan companies, make personal cash loans available to many customers. the majority of their loans support the purchase of passenger cars, home appliances,recreation vehicles, and mobile homes. however, a growing proportion of consumer finance company loans center on aiding customers with medical and hospital expenses, educational costs, vacations, home repair and maintenance, and energy bills. Loans made by small-loan companies are considered to be more risky than other consumer installment loans and therefore generally carry steeper finance charges than those assessed by banks, credit unions, savings and loan associations, and other installment lenders.

Methods of Industry Financing

Finance companies are heavy users of debt in financing their operations. Principal sources of borrowed funds include bank loans, commercial paper, and long-term debentures sold primarily to banks, insurance companies, and non-financial corporations. Which source of funds these companies emphasize most heavily at any given time depends essentially on the structure of interest rate. When long-term rates are high, these companies tend to emphasize commercial paper and shorter-term bank loans as sources of funds. On the other hand, in years when long-term rates are relatively low, usually during a business recession, long-term debt will be drawn upon more heavily

Finance Companies

Finance Companies are sometimes called "department stores of consumer and business credit. these institution grant credit to businesses and consumers for a wide variety of purposes, including the purchase of inventories, business equipment, automobiles, home repairs, vacations, medical care, mobile homes, and home appliances. Most authorities divide firms in the industry into one of three groups-consumers finance companies, sales finance companies, and commercial finance companies.

Saturday, August 29, 2009

Factors Affecting the Growth of Pension Funds

Most experts feel that pension fund growth is likely to slow significantly in future years. One reason is the rising proportion of pension beneficiaries to working contributors, related to the gradual aging of the general population. At the same, the cost of maintaining pension programs has increased dramatically. The full funding of a plan to cover all promised benefits places extreme pressure on corporate profits, while the recent mediocre performance of the stock and bond markets has diminished investment returns.
Even more significant is the rapidly rising cost of government regulation. The employee Retirement Income Security Act (ERISA), Passed by Congress in 1974, imposed costly reporting requirements on the industry and granted employees the right to join a pension program, in most cases, after only one year on the job. More-rapid vesting of benefits was also required so that employees can recover a higher proportion of their past contributions should they decide to retire early or move on to another job. Trying to eliminate the danger that pension may not have adequate funds to pay future claims against them, congress now requires employers to eventually cover any past liabilities not fully covered at present. in addition, a federal agency- the Pension Benefit Guaranty Corporation (PBGC)-was created in 1974 to insure some part of all vested employee benefits. PBGC is supported by premiums contributed annually by participating employers and can borrow up to $100 million from the U.S. Treasury in am emergency.
These new government regulations have forced many private pension plans to close. The controls of other as been turned over to a financial institution- typically a bank trust department or life insurance company- better able to deal with the current rules. Without question, the pension sector faces troubled times and considerable uncertainty in the period ahead

Investment strategies of pension funds

Pension funds are long-term investors with little need for liquidity. their incoming cash receipts are known with great accuracy since a fixed percentage of each employee‘s salary is usually contributed to the fund. At the same time, cash outflows are relatively easy to forecast because benefit payments are stipulated in the contract between the fund and its members. This situation encourages pensions to purchase common stock, long-term bonds, and real estate and hold these assets on a more-or-less-permanent basis. In addition, interest income and capital gains from investments are exempt from federal income taxes, while pension plan members are not taxed on their contributions unless cash benefits are paid out.
While favorable taxation and predictable cash flows favor longer-term somewhat riskier investments, the pension fund industry is closely regulated in all of its activities, including the investing of funds. The employee retirement Income Security Act of (ERISA) requires all private plans to be funded, which means that any assets held plus anticipated investment income must be adequate to cover all promised benefits. ERISA also requires that investments must be made in a "prudent" manner, which is usually interpreted to mean highly diversified holdings of high-grade common stock, corporate bonds, and government securities with only limited real estate investments.
While existing regulations do emphasize caution and conservatism in pension fund investments, the private plans have been under intense pressure in recent years by both management of the sponsoring company and employees to be more liberal in their investment policies. The sponsoring employer has a strong incentive to encourage its affiliated pension plan to reduce operating expenses and earn the highest possible returns on its investments. This permits the company to minimize its contributions to the plan. Both sponsoring employers and employees have a keen interest in seeing that the pension plan earns a high enough return on its investment to at least keep pace with inflation. Otherwise, the employees will tend to seek other jobs whose pension programs offer more lucrative returns.

the role of expectations in shaping the yield curve

How can a factor as intangible as expectations determine thee shape of the yield curve? Expectations are a potent force in the financial market place because investors act on their expectations. For example, if interest rates are expected to rise in the future, this is disturbing news to investors in long-term bonds. Rising interest rates mean falling prices for bonds and other debt securities. Moreover, the longer the term of a bond, the more sensitive its price is to changes in rates. Faced with the possibility of falling bond prices, many investors will sell their long-term bonds and buy shorter-term securities or hold cash. As result, the prices of long-term bonds will plummet, driving their rates (yields) higher. At the same time, increased investor purchases of short-term securities will send the prices of these securities higher and their yields lower. With rising long-term rates and falling short-term rates, the yield curve will gradually assume an upward slope. the yield curve‘s prophecy of rising interest rates will have come true simply because investors responded to their expectations by making changes in their security portfolios.

total demand for loanable funds

The total demand for loanable funds is the sum of consumer, business, and government credit demands. This demand curve slopes downward and to the right with respect to the rate of interest. Higher rates of interest lead some businesses, consumers, and governments to curtail their borrowing plans, while lower rates bring forth more credit demand. However, the demand for loanable funds does not determine the rate of interest by itself.

Government Demand for Loanable Funds

Government Demand for Loanable Funds is a growing factor in the nation‘s financial markets but does not depend significantly upon the level of interest rates. This is especially true of borrowing by the federal government. Federal decisions on spending and borrowing are made by Congress in response to social needs and the public welfare, not the rate of interest. Moreover, the federal government has the power both to tax and to create money in order to pays its debts. State and local government demand, on the other hand, is slightly interest elastic since many local governments are limited in their borrowing activities by legal interest-rate ceilings. When open-market rates rise above these legal ceilings, some state and local units of government are prevented from offering their securities to the public

Business Demand for loanable funds

the credit demands of business generally are more responsive to changes in the rate of interest than is consumer borrowing. Most business credit is for such investment purposes of inventories and new plant and equipment. As noted earlier in our discussion of the classical theory of interest, a higher interest rate eliminates some business investment projects from consideration because their expected rate of return is lower than the cost of funds. on the other hand, at lower rates of interest, many investment projects will be profitable, with their expected returns exceeding the cost of funds. therefore, the demand for loanable funds from the business sector increases as the rate of interest falls.

Consumer demand for loanable funds

Consumer demand loanable funds in order to purchase a wide variety of goods and services. Recent research indicates that consumers are not particularly responsive to the rate of interest when they borrow but focus instead principally upon the "nonprice"terms of a loan, such as the down payment, maturity, and size of installment payments. this implies that consumer demand for credit is relatively inelastic with respect to the rate of interest. Certainly a rise in interest rates leads to some reduction in consumer demand for loanable funds, while a decline in rates stimulates some additional consumer borrowing. however, along the consumer‘s relatively inelastic demand schedule, a substantial change in the rate of interest must occur before consumer demand for funds changes significantly.

The loanable funds theory

An explanation of interest rates which overcomes many of the limitations of earlier theories is the loanable funds approach. This view argues that the risk-free interest rate is determined by the interplay of two forces- the demand for and the supply of loanable funds. The demand for loanable funds consists of credit demands from businesses, consumers, and units of government. The supply of loanable funds stems from three sources-savings, hoarding demand for money, and money creation by the banking system. We consider each of these demand and supply factors in turn.

Friday, August 28, 2009

Use Yield curve for financial intermediaries

The slope of the yield curve is critical for financial intermediaries, especially commercial banks, savings and loan associations, and savings banks. A rising yield curve is generally favorable for these institutions because they borrow most of their funds by selling short-term deposits and lend a major portion of those funds long term. The more steeply the yield curve slopes upward, the wider the spread between borrowing and lending rates and the greater the potential profit for a financial intermediary. However, if the yield curve begins to flatten out or slope downward, this should serve as a warning signal to portfolio managers of these institutions.
a flattening or downward-sloping yield curve squeezes the earnings of financial intermediaries and calls for an entirely different portfolio management strategy than an upward-sloping curve. For example, if an upward-sloping yield curve starts to flatten out, portfolio mangers of financial institution might try to "lock in" relatively cheap sources of funds by getting long-term commitments from depositors and other funds-supplying customers. Borrowers, on the other hand, might be encouraged to take out long-term loans at fixed rates of interest. of course, the financial institution‘s customers also may be aware of impending changes in the yield curve and resist taking on long-term loans or deposit contracts at potentially unfavorable interest rates.

the yield curve and forecasting interest rate

this curve can be an extremely useful tool for investors.if the expectations hypothesis is correct, the yield curve gives the investor a clue concerning the future course of interest rates. if the curve has an upward slope the investor may be well advised to look for opportunities to move away from bonds and other long-term securities into investments whose market price is less sensitive to interest-rate changes. A downward-sloping yield curve, on the other hand, suggests the likelihood of near-term declines in interest rates and a rally in bond prices if the market‘s forecast of lower rates turns out to be true.

default risk and interest rate

another important factor causing one interest rate to differ from another is the degree of default risk carried by individual securities. investors face many different kinds of risk, of course, but one of the most important is default risk-the risk that a borrower will not meet all promised payments at times agreed upon. All securities expect U.S. government securities are subject to varying degrees of default risk.if you purchase a 10-year corporate bond with a $1,000 par value and a coupon rate of 9 percent, the issuing company promises in the indenture (i.e., bond contract) that it will pay you $90 a year (or more commonly, $45 every six months) for 10 years plus $1,000 at the end of the 10-year period. failure to meet any of these promised payments on time puts the borrowers in default, and the investor may have to go to court to recover at least some of the monies owed.

relative changes in long-term and short-term interest rates

The expectations theory does help to explain an interesting phenomenon in the financial markets. Long-term interest rates tend to change slowly over time, while short-term interest rates are highly volatile and often move over wide ranges. The expectations hypothesis argues that the long-term interest rate is the geometric average of a series of rates on short-term loans whose combined maturities equal that of the long-term loan. The rate of interest on a 20-years bond, for example, is equivalent to the geometric average of the rates on a current 1-year loan plus the rates attached to series of 19 future (forward) 1-year loans, adding to 20 years. Experience teaches us that average changes much more slowly than the individual components making up an average. If the long-term interest rate is a geometric average of current and future short-term rates, it is not at all surprising that long-term rates tend to lag behind short-term rates and are less volatile.

Thursday, August 27, 2009

The Call Premium and Interest-rate Expectations

For all of the foregoing reasons, securities that carry a call privilege generally sell at lower price and higher interest rates than non-callable securities. Moreover, there is an inverse relationship between the length of the call deferment period and the required rate of interest on callable securities. The longer the period of deferment and, therefore, the longer the investor is protected against early redemption, the lower the interest rate which the borrower must pay. Issuers of callable securities must pay a call premium in the form of a higher rate of interest for the option of early redemption and for a shorter period of deferment.
The key determinant of the size of the call premium is the interest rate expectations of investors in the marketplace. If the interest rates are expected to rise over the term of a security, the risk that the security will be called is low. Borrowers are very unlikely to call in their securities and issue new ones at higher interest rates. As a result, the yield differential between callable and non-callable securities normally will be minimal. Moreover, in this case call deferments will be of limited value to investors, and yields will be roughly equivalent for securities with varying call features call feature. The same conclusions apply even if interest rates are expected to decline moderately but not enough to entice borrowers to call in their securities and issue new ones.
It is when interest rates are expected to fall substantially that securities are most likely to be called. In this instance security issuers can save large amounts of money-more than enough to cover the call privilege. Thus, the call premium is likely to be significant as investors demand a higher yield on callable issues to compensate them for call risk. Moreover, the yield spreads between bonds with long call deferments versus those with short or no call deferments widen during such periods as investors come to value more highly the deferment feature.

The functions of the rate of interest in the economy

The rate of interest performs several different and highly important roles in the economy:
-It helps guarantee that current savings will flow into investment to promote economic growth.
- the rate of interest rations the available supply of credit, generally providing loanable funds to those projects with the highest expected returns.
- it brings into balance the nation‘s supply of money with the demand for money.
- the rate of interest is also an important tool government policy through its influence upon the volume of saving and investment. If the economy is growing too slowly and unemployment is rising, the government can use its policy tools to lower interest rates in order to stimulate borrowing and investment. On the other hand, an overheated economy experiencing rapid inflation has traditionally called for a government policy of higher interest rates to slow both borrowing and spending.
in the pages of the financial press, the phrase "the interest rate" is frequently used, in truth, there is no such thing as "the interest rate" for there are thousands of different rates in the financial system. Even securities issued by the same borrower will often carry a variety of interest rates. In the next topic, the most important factors which cause rates to vary among different securities and over time are examined in detail. in this blog, our focus is upon those forces that influence the level of all interest rates.
To uncover these general and pervasive rate-determining forces, however, we must make a simplifying assumption. We will assume there is one fundamental interest rate in the economy known as the pure or risk-free rate of interest, which is a component of all rates. The closet approximation to this pure rate in the real world is the yield to maturity on long term U.S. Government bonds. it is a rate of return presenting no risk of financial loss to the investor and represents the true "opportunity cost" of holding idle money because the investor can always invest in risk-less securities and earn this minimum rate of return
Once the pure rate of interest is determined, all other interest rates may be determined from it by examining the special characteristics of the securities issued by individual borrowers. For example, only the government can borrow at the pure, risk-free interest rate; other borrowers pay higher rates than this due, in part, to the greater risk of loss attached to their securities. Difference in liquidity, marketability, and maturity are other important factors causing various interest rates to differ from the pure, risk-free rate. First, however, we must examine the forces which determine the risk-free rate itself.

Commercial paper ratings

Commercial paper is generally rated as prime, desirable, or satisfactory, depending, or satisfactory, depending on the credit standing of the issuing company. Firms desiring to issue paper generally will seek a credit rating from one or more of three rating services- Moody's investor service, standard &Poor's corporation, and Fitch investor service. Moody‘s assigns ratings of prime-1 (p-1) for the highest-quality paper, with lower-quality issues designated as prime-2 (p-2) or prime-3 (p-3). Standard& Poor's assigns ratings of A-1, A-2, A-3, while Fitch uses F-1, F-2, F-3.
it is extremely difficult in today‘s volatile conditions to market unrated commercial paper. Indeed, paper available is mainly from top-quality issuers; about three quarters of the firms currently selling notes bearing credit ratings from at least two rating agencies are preferred by both investors and dealers.

Advantage Of Issuing Commercial Paper(2)

Another advantage of borrowing in the commercial paper market is that rates there are most flexible than bank loan rates. Moreover, a company in need of funds can raise money quickly through either dealer or direct paper. Dealers maintain close contact with the market and generally know where cash may be found. Frequently, notes can be issued and funds rose the same day or within a day or two.
Generally, larger amounts of funds may be borrowed more conveniently through the paper market than from other sources, particularly bank loans. This situation arises due to federal and state regulations which limit the amount of money a bank can lend to any single borrower. For national banks, the maximum unsecured loan is 10 percent of the bank‘s capital and surplus account. frequently, corporate credit needs exceed an individual bank‘s loan limit, and a group of banks (consortium) has to be assembled to make the loan. However, this takes time and requires lengthy and complicated negotiations. Using the paper market is generally much faster than trying to hammer out a loan agreement among several parties. Moreover, the ability to issue commercial paper gives a corporation considerable leverage when negotiating with banks. A banker who knows that the customer can draw upon the commercial paper market for funds is more likely to offer advantageous terms on a loan and be more receptive to future customer credit needs..

Advantage Of Issuing Commercial Paper(1)

The several financial advantages to a company able to tap the commercial paper market for funds. Generally, rates on paper are lower than on corporate loans extended by commercial bank. For example, the bank prime rate was consistently at least a full percentage point and sometimes more than two percentage points higher than the rate on six-month dealer paper. This spread between the bank prime rate and the six-month paper rate widened to three or four percentage points in both 1980 and 1981.
Moreover, the effective rate on most commercial loans granted by banks is even higher than the quoted prime rate, due to the fact that corporate borrowers usually are required to keep a percentage of their loans in a bank deposit. This so-called compensating balance requirement is generally 15 to 20 percent of the amounts of the loan. Suppose a corporation borrower $100,000 at a prime interest rate of 15 percent but must keep 20 percent of this amount on deposit with the bank granting the loan. Then the effective loan rate is 18.75 percent (or $15,000\$80,000).

Wednesday, August 26, 2009

Primary versus secondary markets

The financial markets may also be dividend into primary markets and secondary markets. The primary market is for the trading of new securities never before issued. Its principal function is the raising of financial capital to support new investment in buildings, equipment, and inventories. You engage in a primary-market transaction when you purchase shares of stock just issued by a company, borrow money through a new mortgage to purchase a home, negotiate a loan at the bank to restock the shelves of your business, or purchase bonds just issued by the local school district to construct new classrooms.
In contrast, the secondary market deals in securities previously issued. Its chief function is to provide liquidity to security investors-an avenue for converting stocks, bonds, and other securities into ready cash. If you sell shares of stock or bonds you have been holding for some time to a relative or friend or call a broker and place an order for shares currently being traded on the American stock exchange, you are participating in a secondary-market transaction.
The volume of trading in the secondary market is far larger than trading in primary market. However the secondary market does not support new investment. Nevertheless, the primary and secondary markets are closely intertwined. For example, a rise in interest rates or security prices in the secondary market usually leads to a similar rise in the prices or rates on primary-market securities and vice verse. This happens because investors frequently switch from one market to another in response to differences in price and yields. Many financial institutions are active in both markets.

Federal agency securities

for at least the past 50 years, the federal government has attempted to aid certain sectors of the economy which appear to have an unusually difficult time raising funds in the nation‘s money and capital markets. These so-called disadvantaged sectors include agriculture, housing, and small businesses. Dominated by smaller, less-credit-worthy borrowers, these sectors allegedly get "shoved aside" in the race for scare funds by large corporate borrowers and government, especially in periods of tight money. Beginning in the 1920s and 30s, the federal government created several federal agencies to make direct government loans to, or guarantee private loans for, disadvantaged borrowers. today, these federal credit agencies are large enough and, with the government‘s blessing, financially sound enough to compete successfully for funds in the open market and channel those funds to areas of critical social need.

Changing yields on paper issues

Because yields on commercial paper are open-market rates, they fluctuate daily with the ebb and flow of supply and demand forces in the marketplace. In the wide swings between easy and tight money which characterized the 1970s and early 1980s, commercial paper rates fluctuated between extreme highs and lows. For example, in 1977-a year of modest economic growth and moderate credit demands- paper rates averaged only about 5.5 percent. early in 1981,however, when intense credit demands and rapid inflation characterized the economic situation, paper rates ranged upward to nearly 18 percent, or more than three times as high as in 1977. The commercial paper market is highly volatile and difficult to predict. This is why many corporations eligible to borrow there still maintain close working relationships with commercial banks and other institutional lenders.

Tuesday, August 25, 2009

Possible disadvantages of issuing commercial paper

Despite the advantages, there are some risks for corporations that choose to borrow frequently in the commercial paper market. One of these is the risk of alienating banks whose loans might be needed when a real emergency develops. The paper market is highly volatile and sensitive to financial and economic problems. This fact was demonstrated quite convincingly in 1980when Chrysler financial, the finance-company subsidiary of Chrysler Corporation, was forced to drastically cut back its borrowings in the commercial paper market due to the widely publicized troubles of its parent company. At times, it is extremely difficult even for those companies in sound financial condition to raise funds in the paper market at reasonable rates of interest. It helps to have a loyal and friendly banker available to supply emergency credit when the market turns sour. Another problem lies in the fact that commercial paper cannot be paid off at the issuer‘s discretion but generally must remain outstanding until it reaches maturity. In contrast, many bank loans permit early retirement without penalty.

Dealers in the commercial paper

The market is relatively concentrated among a handful of dealers who account for the bulk of all trading activity. the top commercial paper dealers today include Goldman Sachs&co.;A.G. Becker,Inc.; the first Boston Corporation, Lehman Brothers; and Merrill Lynch, Pierce, Fenner and Smith. Dealers maintain inventories of unsold new issues or repurchased paper but usually expect to turn over all their holdings within a week to 10 days. Like dealers in U.S. government securities, commercial-paper dealers draw upon repurchase agreements (RPs) and demand loans from banks to help finance their inventory positions. They pay interest rates which usually are only a few basis points higher than on RPs collateralized by U.S. treasury securities.

Principal investors in the commercial paper market

The most investors in the commercial paper market include non-financial corporations, money market funds, bank trust departments, smaller commercial banks, pension funds, and insurance companies. In effect, this is a market where corporations borrow from other corporations. These investor groups regard commercial paper as low-risk outlet for their surplus funds.
A recent innovation in the direct paper market is the master note, most frequently issued to bank trust department and other "permanent" money market investors. Under a master note agreement, the investing company notifies the issuing company how much paper it will purchase each day up to an agreed-upon maximum amount. Interest owed is figured on the average daily volume of paper taken on by the investor during the current month. The prevailing interest rate on six-month commercial paper generally is used to determine the appropriate rate of return.

maturities of commercial paper

Maturities on commercial paper range from three days ("weekend paper) to nine months. Most commercial notes carry an original maturity of 60 days or less, with an average maturity ranging from 20 to 45 days. Commercial paper is generally not issued for longer maturities than 270 days since, under the provisions of the securities Act of 1933, any security sold in the open market for a longer term must be registered with the Securities and Exchange Commission.
Yields to the investor are calculated by the bank discount method as in the case of treasury bills. Like T-bills, most commercial paper is issued at a discount from par, and the investor‘s yield stems from the price appreciation of the security between purchase date and maturity date. However, coupon-bearing paper is also available. The minimum denomination is usually $25,000, and the notes typically are issued in bearer form. New issues generally average about $2 million each in total amount. Payment is made at maturity upon presentation to the particular bank listed as agent on the front of the note. Settlement in federal funds usually made the same day the note is presented for payment.

Types of commercial paper(2)

Directly placed paper must be sold in large volume to cover the substantial costs of its distribution and marketing. On average, each direct issuer has between $600 and $700 million outstanding at any one time and will usually borrow at least $100 million per month. While issuers of direct paper do not have to pay dealer's commissions and fees, these companies must operate a marketing division to maintain constant contact with active investors. Sometimes direct issuers must sell their paper even when they have no need for funds. This is the price of maintaining a good working relationship with active investor groups. These companies also cannot escape paying fees to banks for supporting lines of credit, to rating agencies who rate their paper issues, and to agents (usually banks) who dispense required payments and collect funds.
The other major variety of commercial paper is dealer paper, issued by securities dealers on behalf of their corporate customers. Also Known as industrial paper, dealer paper is issued mainly by non-financial companies as well as by smaller bank holding companies and finance companies. The issuing company may sell the paper directly to the dealer, who buys it less discount and commission and then attempts to sell it at the highest possible price in the market. Alternatively, the issuing company may carry all the risk, with the dealer agreeing only to sell the issue at the best price available less commission (often refereed to as a best efforts basis). Finally, the open-rate method may be used, in which the borrowing company receive some money in advance but the balance depends upon how well the issue sells in the open market

Types of commercial paper(1)

There are two major types of commercial paper-direct paper and dealer paper.
The main issuers of direct paper are large finance companies and bank holding companies, who deal directly with the investor rather tan using a securities dealer as an intermediary. These companies, which regularly extend installment credit to consumer and large working-capital loans and leases to businesses firm, announce the rates they are currently paying for various maturities. Investors then select those maturities which most closely approximate their expected holding periods and buy the securities directly from issuer.
Leading finance-company borrowers in the direct paper market include General Motors Acceptance Corporation, CIT Financial Corporation, commercial credit corporation, and general electric credit corporation. The lending bank holding companies which issue commercial paper are centered around the largest banks in New York, Chicago, San Francisco, and other major U.S. Cities. Today, about 80 financially oriented U.S. companies' account for nearly all the directly placed paper, with finance companies issuing approximately three fourths of the total. All of these firms have an ongoing need for huge amounts of short-term money; posses top credit ratings, and have established working relationship with major institutional investors in order to rapidly place their new note issues.

how Acceptances Arise (2)

The foreign bank which has now acquired the time draft from the exporter will forward it to the bank issuing the original letter of credit. The issuing bank checks to see that the draft is correctly drawn and then stamps "accepted" on its face. two things happen as a result of this actions: (1) a banker‘s acceptance- a high-quality, negotiate money market instrument-has been created; and (2) the issuing bank has acknowledged a debt which must be paid in full at maturity. Frequently, the issuing bank will discount the new acceptance for the foreign bank which sent it and credit that bank‘s correspondent account. The acceptance may then be held as an asset or sold to a dealer. Meanwhile, shipping documents are handed to the importer against a trust receipt, permitting the importer to pick up and distribute the goods. However, under the terms of the letter of credit, the importer must deposit the proceeds from selling these goods at the issuing bank in sufficient time to pay for the acceptance. When the time draft matures, the acceptance will be presented for payment by its holder.
it should be clear that all three principal parties to the acceptance transaction-the exporter, importer, and issuing bank-benefit from this method of financing international trade. The exporter receives funds with little or no delay. the importer, however, may delay payment for a time until the related bank line of credit expires. the issuing bank regards the acceptance as a readily marketable financial instruments which can be sold before maturity to an acceptance dealer in order to cover short-term cash needs. However, there are costs associated with all of these benefits. A discount fee is charged off the face value of the acceptance whenever it is discounted in advance of maturity. And the accepting bank earns a commission, which may be paid by either exporter or importer.

how Acceptances Arise (1)

trade acceptance usually begin when an importer goes to a bank to secure a line of credit to pay for A shipment of goods from aboard. Once the line of credit is approved, the bank will issue an irrevocable letter of credit in favor of the foreign exporter. this document authorizes the exporter to draw a time draft for a specified amount against the issuing bank.
because the latter of credit authorizes the drawing of a time draft and not a sight draft ( which is payable immediately upon presentation), the exporter must wait until the draft matures (perhaps as long as six months) to be paid. however, such a delay is unacceptable for most export firms. they must meet payrolls, purchase inventories, pay taxes, and safety other near-term obligations.moreover, the time draft will generally be redeemed in the home currency of the issuing bank, and this particular currency may not be needed by the exporter. A french exporter holding a time draft from U.S. Bank, for example, would be paid in dollars on its maturity date, even though the exporter probably needs francs to pay his employees and meet other expenses. typically, then, exporters will discount the time draft with their own bank, negotiating a reasonable price for it. the exporters then receive immediate payment in local funds and avoid the risks of trading in foreign currencies.

Monday, August 24, 2009

Why acceptances are used in international trade

Acceptances are used in the important and export trade because most exporters are uncertain of the credit standing of the importers to whom they ship goods. Exporters may also be concerned about businesses conditions or political developments in foreign countries. Nations experiencing terrorist violence or even civil war have serious problems in attracting financing for imports of goods and services because of the obvious risks carried by businesses extending credit to them. However, exporters usually are quite content to rely upon acceptance financing by a foreign bank.

Opening and closing a hedge

Suppose an agricultural firm produces a commodity such as wheat and is anticipating a decline in wheat prices. This unfavorable price movement can be hedged by selling futures contracts equal to the current value of the wheat. Sale of these contracts, which promise the future delivery of wheat days, weeks, or months from now, is called "opening a hedge." when the firm does sell its wheat, it can buy back the same number of futures contracts as it sold originally and "close the hedge."
Of course, the firm could deliver the wheat as specified in the original futures contracts. However, this is not usually done. If the price of wheat does decline as expected, then it costs the firm less to repurchase the futures contracts than it originally sold them for. Thus, the profit on the repurchase of wheat futures offsets the decrease in the price of wheat it self. The firm would have perfectly hedged itself against any adverse change in wheat prices over the life of the futures contract.
What would happen if wheat rose in price instead of declined? A perfect hedge would result in a profit on the sale of the wheat itself, but a loss on the futures contract. This happens because the firm must repurchase its futures contract at a higher price than its original cost due to the higher price for wheat.

risk selection through hedging

In the preceding paragraphs we have described a complete (perfect) hedge. Such a hedge is essentially a profitless hedging position. Many speculators and investors, however, are willing to take on added risk by not fully closing a hedge, believing they can guess correctly which way prices are going. Through the future market, the investor can literally "dial" the degree of risk he or she wishes to accept. If the investor wishes to take on all the risk of price fluctuations in the hope of achieving the maximum return, no hedging will take place. On the other hand, risk can be eliminated completely by using a perfect hedge.

Mutual savings banks

Like savings and loans associations, mutual savings banks were started in the United States approximately 150 years ago to meet the financial needs of the small sever. However, unlike savings and loans, which have spread nationwide, mutual; have remained essentially rooted along the eastern seaboard of the United States, where they began. These institutions play an active role in the residential mortgage market, as do savings and loans, but are much more diversified in their investments, purchasing corporate bonds and common stock, making consumer loans, and investing in commercial form their earliest origins mutual savings banks have designed their financial services to appeal to individuals and families. Deposit accounts can be opened for amount as small as one dollar, with transactions carried out by mail or, in many instances, through 24-hour automated tellers in convenient locations. Mutual savings banks in Massachusetts and New Hampshire were the first to develop the interest-bearing now account, perhaps the most important new consumer financial service of the past decade. Many savings banks advertise the availability of family financial counseling service, low-cost insurance, and travel planning as well as a wide variety of savings instruments.

Saturday, August 22, 2009

government regulation of loans, investment , and dividends

Credit unions, like commercial banks, are heavily regulated in the services they are permitted to offer, the rates charged for credit, and dividends paid on deposits. Under current federal regulations, these institutions are permitted to make unsecured loans, including credit-card loans, not exceeding 5 years to maturity or secured loans out to 30 years. However, the interest rates on these loans cannot exceed 21 present annually on the unpaid balance. loans to officers and directors of the credit union cannot exceed $2.500 without approval of each association‘s board of directors.
association‘s permissible investments are limited to a list prescribed by either state or federal regulations. In the main, credit unions are permitted to acquire U.S. government securities; make loans to other credit unions not exceeding 25 percent of their capital and surplus; hold savings deposits at savings and loan associations, mutual savings banks, and federally insured credit unions; and purchase selected federal agency securities. Credit unions rely heavily on U.S. government securities and savings deposits in other financial institutions to provide liquidity in order to meet deposit withdraws and accommodate member credit needs.
credit unions pay dividends to their members, who are technically owners rather than credits of the association. These dividend payments may be paid only if sufficient revenues are available after all expenses are met. The maximum annual dividend payable by an association is 7 present. Credit unions are labeled nonprofit associations doing business only with their owners and therefore are classified as tax-exempt mutual organizations. To qualify for tax exemption, however, all earnings except those flowing to equity reserves must be paid out to members.

A strong competitive force for credit unions

Credit unions today represent stiffer competition for commercial banks, savings banks, finance companies, and other financial institutions serving the consumer than was true in the past. Today, one out of every six Americans belongs to a credit union- roughly double the proportion a decade earlier. During the 1960s and 1970s the industry repeatedly demonstrated its capacity for innovation and the ability to compete successfully for both installment loans and small savings accounts. With the authority recently granted associations by the depository institutions deregulation and monetary control Act and by other federal and state laws to make long-term mortgage loans and offer credit cards, transactions accounts, and higher-yielding savings certificates, the credit union is likely to be an even more significant competitive force in offering consumer credit and savings plans in the years ahead.

Credit union membership

Credit unions are organized around a common affiliation or common bond among their members. Most credit union members work for the same employer or for one a group of related employers. In most cases if one family belongs to a credit unions. Other family members are eligible as well. Occupation-related credit unions accounts for about four fifths of all U.S. credit unions. A bout one sixth of American credit unions are organized around a nonprofit association, such as a labor union, a church, or a fraternal or social organization. Common area of residence, such as a city or state, has also been used in recent years as a base from which to get credit unions started.

Size of the credit union

There is strong shift today toward smaller numbers of credit union. For example the number of associations reached an all-time high in 1969 at almost 24,000 and now totals less than 22,000. Meanwhile, the average credit union has increased significantly in size. For example, in 1970 only about one sixth of the nation‘s credit unions held more than $1 million in assets, but today that figure exceeds 40 percent.
The average-size credit union remains relatively small compared with other depository financial institutions, however. Nevertheless, credit union membership continues to grow rapidly, increasing about 3 million a year. There were fewer than 5 million U.S. credit union members in 1950, but this total exceeded 45 million in 1980. Worldwide, there are more than 55 million members associated with 45,000 credit unions operating in 69 countries.

Chartering and regulation of the credit union

In the United States credit unions are charted and regulated at both state and federal levels. Today about 55 percent of all credit unions are charted by the federal government and the remainder by the states. Federal credit unions have been regulated since 1970 by the National credit union (NCUA), an independent agency within the federal government. Deposits are insured by the national credit union share insurance fund (NCUSIF) up to $100,000. State-charted credit union may qualify for federal insurance if they conform to NCUA‘S regulations.

the Comptroller of the Currency

The Comptroller of the Currency-also known as the Administrator of National Banks- is division of the United States treasury, established under the national banking act of 1863. The comptroller has the power to issue federal charters for the creation of national banks. These banks are subject to an impressive array of regulations, most of which pertain to the kinds of loans and investments that may be made and the amount and types of capital which each bank must hold. all national Banks are examined at least once each year by the comptroller‘s staff.
In chartering new national banks the comptroller reviews all charter applications for the adequacy of their capital, the earnings potential of the proposed bank, the character of its management, and the convenience and needs of the community to be served. Similar criteria are applied to applications from existing national banks to open new branch office, merge, or from holding companies.

What is a Eurodollar?

Because the dollar is the chief international currency today, the market for Eurodollar dominates the Eurocurrency markets. What are Eurodollars? Eurodollars are deposits of U.S. dollars in banks located outside the United States. The banks in question record the deposits on their books in U.S. dollars, not in the home currency. While the large majority of Eurodollar (and other currency) deposits are held in Europe, these deposits have spread worldwide, and Europe‘s share of the total is actually declining.
Frequently, banks accepting Eurodollar deposits are foreign branches of American banks. For example, in the city of London-the center of the Eurocurrency market today-branches of American banks outnumber British banks and bid aggressively for deposits denominated in U.S. dollars. Many of these funds will then be loaned to the home office in the states to meet reserve requirements and other liquidity needs. The remaining funds will be loaned to private corporations and governments abroad who have need of U.S. dollars.
No one knows exactly how large the Eurodollar market is. One reason is that the market is almost completely unregulated. Moreover, many international banks refuse to disclose publicly their deposit balances in various currencies. Another reasons for the relative lack of information on market activity is that Eurocurrencies are merely bookkeeping entries on a bank ‘S ledger and not really currencies at all. You cannot put Eurodollars in your pocket like bank notes. Moreover, Eurodollar deposits are continually on the move in the form of loans. They are employed to finance the import and export of goods, to supplement government tax revenue, to provide working capital for the foreign operations of U.S. multinational corporations, and, as we noted earlier, to provide liquid reserves to the largest banks headquartered in the United States.
One recent estimate for mid-1980 drawn from figures compiled by Morgan guaranty trust company in New York gave the gross size of the entire Eurocurrency market at $1,470 billion. The term gross in this instance means the sum of all foreign-currency –denominated liabilities outside the country of the currency‘s origin. The net size of the Eurocurrency market, netting out deposits owned by Eurocurrency banks, was estimated at close to $700 billion. Because Eurodollar represent about three quarters of all Eurocurrency liabilities, the gross size of the Eurodollar market would be about $1,100 billion, while the net total is probably close to $500 billion. Figures of this magnitude would make the Eurodollar market the largest of all money markets.

Friday, August 21, 2009

Why hedging can be effective?

The hedging process can be effective in transferring risk because prices in the spot (or cash) market for commodities securities are generally correlated with prices in the futures (or forward) market. Indeed, the price of a future contracts in today‘s market represent an estimate of what the spot (or cash) market price will be on the contract's delivery date. Hedging essentially means adopting equal and apposite positions in the spot and futures markets for the same asset.

Benefits and costs of the Eurodollar market

The development of Eurodollar trading has resulted in substantial benefits to the international community and especially to U.S. banks and multinational corporations. The market ensures a high degree of funds mobility between international capital markets and provides a true international market for bank and non-bank liquidity adjustments.It has provided a mechanism for absorbing huge amounts of U.S. dollars flowing overseas and generally lessened international pressure to forsake the dollar for gold and other currencies.
The market reduces the costs of international trade by providing an efficient method of economizing on transactions balances in the world‘s most heavily traded currency, the dollar. Moreover, it acts as a check on domestic monetary and fiscal policies, especially on the European continent, and encourages international cooperation in economic policies because interest-sensitive traders in the market will quickly spot interest rates that are out of line and move huge a mounts of funds quickly to any point on the global.
Central banks, such as the bank of England, the Bundesbank, and the Federal Reserve System, monitor the Eurodollar market continuously in order to moderate heavy inflows or outflows of funds which may damage their domestic economics.
The capacity of Eurocurrency market to quickly mobilize massive amounts of funds has brought severe criticisms of this market from central bankers in Europe and from certain government officials, economists, and financial analysts in the United States. They see the market as contributing to instability in currency values, particularly when Eurocurrency trading places severe downward pressure on the dollar and other key trading currencies. As noted above, the market can wreak havoc with monetary and fiscal policies designed to cure domestic economic problems. This is especially true if a nation is experiencing severe inflation and massive inflows of Eurocurrency occur at the same time. The net effect of Eurocurrency expansion, other things equal, is to push domestic interest rates down, stimulate credit expansion, and accelerate the rate of inflation. The ability of local authorities to deal with inflationary problems might be completely over whelmed by a Eurocurrency glut. This danger is really the price of freedom, for an unregulated market will not always conform to the plans of government policy makers.
It is not surprising that certain European central banks have for more than a decade called for controls on Eurocurrency trading. One of the most frequently heard proposals is to impose reserve requirements on Eurodollar deposits. For example, during the 1970s France levied a 9.5 percent reserve requirement on Eurodollar loans. But such controls have not really been effective because of unanimity among foreign governments and central banks. Funds tend to flow away from areas employing controls and toward free and open markets. The key to the future of controls in this market probably rests with the bank of England, because London is the heart of the Eurodollar market. And thus far, the Old Lady of Threadneadle Street, as that bank is often called, remains firmly against significant government restraints on Eurocurrency trading.

The supply of Eurodollars

Where does Eurodollar come from? A major factor in market‘s growth has been the enormous balance-of-payments deficits which the United States has run since the late 1950s. American firms building factories and purchasing goods and services abroad have transferred ownership of dollar deposits to foreign companies, banks, and governments. Domestic shortages of oil and natural gas have forced the United States to import from a third to 40 percent of its petroleum needs generating an enormous outflow of dollars to oil-producing nations. The OPEC countries, for example, accept dollars in payment for crude oil and use the dollar as standard for valuing the oil they sell. American tourists visiting Europe, Japan, Singapore, and the middle East frequently use dollar-denominated traveler‘s checks or take U.s. currency with them and convert it into local currency overseas. Dollar loans made by U.S. Corporation and foreign-based firms have added to the vast Eurodollar pool. Many of these dollar deposits have gravitated to foreign central banks, such as the bank of England and the Bundesbank in the Federal Republic of Germany, as these institutions have attempted to support the dollar and their own currencies in international markets.

Thursday, August 20, 2009

Eurodollar maturities

Most Eurodollar deposits are short term (ranging from overnight loans to call money loaned for a few days out to one year) and therefore are true money market instruments. However, a small percentage is long-term time deposits, extending in some instances out to about five years. However, most Eurodollar deposits carry one-month maturities to coincide with payments for shipments of goods. Other common maturities are 2, 3, 6, and 12 months.
Even though Eurobanks do not issues demand deposits, funds move rapidly in the Eurocurrency market from bank to bank in response to the demand for short-term liquidity from corporation, government, and Eurobanks themselves. There is no central trading location in the market. Traders may be thousands of miles distant from each other, conducting negotiations by cable, telephone, or telex with written confirmation coming later. Funds normally are transferred on the second business day after an agreement is reached through correspondent banks.
Eurocurrency deposits are known to be volatile and highly sensitive to fluctuations in interest rates. A slight difference in interest rates on currency values between two countries can cause a massive flow of Eurocurrencies across national boundaries. One of the most famous examples of this phenomenon occurred in West Germany in 1971, when speculation that the German mark would be up valued brought an inflow into Germany of more than $5 billion in a few days, forcing the West German government to cut the mark loose from its officials exchange value and allow that currency to float.

convertible preferred stock

Convertible preferred stock is similar in conversion features and market behavior to controvertible bonds. Each share of convertible preferred is usually exchangeable for fixed number of shares (or fractional shares) of common stock issued by the same company. unlike convertible bonds, convertible preferred represents an ownership share in a company and will earn nothing if the firm‘s board of directors decide not to vote a dividend. Moreover, in the event of liquidation, preferred stockholders have a lower-priority claim on the issuing company‘s assets than do bondholders and general creditors. Therefore, convertible preferred stock is generally regarded as more risky investment than convertible bonds.
Nevertheless, preferred shares offer the potential for greater price appreciation than do most convertible bonds and a greater guarantee of annual income than is available with common stock issued by the same company. Issues of convertible preferred have grown quite rapidly in recent years, and more than 200 issues are now listed on the New York stoke exchange. Among the more prominent companies which have issued convertible preferred in the recent past are American Telephone &Telegraph, the Columbia Broadcasting System, household finance Corporation, Occidental petroleum, RCA, and union oil of California.

Wednesday, August 19, 2009

calculating the yield on treasury bills

Treasury bills do not carry a promised interest rate but instead are sold at a discount from par. Thus, their yield is based on their appreciation in price between the time the bills are issued and the time they mature or are sold by the investor. Any price gain actually realized by the investor is treaded, not as a capital gain, but as ordinary income for federal tax purposes. We will see in the next topic that the rate, or yield, on most debt instruments is calculated as a yield to maturity. However, bill yields are determined by the bank discount method, which ignores the compounding of interest rates and uses a 360-day year for simplicity.
The bank discount rate (DR) on bills is given by the following formula:
DR = (per value-purchase price ÷ par value ) × (360÷ number of days to maturity)

How treasury bills are sold?

Treasury bills are sold using the auction technique. The marketplace, Not the U.S. treasury, sets bill prices and yields. A new regular bull issue is announced by the treasury on treasury of each week, with bids from investor due the following Monday at 1:30 p.m., eastern standard time (unless a federal holiday intervenes). Interested investors fill out a form tendering an offer to the treasury for a specific bill issue at a specific price. These forms must be filed by the Monday deadline with one of the 37 regional Federal Reserve banks or branches. The interested investor can appear in person at a Federal Reserve Bank or branch to fill out a tender from, submit the form by mail, or place an order through a security broker or bank.
the treasury will entertain both competitive tenders typically are submitted by large investors, including commercial banks and government securities dealers, who buy several million dollars worth at one time. Institution submitting competitive tenders bid aggressively for bills, trying to offer the treasury a price high enough to win an allotment bills but not too high, because the higher the price bid, the lower the rate of return. Noncompetitive tenders (normally less than $500,000 each) are submitted by small investors who agree to accept the average price set in the weekly or monthly bill auction. Generally, the Treasury fills all noncompetitive tenders for bills.
In the typical bill auction, Federal Reserve officials open all the bids at the designated time and array them from the highest down to the lowest price.
For example, a typical series of bids in a Treasury bill auction might appear as follows:

Note that all bids are expressed on a $100 basis as though T-bills have a$100 par value. In fact, the minimum denomination for bills is $10,000, and they are issued in multiples of $5,000 above that minimum. The highest bidder (in this case the one offering tTreasury bills are sold using the auction technique. The marketplace, Not the U.S. treasury, sets bill prices and yields. A new regular bull issue is announced by the treasury on treasury of each week, with bids from investor due the following Monday at 1:30 p.m., eastern standard time (unless a federal holiday intervenes). Interested investors fill out a form tendering an offer to the treasury for a specific bill issue at a specific price. These forms must be filed by the Monday deadline with one of the 37 regional Federal Reserve banks or branches. The interested investor can appear in person at a Federal Reserve Bank or branch to fill out a tender from, submit the form by mail, or place an order through a security broker or bank.
the treasury will entertain both competitive tenders typically are submitted by large investors, including commercial banks and government securities dealers, who buy several million dollars worth at one time. Institution submitting competitive tenders bid aggressively for bills, trying to offer the treasury a price high enough to win an allotment bills but not too high, because the higher the price bid, the lower the rate of return. Noncompetitive tenders (normally less than $500,000 each) are submitted by small investors who agree to accept the average price set in the weekly or monthly bill auction. Generally, the Treasury fills all noncompetitive tenders for bills.
In the typical bill auction, Federal Reserve officials open all the bids at the designated time and array them from the highest down to the lowest price.
For example, a typical series of bids in a Treasury bill auction might appear as follows:
Hypothetical bid price for three-months U.S. Treasury bills
$ 99.113
$ 98.985
Note that all bids are expressed on a $100 basis as though T-bills have a$100 par value. In fact, the minimum denomination for bills is $10,000, and they are issued in multiples of $5,000 above that minimum. The highest bidder (in this case the one offering to pay $99.155) receives his bills, and those who bid successively lower prices also receive their bills, until all available securities have been allocated.
The lowest price at which at least some bills are awarded is called the stop-out price. Let‘s suppose that this is a price of $97.729, the third price from the bottom in the array of prices shown above. No one bidding less than the stop-out price will receive any bills in this particular auction. However, once bills are acquired by successful bidders, many of them will be sold right away in the secondary market, giving the unsuccessful bidders a chance to add to their T-bill portfolio. Payment for bills won in the auction must be made in federal funds, cash, by redeeming maturity bills, or, when permitted by the Treasury, through crediting tax and loan accounts at banks. All bills today are issued only in book-entry form.
o pay $99.155) receives his bills, and those who bid successively lower prices also receive their bills, until all available securities have been allocated.
The lowest price at which at least some bills are awarded is called the stop-out price. Let‘s suppose that this is a price of $97.729, the third price from the bottom in the array of prices shown above. No one bidding less than the stop-out price will receive any bills in this particular auction. However, once bills are acquired by successful bidders, many of them will be sold right away in the secondary market, giving the unsuccessful bidders a chance to add to their T-bill portfolio. Payment for bills won in the auction must be made in federal funds, cash, by redeeming maturity bills, or, when permitted by the Treasury, through crediting tax and loan accounts at banks. All bills today are issued only in book-entry form.

Investors in treasury bills

Principal holders of treasury bills include commercial banks, non-financial corporations, state and local governments, and the Federal Reserve banks. Commercial banks and private corporations hold large quantities of bills as a reserve of liquidity until cash is needed. The most-attractive feature of bills to these institutions is their ready marketability and relatively stable price. The Federal Reserve banks conduct the bulk of their open-market operations in T-bills because of the depth and volume of activity in this market. In fact, bills play a crucial role in the conduct of monetary policy by the Federal Reserve System. The fed purchases and sells bills in an effort to influence other money market interest rates and thereby alter the volume and growth of bank credit and ultimately the total amount of investment spending and borrowing in the economy.

types of Treasury bills

there are several different types of Treasury bills. Regular-series bills are issued routinely every week or month in competitive auctions. Bills issued in the regular series have have original maturities of three months , six months , and one year. New three-and six-months bills are auctioned weekly, while one year bills normally are sold once each month. of these three bill maturities, the six-month bill provides the largest amount of revenue for the Treasury.
on the other hand, irregular-series bills are issued only when the Treasury has a special cash need. these instruments include tax-anticipation bills(TABs), strip bills, and cash management bills. Tax-anticipation bills were issued a number of years ago in an effort to attract the money set aside by corporations to pay their federal taxes. TABs were set up to mature one week after the quarterly date when corporate taxes came due; however, a corporation could redeem TABs at the Treasury for their full face value in payment of its taxes.
A package offering of bills requires investors to bid for an entire series of different maturities, Known as strip bills. investors who bid successfully must accept bills at their bid price each week for several weeks running. cash-management bills consist simply of reopened issues of bills that were sold in prior weeks. the reopening of a bill issue normally occurs when there is an unusual or unexpected need for Treasury cash.

Tuesday, August 18, 2009

U.S . Treasury Bills

Treasury Bills are direct obligations of the United Stated government. by law, they must have an original maturity of one year or less T-bills were first issued by the U.S. Treasury in 1929 in order to cover the federal government‘s frequent short-term cash deficits.
The federal government's fiscal year runs from October 1 to September 30. However, the largest single source of federal revenue, individual income taxes, is not fully collected until April of each year. Therefore, even in those rare years when a sizable federal budget surplus is expected, the government is likely to be sort of cash during the fall and winter months and often in the summer as well. During the spring, personal and corporate tax collections are usually at high levels, and the resulting inflow of funds can be used to retire some portion of those securities issued earlier in the fiscal year. T-bills are well suited to this seasonal ebb and flow of treasury cash since their maturities are short, they find a ready market among banks and other investors, and their prices adjust readily to changing market conditions.

the nominal and real interest rate

To examine the relationship between inflation and interest rate, several key terms must be defined. First, we must distinguish between nominal and real interest rates. The nominal rate is the published or quoted interest rate on a security or loans. For example, an announcement in the financial press that major commercial banks have raised their prime lending rate to 15 percent per annum indicates what nominal interest rate is now being quoted by banks to their most credit-worthy customers. In contrast, the real rate of interest is the return to the lender or investor measured in terms of its actual purchasing power. In a period of inflation, of course, the real rate will be lower than the nominal rate. Another important concept is the inflation premium, which measures the rate of inflation expected by investors in the marketplace during the life of financial instruments.
These three concepts are all related to each other. Obviously, a lender of funds is most interested in the real rate of return on a loan-that is, the purchasing power of any interest earned. For example, suppose you loan $1000 to a business firm or individual for a year and expect prices of goods and services to rise 10 percentages during the year. If you charge a nominal interest rate of 12 percent on the loan, your real rate of return on the $1.000 face amount of the loan is only 2 percentages, or $20. However, if the actual rate of inflation during the period of the loan turns out to be 13 percent, you have actually suffered a real decline in the purchasing power of the monies loaned. In general, lenders will attempt to charge nominal rates of interest which give them desired real rates of return on their loanable funds. And nominal interest rates will change as frequently as lenders alter their expectations regarding inflation

Portfolio decisions by financial intermediaries

In acting as a middleman between savers and borrowers, the management of financial intermediary is called upon daily to make portfolio decisions-what uses to make of incoming funds and what sources of funds to draw upon? A number of factors affect these critical decisions. For example, the relative rates of return and risk attached to different sources and uses of funds will affect the composition of the intermediary ‘S portfolio. Obviously, if management is interested in maximizing profits and has minimal aversion to risk, it will tend to pursue the highest-yielding asset available, especially corporate bonds and stocks. A more risk-averse institution, on the other hand, is likely to surrender some yield in return for the greater safety available in acquiring government bonds and high-quality money market instruments.
The cost, volatility, and maturity of incoming funds provided by surplus budget units also has a significant impact upon the loans and investments made by a financial intermediary. Commercial banks, for example, must derive much of their funds from checking accounts, which are relatively inexpensive but highly volatile. Such an institution will tend to concentrate its lending activities in short-term and medium-term loans in order to avoid an embarrassing and expensive liquidity crisis. On the other hand, a financial institution, such as a pension fund, which receives a stable and predictable inflow of savings, is largely freed from concern over short-run liquidity needs. It is able to invest heavily in stocks, bonds, mortgages, and other long-term assets. Thus, the hedging principle- the approximate matching of the maturity of assets held with liabilities taken on- is an important guide for choosing those financial assets that a financial intermediary will hold in its portfolio.
Decisions by intermediaries on what loans and investments to make and what sources of funds to draw upon are also influenced by the size of the individual financial institution. Larger financial intermediaries frequently can take advantage of greater diversification in sources and uses of funds than smaller institutions. This means that the overall risk of portfolio of securities can be reduced by acquiring securities from many different borrowers.

classification of financial intermediaries

Financial intermediaries may be grouped in a variety of different ways. For example, we can identify depository intermediaries (commercial banks, savings and loan associations, mutual savings banks, and credit unions) and contractual intermediaries (insurance companies and pension funds). Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the public, while contractual intermediaries attract funds by offering legal contracts to protect the saver against risk.
Other methods of classification focus upon the form of organization used by intermediary. For example, mutual organizations (prominent in the insurance industry and among savings and loans, mutual savings banks, and credit union) legally are owned by their policyholders, depositors, or borrowers. In contrast, stockholder-owned intermediaries are owned, as is any private corporation, by their stockholders, and the depositors or policyholders are simply creditors of the organization. Commercial banks, finance companies, investment companies, real estate investment trusts, and some insurance companies and savings and loans are stockholder-owned corporations.
We may also classify an intermediary as a unit, if it operates out of only one office, or a branch, if it conducts its business from several office locations. This distinction is especially important in the commercial banking industry and in savings banking, where both state and federal laws prohibit or restrict some forms of branching activity.
Some authorities find it useful to distinguish between local intermediaries and regional or national intermediaries. A financial institution is local in character if it receives the bulk of its funds and makes a majority of its loans and investment in the surrounding community (usually a city or country area). Most creditors unions, savings and loans, and smaller commercial banks are locally oriented intermediaries. Other financial institutions- especially insurance companies, finance companies, larger commercial banks, pension funds, and investment companies-tend to be regional or national in scope. Their sources of funds, loans, and investment in securities tend to cover wide geographic areas and may even reach into foreign markets. This distinction between local, regional, national, or international intermediaries is especially important in trying to assess the degree of competition prevailing in the financial institution's sector and in evaluating how well each institution is serving the public in its chosen market area.

Monday, August 17, 2009

Principal actors in the foreign market

The motivations for demanding or selling foreign exchange are based in the transactions related to the current and financial accounts. This action involves individuals and institutions of all kinds at the retail level and the banking system at the wholesale level. The major participants in the foreign exchange market are the large commercial banks, although multinational corporations whose day-to-day operations involves different currencies, large nonbank financial institutions such as insurance companies, and various government agencies including central banks such as the U.S. Federal reserve and the European Central Bank also play important roles. Not surprisingly, the large commercial banks play the central role since the buying and selling of currencies most often involves the debiting and crediting of various bank accounts at home or abroad. In fact, most foreign currency transactions take place through the debiting and crediting of bank accounts with no physical transfer of currencies across country borders. Consequently, the bulk of currency transactions takes place in the wholesale market in which these banks trade with each other, the interbank market. In this market a large percentage of these interbank transactions are conducted by foreign exchange brokers who receive a small commission for arranging traders between sellers and buyers. The buying and selling of foreign exchange brokers, but directly with other banks, is called interbank trading. While bank currency transactions are done to meet their various retail customers‘s needs (corporations and individuals alike),banks also enter the foreign exchange market to alter their own portfolio of currency assets.

the role of arbitrage in the foreign exchange market

The foreign exchange market consists of many different markets and institutions. Yet, at any given point in time, all markets tend to generate the same exchange rate for given currency regardless of geographical location. The uniqueneness of the foreign exchange rate regardless of geographical location occurs because of arbitrage. As you recall, arbitrage refers to the process by which an individual purchases a product (in the case foreign exchange) in a low-priced market for resale in a high-priced market for the purpose of making a profit. In the process, the price is driven up in the low-priced market for the purpose of making a profit. In the process, the price is driven up in the low-priced market and down in the high-priced market. This activity will continue until the prices in the two markets are equalized, or until they differ only by the transaction costs involved. Because currency is going bought and sold simultaneously, there is no risk in this activity and hence there are always many potential arbitragers in the market. In addition, because of the speed of communications and the efficiency of transactions in foreign exchange, the spot market quotations for a given currency are remarkably similar worldwide, and any profit spread on a given currency is quickly arbitraged away.
In world of many different currencies, there is also a possibility for arbitrage if exchange rates are not consistent between currencies. This is a situation of multicurrency arbitrage, in this case called triangular arbitrage since it involves an inconsistency between different currencies. The triangular arbitrage produces cross-rate equality, meaning that all three exchange rates are internally consistent. Arbitragers are constantly watching the foreign exchange to take advantage of such a situation. The arbitrage process is thus relied upon not only to maintain a similar individual currency value in different foreign exchange markets but also to make certain that all the cross rates between currencies are consistent.

Saturday, August 15, 2009

accounting information system

An Accounting information system collects and processes transaction date and then disseminates the financial information to interested parties. accounting information systems vary widely form one business to another.
Various factors shape these systems:
- the nature of the businesses and the transactions in which it engages.
- the size of the firm the volume of data to be handled, and
- the information demands that management and other require.
accounting information system helps management answer such question as:
. how mush and what kind of debt is outstanding?
. were sales higher this period than last?
. what assets do we have?
. what were our cash inflows and outflows?
. did we make a profit last period?

Eurodollar interest rate futures(5)

When it is desired to hedge against changes in the interest rate for periods longer than three months, it is possible to do so by acquiring a series of successive future contracts. For example, if someone wished to fix his return for a one-year period starting in September, he would simply purchase a December futures contract, a March futures contract, a June futures contract, and a September future contract. As the December contract came to an end, it would be replaced by (rolled over into) the March contract and that would be rolled over into the June contract and that into the September contract. He would thus be protected against shifts in the overall level of interest rate. This collection of multiple short-term three-month futures contracts to hedge changes in interest rates for a longer period is referred to as a Eurodollar strip. Eurodollar futures can thus be used to hedge as much as seven years out. Another way to hedge a more distant future than is available directly in the futures markets is to acquire a shorter-term futures contract or strip and replace it with new contracts closer to the desired time period as each of the shorter contracts gains in liquidity. For example, you could acquire the strip just discussed, hold it for the first three-month period and roll it over into a new twelve-month strip, and keep doing this until the desired period is attained, say , three years from now . Such hedging wit a short-term futures contract that is subsequently replaced with other contracts is referred to as a stack.
Finally, it has become common to combine interest rate hedges with currency hedges to provide interest rate protection in a particular currency. For example, a eurobanker in France may be faced with needing to guarantee a French customer an interest rate for a future three-month loan in Swiss francs. To do so, the banker would lock in the future Eurodollar interest rate with a Eurodollar futures contract, and then couple that with both a forward contract to buy Swiss francs at the time the loan is made and a forward contract to sell Swiss francs three months later, when the loan is repaid.

Eurodollar interest rate futures(4)

Similarly, potential borrowers in the future can guard against a rise in the borrowing rate by selling a future contract for the period in the future during which they are going to be in need of borrowing funds (that is, a contract to acquire funds at a specific loan rate). This activity is referred to as a short hedge. If interest rates rise by the time that the loan is needed, the seller receives the funds associated with the daily margin adjustment, which can be used to reduce the amount of the necessary loan. The result is that the borrower has the necessary funds over the period needed at approximately the contracted rate because the lower amount of the required borrowing offsets the higher market interest rate. More simply, the gain from future contracts offsets the increased cash borrowing costs. In fact, the borrower actually ends up a slightly lower rate than would have been the case if the same hedge had been made using the forward market. It should be pointed out that the Eurodollar contract is unlikely to provide a perfect hedge since there is unlikely to be a perfect match between the hedging instrument and the financial instrument being hedged. The lack of a perfect hedge is often referred to as basis risk.