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CONTENTS

List of Figures xvi

List of Tables xviii

List of Boxes xxi

Preface xxii

Acknowledgements xxiv

1 The World of Finance 11.1 Introduction 21.2 Financial centres 31.3 The role of a financial centre 31.4 Money markets, capital markets and the banking system 51.5 Services of a financial centre 61.6 The growth of the financial services industry 91.7 The globalization of financial markets 101.8 Technology 111.9 Deregulation 131.10 Financial innovation 141.11 Types of financial innovations 181.12 Emerging markets 181.13 Problems concerning investment in emerging markets 211.14 The future 221.15 Conclusions 24

2 Financial Intermediation and Financial Markets 262.1 Introduction 272.2 Surplus and deficit agents 272.3 What is a financial security? 282.4 Types of financial claims: debt and equity 282.5 The role of financial intermediaries 292.6 Provision of a payments mechanism 302.7 Maturity transformation 302.8 Risk transformation 302.9 Liquidity provision 312.10 Reduction of contracting, search and information costs 322.11 Types of financial markets 322.12 The classification of financial markets 34

Copyrighted material – 9781137515629


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2.13 The role played by financial markets 352.14 Participants in financial markets 362.15 Conclusions 37

3 Financial Institutions 393.1 Introduction 403.2 The central bank 403.3 The implementation of monetary policy 413.4 Management of the national debt 413.5 Supervisory function 413.6 Types of financial intermediaries 433.7 Deposit institutions 433.8 The banking sector 443.9 Savings institutions 453.10 Insurance companies 453.11 The phenomenon of Bancassurance 503.12 Mutual funds or unit trusts 513.13 Investment companies and investment trusts 523.14 Exchange traded funds 533.15 Pension funds 553.16 Hedge funds 563.17 Private equity 573.18 Specialist financial institutions 603.19 Venture capital companies 613.20 Finance companies or finance houses 613.21 Factoring agencies 623.22 The role of financial institutions 623.23 Conclusions 65

4 Monetary Policy and Interest Rate Determination 674.1 Introduction 684.2 The functions of money 684.3 Bills and bonds 694.4 The operation of monetary policy 704.5 Monetary policy in practice and the announcement effect 734.6 The commercial banking system and the narrow and broad money supply 754.7 Formula for the money multiplier 774.8 Controlling the money supply 784.9 The determination of interest rates 794.10 The loanable funds approach to interest rate determination 814.11 Money market or loanable funds theory? 834.12 Inflation and interest rates 834.13 Fiscal policy and interest rates 854.14 Other factors influencing the interest rate 864.15 Theories of the yield curve 864.16 Expectations theory 874.17 Liquidity preference theory 894.18 Preferred habitat theory 90



C O N T E N T S ix

4.19 Market segmentation theory 904.20 The importance of alternative views of the term structure 914.21 Problems with monetary policy 914.22 Conclusions 92

5 Domestic and International Money Markets 945.1 Introduction 955.2 Types of domestic money market instruments 955.3 Treasury bills 955.4 Commercial paper 975.5 The interbank market 975.6 Banker’s acceptances 1005.7 Repurchase agreements 1015.8 Certificates of deposit 1015.9 The international money market 1025.10 Euromarkets 1025.11 The origins and development of the Euromarkets 1025.12 The characteristics of the Eurodollar market 1045.13 The competitive advantage of Eurobanks 1065.14 The coexistence of domestic banking and Eurobanking 1085.15 The creation of Eurodeposits 1095.16 The pros and cons of the Eurocurrency markets 1105.17 Syndicated loans 1105.18 Euronotes 1115.19 Conclusions 112

6 The Domestic and International Bond Market 1146.1 Introduction 1156.2 Trading in government bonds 1156.3 Determining the price of government bonds 1166.4 Clean and dirty bond prices 1176.5 The current yield 1176.6 The simple yield to maturity 1186.7 Yield to maturity 1186.8 The par value relation 1196.9 Bond price volatility 1216.10 Duration 1226.11 Modified duration 1236.12 The duration for a portfolio of bonds 1256.13 A formula to calculate duration 1266.14 Duration and the problem of curvature of the bond–price relationship 1266.15 The usefulness of the duration measure 1276.16 Yield curves 1286.17 Corporate bonds 1286.18 Credit ratings 1296.19 Risks associated with corporate bonds 1336.20 Financial innovation and corporate bonds 1336.21 Junk bonds 135



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6.22 Medium-term notes 1366.23 The international capital market 1366.24 Motivations behind international capital flows 1376.25 The origins and development of the Eurobond market 1376.26 Typical features of a Eurobond 1386.27 Control and regulation of the Eurobond market 1406.28 The management of a Eurobond issue 1416.29 Innovations in the Eurobond market 1426.30 Conclusions 144

7 Portfolio Analysis: Risk and Return in Financial Markets 1477.1 Introduction 1487.2 Determining the price of a financial asset 1487.3 The rate of return on a security 1497.4 The variance and standard deviation of the rate of return 1507.5 Risk on a security 1517.6 Covariance and correlation of rates of return 1527.7 Different types of investors 1537.8 The indifference curves of risk-averse investors 1547.9 Portfolio theory 1557.10 Reducing risk through diversification 1557.11 Measuring risk on a portfolio 1567.12 The two-asset efficiency frontier 1587.13 The minimum variance portfolio in the two risky assets case 1597.14 The portfolio efficiency frontier 1607.15 Market risk and specific risk 1637.16 The efficient set with a riskless security 1657.17 The market portfolio 1667.18 The market price of risk 1687.19 Measuring the market index 1687.20 Conclusions 169

8 The Capital Asset Pricing Model 1728.1 Introduction 1738.2 The market model 1738.3 Portfolio risk and return using the market model 1758.4 The capital asset pricing model 1768.5 Assumptions of the CAPM 1768.6 The theory behind the CAPM 1778.7 Expressing the CAPM in risk premium form 1798.8 The securities market line 1808.9 The CAPM in action: measuring the beta coefficient 1828.10 Empirical testing of the CAPM 1848.11 The empirical evidence on the CAPM 1888.12 The multifactor CAPM 1898.13 The arbitrage pricing theory (APT) critique of the CAPM 1908.14 Conclusions 191



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9 Stockmarkets and Equities 1959.1 Introduction 1969.2 The major international stockmarkets 1969.3 Stockmarket participants 1999.4 The primary and secondary markets 1999.5 Different types of equity 2009.6 The buying and selling of shares 2039.7 A rights issue 2039.8 A simple model of the pricing of a rights issue 2069.9 Does the performance of the stockmarket matter? 2069.10 The pricing of equities 2079.11 The dividend pricing approach 2089.12 The Gordon growth model 2089.13 A non-constant growth version of the dividend discount model 2109.14 The dividend irrelevance theorem 2119.15 Measurement of the required rate of return 2119.16 The subjectivity of share pricing 2129.17 Forecasting future dividends: business risk and the effects of gearing 2139.18 Debt or equity finance? 2189.19 Other approaches to equity valuation: financial ratio analysis 2199.20 The usefulness of financial ratios 2239.21 Conclusions 224

10 The Efficiency of Financial Markets 22710.1 Introduction 22810.2 Three levels of efficiency 22910.3 The efficient market hypothesis and a random walk 22910.4 Implications of various forms of efficiency tests 23110.5 Active versus passive fund management 23210.6 Testing for weak market efficiency 23210.7 Tests of the random walk hypothesis 23210.8 Filter rule tests 23210.9 Other statistical tests 23410.10 The day-of-the-week effect 23410.11 The January effect 23410.12 The winner–loser problem 23510.13 Testing for semi-strong market efficiency 23610.14 The results of event studies 24010.15 The size effect 24110.16 The price–earnings effect 24110.17 The earnings-announcement effect 24110.18 Stockmarket crashes 24210.19 Testing the strong form of market efficiency 24310.20 Directors’/managers’ share purchases 24310.21 Information content of analysts’ forecasts 24310.22 Conclusions 244



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11 The Foreign Exchange Market 24611.1 Introduction 24711.2 Exchange rate definitions 24711.3 Characteristics of and participants in the foreign exchange market 24811.4 Arbitrage in the foreign exchange market 25011.5 The spot and forward exchange rates 25211.6 A simple model for determining the spot exchange rate 25411.7 Alternative exchange rate regimes 25711.8 Determination of the forward exchange rate 26311.9 Nominal, real and effective exchange rate indices 26611.10 Conclusions 273

12 Theories of Exchange Rate Determination 27512.1 Introduction 27612.2 Purchasing power parity theory 27712.3 Absolute PPP 27712.4 Relative PPP 27812.5 Measurement problems in testing for PPP 27812.6 Empirical evidence on PPP 28012.7 Summary of the empirical evidence on PPP 28512.8 Explaining the poor performance of purchasing power parity 28512.9 Modern theories of exchange rate determination 28712.10 Uncovered interest rate parity 28712.11 Monetary models of exchange rate determination 28812.12 The flexible price monetary model 28912.13 The Dornbusch sticky price monetarist model 29312.14 A simple explanation of the Dornbusch model 29312.15 A formal explanation of the Dornbusch model 29512.16 A money supply expansion and exchange rate overshooting 29812.17 Importance of the Dornbusch overshooting model 30012.18 The Frankel real interest rate differential model 30012.19 Conclusions 303

13 Financial Futures 30513.1 Introduction 30613.2 The growth of futures exchanges 30613.3 Comparison between futures and forward contracts 30713.4 Exchange traded derivative contracts versus the over-the-counter market 30913.5 Trading in exchange futures contracts 30913.6 The role of the clearing house 31013.7 Open interest and reversing trades 31013.8 Stock index futures 31113.9 The symmetry of profits/losses on futures/forward positions 31613.10 The pricing of stock index futures 31813.11 Short-term interest rate futures 31913.12 The pricing of a Euribor interest rate futures contract 32113.13 Using interest rate futures 322



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13.14 Bond futures contracts 32313.15 Currency futures 32513.16 The pricing of currency futures 32613.17 Conclusions 327

14 Options 33014.1 Introduction 33114.2 The growth of options markets 33114.3 Options contracts 33114.4 A call option contract 33214.5 A put option contract 33414.6 Stock index options 33714.7 Interest rate options 33814.8 Currency options 33914.9 The uses of options contracts 34014.10 Differences between options and futures contracts 34214.11 A currency option versus a forward contract for hedging 34214.12 A currency option versus a forward contract for speculating 34414.13 Options strategies 34514.14 Exotic options 34814.15 Conclusions 349

15 Option Pricing 35215.1 Introduction 35315.2 Principles of option pricing 35315.3 Intrinsic value and time value 35415.4 The distribution of the option premium between time and intrinsic value 35515.5 The Black–Scholes option pricing formula 35915.6 Different measures of volatility 36315.7 The calculation of historical volatility 36315.8 Problems with the Black–Scholes option pricing formula 36515.9 The sensitivity of options prices 36515.10 Put–call parity 36615.11 Conclusions 369

16 Swap Markets 37316.1 Introduction 37416.2 Potential swap scenarios 37416.3 An interest rate swap 37716.4 A currency swap agreement 38016.5 The role of the intermediary in the swap 38416.6 The secondary market in swaps 38516.7 Distinguishing characteristics of the swap market from the forward

and futures markets 38616.8 Reasons for the existence of the swap market 38716.9 Innovations in the swap market 38716.10 Conclusions 388



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17 Financial Innovation and the Credit Crunch 39017.1 Introduction 39117.2 Financial innovation: collateralized debt obligations and credit default swaps 39217.3 Special purpose vehicle/special purpose entity 39517.4 A structured investment vehicle 39617.5 Credit derivatives and credit default swaps 39717.6 The pricing of credit derivatives 40317.7 The credit crunch 40517.8 Causes of the credit crunch 40817.9 Legislative changes and deregulation 40817.10 Deterioration in bank lending standards and adverse selection 41117.11 Increase in household indebtedness 41217.12 Financial innovation and the credit rating agencies 41317.13 Increased leverage in the financial system 41317.14 Mispricing of risk 41417.15 Incentive structures and risk management practices in the banks 41517.16 The response to the credit crunch 41617.17 Cuts in official short-term interest rates 41917.18 Liquidity provision 41917.19 Quantitative easing 42117.20 Fiscal stimulus 42217.21 Bailouts of financial institutions 42317.22 Bank stress tests 42417.23 Regulatory response 42617.24 The UK response 42917.25 Fines 43417.26 Conclusions 435

18 Regulation of the Financial Sector 43918.1 Introduction 44018.2 The rationale for government intervention 44018.3 The objectives of government regulation 44218.4 Types of government regulation 44218.5 Regulation of the banking sector 44418.6 Statutory regulation versus self-regulation 44618.7 Regulation in the UK 44618.8 Big bang, 1986 44718.9 The Financial Services Act 1986 44818.10 The Banking Act 1987 44918.11 The Bank of England Act 1998 44918.12 Financial Services and Markets Act 2000 45018.13 Banking Act 2009 45018.14 The Financial Services Act 2013 45018.15 European regulation 45218.16 The First Banking Directive 1977 45418.17 The Second Banking Directive 1989 45518.18 The creation of a European Banking Union 455



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18.19 International regulation: the Basel I Accord 1988 45718.20 The Basel II Accord 2004 45918.21 The Basel III Accord 2011–19 46018.22 Issues for regulatory reform raised by the credit crunch 46118.23 Conclusions 462

Glossary 464References 487Bibliography 491Index 495



1

1.1 Introduction

1.2 Financial centres

1.3 Th e role of a fi nancial centre

1.4 Money markets, capital markets and the banking system

1.5 Services of a fi nancial centre

1.6 Th e growth of the fi nancial services industry

1.7 Th e globalization of fi nancial markets

1.8 Technology

1.9 Deregulation

1.10 Financial innovation

1.11 Types of fi nancial innovations

1.12 Emerging markets

1.13 Problems concerning investment in emerging markets

1.14 Th e future

1.15 Conclusions

THE WORLD OF FINANCE

1

Learning objectives

In this chapter you will learn about:

the various statistics on international fi nancial markets

the various forces for change in international fi nancial markets

the role of fi nancial centres such as London, New York and Tokyo

the globalization of fi nancial markets

the various types of fi nancial innovation

the growing importance of emerging markets



2 F I N A N C E A N D F I N A N C I A L M A R K E T S

1.1 IntroductionThe world of finance has changed beyond all recognition over the last few decades, and among the most important changes have been:

1 the so-called globalization of the world of finance with literally trillions of dollars swirling around the global financial markets;

2 the unprecedented increase in the volume of funds and the size of the financial services industry;

3 the growing institutionalization of markets with funds increasingly managed on behalf of individual investors by pension funds, unit trusts/mutual funds, insurance companies, hedge funds and the like;

4 the range of new instruments traded, such as junk bonds, collateralized debt obligations (CDOs), credit default swaps (CDS), and derivative instruments such as futures, options and swaps;

5 the use of new technology which has permeated the financial industry from delivery of services, creation of new products and trading of financial securities;

6 the development of the internet, enabling retail customers to access online dealing, extensive information and banking services;

7 increased pressures on banks as they have seen corporate lending fall dramatically due to the development of new forms of corporate finance such as Eurobonds;

8 the trend towards deregulation of the financial sector;9 the use of the euro in financial markets following the creation of a European

Monetary Union in January 1999 and its introduction at street level in January 2002;

10 the increased importance of so-called emerging markets and their economies;11 the impact of the so-called ‘credit crunch’, which started on 9 August 2007.

Its effects and repercussions were ongoing a decade later. It led to the failing of major financial institutions, massive bailouts of the financial system, huge government fiscal deficits and accompanying rises in national debt levels and the adoption of quantitative easing by central banks; and

12 the vote of 23 June 2016 for the United Kingdom to leave the European Union (EU) will have repercussions for London’s role as a leading international financial centre for years to come. For example, UK-based financial institutions are at risk of losing their EU passport which permits them to sell their services throughout the Single Market.

These changes have not taken place in isolation, rather they have fed off each other, and interacted in a dynamic self-reinforcing manner. The credit crunch mentioned in point 11 was the culmination of many years of debt build-up, deregulation, financial innovation and other forces that were not fully understood by market participants.

In this opening chapter we attempt to give an overview of the world of finance. We look at some of the factors that have influenced the development of the financial services industry from the 1980s up to the present. In particular, we focus upon four factors: the globalization of financial markets; the impact of technology; the deregulation of the financial services industry and the importance of product innovation. We then proceed to a brief look at the so-called emerging markets which are becoming more important to the global financial system, and some of

emerging market the market of a country which is experiencing rapid economic growth but whose income per capita usually makes it a low to middle income economy



1 . T h E W O R L D O F F I N A N C E 3

the issues and obstacles that these markets will have to tackle as they develop. The chapter concludes with a rather speculative gaze into the financial crystal ball.

1.2 Financial centresMost developed countries of the world have a major financial centre that meets much of the demand for financial services of the domestic market, and these centres compete to various degrees for international business. Inter-market competition is on the increase. New York, London and Tokyo vie with each other for recognition as the foremost financial centre. At the European level, London is the pre-eminent financial centre but in some areas it faces healthy competition from Paris and Frankfurt. In Southeast Asia, although Tokyo is the dominant financial centre, it finds itself increasingly in competition with Shanghai, Singapore and hong Kong. Qatar and Dubai have become important regional centres serving the specific needs of the Middle East region and have begun to make an impact at the global level. Financial centres, whether major or relatively minor, increasingly find themselves competing in a global marketplace, both to retain their domestic market and for international business. Many governments have sought to enhance the status of their financial centres, especially since a competitive financial centre can prove to be an important foreign exchange earner and provide employment for substantial numbers of people. A healthy financial centre can also aid an economy by channelling investors’ funds into the best-performing investments and businesses.

1.3 The role of a financial centreA financial centre has a number of diverse and important roles to play. Perhaps the most important is to recycle funds from surplus to deficit agents as efficiently as possible. This process is illustrated in Figure 1.1 which shows surplus agents, made up of individuals, companies and public/private bodies including central government, with surplus funds that they wish to invest. On the other hand, there are individuals, companies and public/private bodies including central government that need to borrow money and do not have sufficient current funds themselves. A key role of a financial centre is to channel funds from the surplus agents to the deficit agents in as efficient a manner as possible. however, it must be recognized that there is an enormous amount of heterogeneity within the two groups. Agents with surplus funds vary enormously, with some individuals saving only for the short term, some for the long term, for retirement and the like. Similarly, companies with excess money balances might wish to invest only for the short run or in some cases for the long term. When it comes to the deficit agents, their needs are again very varied, with some individuals requiring just short- or medium-term loans to solve a short-term cash problem, whereas others borrow long term, for example by taking out a mortgage to finance a house purchase. Similarly, some companies need to borrow only short term to iron out certain cash-flow problems, while others need to borrow long term to undertake new investment.

One of the prime functions of a financial centre is to facilitate the transfer of funds from surplus to deficit agents. For this purpose, a financial centre will have a range of what are known as financial intermediaries that design products/securities to facilitate the exchange of funds between the surplus and deficit agents. In designing such products/securities, financial intermediaries must recognize that




there are significant problems to overcome. In general, surplus agents tend to be risk averse, that is only willing to take increasing risks with their surplus funds so long as there is a sufficient increase in expected return to compensate them for those risks. Because they are risk averse, surplus agents tend to want to invest in fairly low-risk financial instruments. Also, surplus agents in general have quite short-term time horizons and usually require the ability to access their funds at very short notice. By contrast, in general deficit agents frequently require funds to undertake risky ventures – for example, a company may borrow money to set up a new factory that may or may not succeed, an individual may borrow funds to set up a company that may or may not succeed. Also, the time frame of deficit agents is typically longer than that of surplus agents – they require funds normally for the medium- to long-term time horizon. The heterogeneity within the two groups and the different risk and time preferences of deficit and surplus agents need to be somehow reconciled if there are to be economically significant transfers of funds between the two groups. As we shall see in Chapter 3, there exists a wide range of financial intermediaries with niches that try to meet the varying needs of both surplus and deficit agents. In much of this book we shall also be looking at a range of financial securities such as Treasury bills, commercial bills, Treasury and corporate bonds and equities that exist to meet the varying risk–return and time preferences of both surplus and deficit agents.

Today’s financial centres are increasingly global, concerned not only with channelling funds from domestic savers to domestic borrowers but also from international investors to international borrowers. In transferring these funds a

risk averse describes an investor that will only take on increased risk if there is sufficient prospective return to compensate

Interest, profits, dividends

capital gains/losses

funds loans

funds debtequity

Financial intermediaries

Financial securities

Surplus agentsHouseholds,companies,government

Deficit agentsHouseholds, companies,government

Notes:Surplus agents are generally risk-averse, with relatively short-term horizons. Deficit agents are generally risk-taking, with medium- to long-term horizons.

Figure 1.1 The role of a financial centre




financial centre must provide a range of products to meet investors’ and borrowers’ diverse demands at a competitive price. In addition, a financial centre should provide a range of financial services to meet the demands of investors, borrowers, firms, governments and households. Among the services most in demand are foreign exchange, risk management, insurance, swaps, secondary and primary markets in bonds and equities, domestic and international bank lending, a range of derivative instruments and research/advisory services.

1.4 Money markets, capital markets and the banking systemThe transfer of funds in the financial system is carried out by several means, three of the most important being money markets, capital markets (bond and equity markets) and the banking system. There are considerable differences in the relative importance of these as a means of recycling funds between economic agents. In Table 1.1 we present the figures for stockmarket capitalization at the end of January 2017, which shows the importance of the stockmarket particularly for the United States and the United Kingdom. In those economies there has been a long tradition of firms relying on stockmarkets as a source of finance. This is much less the case in countries such as Germany and Japan which have tended to rely on their banking systems as a means of recycling finance.

Debt markets are another key means of deficit agents raising finance through the issue of short-term debt instruments such as Treasury and commercial bills

risk management the process of identifying and reducing risks facing an institution or individual. The aim is to quantify the risks and take action to achieve a target risk–return trade-off

Table 1.1 Global stockmarkets, end 2006 (US$ billions)

Stockmarket

Listings

Capitalization Domestic/Foreign

NYSE Group (US) 19,573 1822/485

Nasdaq (US) 7,779 2509/388

Japan Exchange Group 4,955 3535/6

London Stock Exchange 5,440 1489/547

Euronext 3,120 936/115

Shanghai 4,099 1182/n.a

Shenzen 3,213 1870/n.a

hong Kong Exchanges and Clearing 3,193 1872/101

Deutsche Börse AG 1,547 531/61

BME Spanish Exchanges 635 3480/26

Bombay Stock Exchange 1,567 5820/1

National Stock Exchange India 1,540 1839/1

Notes:1 The United States has two national exchanges, the New York Stock Exchange and the National

Association of Securities Dealers Automatic Quotations (Nasdaq).2 Euronext Europe is a merger of the Paris, Lisbon, Brussels and Amsterdam exchanges.3 London Stock Exchange figures were calculated by the author based on February 2017 data using

$1.25/£1 exchange rate where domestic is a company registered in the United Kingdom.

Source: World Federation of Exchanges, Annual Statistics 2016

capital market a market in which individuals and institutions trade financial securities of greater than one year to maturity such as stocks and bonds




(less than 1 year) or Treasury and corporate bonds (usually 1 to 30 years). As Table 1.2 shows, there are considerable differences in both the size of the debt markets and the balance between government and private-sector debt issuance. In the United States there is also huge use by corporations of the debt markets to raise finance. In Europe the corporate bond market is less developed and is much more extensively used by governments to finance their fiscal deficits, and this has also been true of Japan where since the collapse of its bubble economy in the early 1990s the government has made frequent recourse to debt finance to prop up its economy.

Some countries, such as Germany and Japan, have traditionally relied on close relationships between their banking systems and corporations as a means of financing their corporations, and banks have been allowed to have stakes in companies – a situation not normally allowed in the USA or the UK. As Table 1.3 shows, the Chinese banking system, despite China’s smaller economy, has assets which are actually greater than those of the US banking system. In fact, it can be seen that the US banking system’s assets are significantly lower as a percentage of gross domestic product (GDP) compared to the other economies listed in Table 1.3. Interestingly, there is a significant difference in the importance of the banking system in terms of GDP between the USA and the UK despite their similarities with respect to the importance of stockmarkets and debt securities.

1.5 Services of a financial centreTo stake a claim to being a key international financial centre, it should have some or all of the following characteristics and offer the following kinds of services:

• There should be a large number of both domestic and foreign banks, and the centre should have a reasonable share of international bank lending.

• A substantial amount of foreign exchange business should be conducted.

bubble a rapid and substantial rise in equity prices that is not warranted by the economic fundamentals; it is ultimately followed by a dramatic price decline when the bubble bursts

Table 1.2 Global debt securities, 2016 (US$ billions)

PublicPrivate

financialPrivate

corporate Total debt

Total percentage

of GDP

United States 16,736 15,074 5,836 37,865 204

Japan 10,504 2,701 747 13,952 318

China 3,283 3,520 2,598 9,401 85

Italy 2,090 844 140 3,074 169

France 2,051 1,489 641 4,182 195

Germany 1,833 1,457 170 3,460 103

Spain 1,053 753 32 1,837 159

United Kingdom 2,690 2,693 571 5,959 208

Canada 1,155 616 442 2,214 143

Belgium 437 180 63 681 145

Note: Figures refer to Q3 2016.

Sources: Bank for International Settlements Debt Securities Statistics, and author calculations. Figures refer to Q3 2016




• There should be a significant offshore market; that is, deposit and lending markets that deal in currencies different from those of the financial centre.

• The stockmarket should be well capitalized and offer investors a high degree of liquidity.

• The centre should be a major market for corporate bond finance, be it domestic bond issues, foreign bond issues or Eurobond issues.

• There should be a range of financial institutions and associated services other than commercial banks, such as merchant/investment banks, insurance companies, securities houses, brokers, accountancy firms, commercial law firms and consultancy services.

• The centre should have a significant presence in derivative markets such as future and forward contracts, options and swaps.

In Table 1.4 we present some comparative statistics on three key financial centres of the world, namely London, New York and Tokyo, and, for comparative purposes, those of France and Germany. London differs from the other two key financial centres in one very important respect: its claim to be a pre-eminent financial centre is heavily dependent on international business. New York is supported in its claim of being a pre-eminent financial centre by the huge size of the US economy, and Tokyo’s claim is similarly supported because Japan has the third-largest global economy, the biggest being the United States followed by China. These two financial centres are much more domestically oriented in their business than London. The international nature of the UK financial sector is amply illustrated by the high number of foreign firms listed on the UK stockmarket (see Table 1.1), the large share of cross-border bank lending shown in Table 1.4 and its 70 per cent share of international bond issues, that is, bonds issued by foreign entities or denominated in a currency other than the domestic currency. In addition, London is by far the biggest centre for foreign exchange trading and for trading in over-the-counter derivative contracts, that is, non-exchange traded derivatives.

over-the-counter derivatives ‘tailor made’ derivative contracts that are not traded on organized exchanges but between banks and other financial institutions/dealers and with their clients

Table 1.3 Largest banking centres, 2015

Commercial bank assets ($ billions) Number of banks

Bank assets as percentage of GDP

China $20,000 4,261 184

United States $15,900 5,330 89

United Kingdom $9,800 361 344

Japan $9,200 13,721 223

France $9,000 486 372

Germany $8,500 1,808 253

Italy $4,400 670 242

Notes:1 Banking assets are those of commercial banks and their subsidiaries.2 The Japanese figure is for 2015, made up of 2,873 city banks, 10,571 regional banks and 277 trust

banks.3 The US figure is the number of FDIC insured commercial banks in 2015.

Sources: Data from TheCityUK, European Banking Federation, IMF Financial Access Survey




Table 1.5 World’s largest insurance markets, 2015

Gross insurance premiums ($ billions) Premium per capita

World percentage share

United States 1,317 $4098 28.90

Japan 449 $3535 9.88

China 387 $282 8.49

United Kingdom 320 $4912 7.03

France 231 $3458 5.06

Germany 213 $2616 4.68

Italy 165 $2714 3.62

South Korea 154 $3042 3.37

Canada 115 $3208 2.52

Taiwan 97 $4124 2.11

Source: Swiss Re, sigma, No. 3/2016, and author calculations

Table 1.4 The importance of different financial centres, 2014–2016 (percentage shares)

UK US JP FR DE SG HK Others

Cross-border bank lending (2015) 16 11 11 8 8 3 4 39

Foreign exchange turnover (2016) 37 19 6 3 2 8 7 45

Exchange traded derivatives – number of contracts traded (2014) 6 36 2 – 10 – 1 45

Interest rates OTC* derivatives turnover (2016) 39 41 2 5 1 2 4 6

Marine insurance net premium income (2014) 29 6 7 4 4 1 1 48

hedge fund assets (2014) 17 66 2 1 – 1 1 12

Private equity investment value (2014) 7 58 2 3 2 1 – 27

* Over-the-counterSource: Data from TheCityUK

Table 1.5 shows that the insurance industry is also a significant part of the financial services sector, with the United States and Japan by far the largest markets followed by the UK. however, in terms of insurance premiums per capita, the UK is in fact a more significant market, with premiums per capita being significantly lower in France, Germany and Italy. In Table 1.6 we can see that in terms of institutional funds under management, the US market is clearly a dominant player, with its pension funds and mutual funds of roughly equal significance to institutional investors. By contrast, in Japan mutual funds are less significant as institutional investors, while the insurance industry is more significant. Table 1.6 shows that the balance of funds between these different forms of institutional investors varies significantly between countries. Table 1.7 presents some statistics on the growth of derivatives trading by region and indicates rapid growth in all regions, but especially in the Asia Pacific




Table 1.6 Conventional investment assets, 2015 (US$ billions)

Pensions Insurance Mutual FundsTotal percentage

share

United States 24,487 8,881 17,826 51,194 47

Japan 1,836 4,463 1,172 7,471 7

United Kingdom 3,240 2,512 1,435 7,187 7

France 288 2,713 1,940 4,941 5

Canada 2,575 1,005 982 4,562 4

Others 7,974 11,579 13,640 33,184 30

World 40,400 31,144 36,455 108,539 100

Note: Data refer to the start of 2015.

Source: TheCityUK

Table 1.7 Annual number of derivative contracts traded by region (millions)

Other North America Latin America Europe Asia Pacific

2005 123 3,556 589 2,320 3,385

2006 195 4,617 864 2,674 3,518

2007 466 6,137 1,046 3,586 4,290

2008 668 6,995 850 4,162 5,001

2009 333 6,353 1,015 3,830 6,207

2010 323 7,170 1,519 4,416 8,991

2011 350 8,191 1,603 5,017 9,826

2012 317 7,204 1,731 4,389 7,526

2013 377 7,832 1,683 4,365 7,302

2014 433 8,216 1,517 4,410 7,257

2015 658 8,195 1,450 4,770 9,702

Source: Futures Industry Association

region. In Table 1.8 we can see that the Chicago Mercantile Exchange currently has higher trading in derivatives than its European competitors, the Eurex Exchange and the London-based Intercontinental Exchange Europe. There are of course other derivatives exchanges with high trading volumes such as the Chicago Board Options Exchange (CBOE) and the Korean Exchange.

1.6 The growth of the financial services industryThe financial services sector has expanded since the 1980s to become important both in terms of employment and as a percentage of GDP. In the UK, employment in the financial services industry rose from 782,000 in 1981 to more than one million in 2015. Not only that, but in 2015 it was estimated that the sector was a net exporter for the British economy to the tune of £60 billion and accounted for 9.6 per cent of UK GDP. A number of influences have led to the rapid expansion of the financial services industry since the 1980s, in particular the continued globalization of finance, the adoption and impact of new technology, government deregulation of financial




Table 1.8 Growth of exchange traded derivatives by volume of contracts (millions)

ICE Futures Europe Eurex CME

2000 137 454 231

2001 225 674 412

2002 267 801 558

2003 346 1,015 640

2004 399 1,065 805

2005 425 1,249 1,090

2006 528 1,527 1,403

2007 714 1,900 1,775

2008 828 2,165 1,893

2009 848 1,687 1,476

2010 984 1,897 1,656

2011 932 2,043 1,804

2012 788 1,661 1,430

2013 794 1,552 1,552

2014 586 1,491 1,776

2015 444 1,673 1,749

2016 521 1,728 1,940

Source: Futures and Options World

services, and an unprecedented amount of financial innovation resulting in a range of new financial instruments and products. Given that there were so many positive influences combining at the same time, and to a large extent feeding off each other, it is not surprising that the sector grew and changed so dramatically. We now briefly examine some of the major forces for change since 1980.

1.7 The globalization of financial marketsThe term globalization was one of the buzzwords that characterized the financial services industry in the 1980s. In the modern world people communicate with one another almost instantaneously and at low cost, information is speedily disseminated, and governments have greatly reduced, and in many cases removed, controls on the movement of funds. The growth of international trade has outpaced the economic growth rates of most countries, making them more trade dependent. In turn, these factors have stimulated the demand for trade finance products, such as foreign exchange management and borrowing and lending facilities in foreign countries and currencies. The breakdown of the Bretton Woods system of pegged exchange rates in the early 1970s made currencies more volatile both in the short and medium term. At the same time businesses have become more global and so too have international investors who have sought the benefits of international portfolio diversification. All these factors have contributed to the phenomenon of the ‘globalization’ of financial markets.

Globalization is a loose term capturing the idea that the world of finance has become a globalized industry; national financial markets are increasingly integrated

Bretton Woods a fixed but adjustable exchange rate regime (1947–71) whereby the major currencies were pegged to the US dollar within a ±1 per cent band; the dollar was pegged to gold at $35 per ounce

globalization the tendency of financial institutions and their customers to move beyond their domestic markets to other markets around the globe




into a globally integrated network of markets. In layman’s terms the concept is about the ability to ‘do anything anywhere’. Globalization has many characteristics. Borrowers seeking to raise funds are no longer limited purely to their national markets, they can raise funds on the financial markets of other countries. Similarly, investors with surplus funds are no longer restricted to the investment opportunities of their national markets but can increasingly take advantage of investment opportunities in other nations. Financial institutions seek to have a global presence both as a means of expansion and to retain their existing customers who are ever more reliant on trade and economic interactions with foreign residents. By abolishing exchange controls, as the Conservative government did on coming into office in the United Kingdom in 1979, or by relaxing controls, governments have enabled financial capital to seek out investment opportunities in other countries.

Globalization is not always beneficial. One problem is the loss of local knowledge – do bankers in London really know the best firms to lend to or the best banks to buy in the United States? In the 1970s and early 1980s huge sums of money were lent to countries in Latin America, and Mexico’s moratorium on its debt repayments in 1982 sparked off an international debt crisis as the Mexicans were quickly followed by Brazil, Argentina and Venezuela. More recently, the American subprime problem was exported around the world as foreign banks and other investors invested heavily in securities made up of subprime mortgages. Globalization has also led to problems in detecting wrongdoing. The main operations of Bank of Commerce and Credit International (BCCI) were based in the UK, but its headquarters was in Luxembourg, so investigations into its illegal activities in 1991 involved authorities in seven countries. In 1995, Barings Bank was brought to the brink of collapse by the infamous Nick Leeson operating on behalf of the bank on the SIMEX exchange in Singapore. Wealthy investors around the world also faced huge losses in 2008 when they learnt that their investments held by Bernard Madoff were in fact invested in a huge ponzi scheme. The French Bank Société Générale lost €4.9 billion as a result of a rogue futures trader Jérôme Kerviel in 2008 who had managed to vastly exceed his authorized trading limits in various futures contracts without being detected.

Globalization has also brought with it increased interactions and spillovers between markets, amply illustrated during the Asian financial crisis of 1997 when investors decided to pull out of Asian stocks and currencies almost indiscriminately. This led to large falls in the values of some Asian currencies and stockmarkets and caused major economic disruption to their economies. The credit crunch amply demonstrated the interlinked nature of today’s global financial system, when problems in the US subprime mortgage market and housing market got transmitted around the world, leading to large falls in global equity markets and huge bank losses worldwide. In general, across the globe it seems to be the case that stockmarkets and bond markets move increasingly in synch with each other and, as we shall see, this reduces the potential for investors and fund managers to reduce risks to their portfolios.

1.8 TechnologyThe 1980s witnessed an unprecedented increase in the use of new technology, and especially the widespread use of computers in the financial services industry. New technology has enabled some markets such as the London Stock Exchange to switch over to screen-based trading. Improved information systems mean the

moratorium a situation in which a debtor declares that it is suspending repayments of principal and interest

subprime mortgages mortgages made to people with a poor credit rating; they have a higher rate of interest than conventional mortgages to compensate for the higher risk of default

ponzi scheme a fraudulent investment scheme offering a high rate of return which is financed by payments made by newly acquired investors; eventually the scheme will collapse with large losses for the late joiners




almost instantaneous transfer of price-sensitive information around the globe, and computers have enabled the industry to store and analyse masses of information. More importantly, computers have enabled new complex products to be devised and priced in real time. The complexity of some of these products has meant that higher skills are required than those of traditional traders, and many advertisements for trading positions in the financial services industry require PhDs in mathematics, engineering and physics.

Technology has also had a dramatic effect on the way banks conduct their business, and process and dispense payments. Automatic telling machines (ATMs) have reduced the need for cashiers and the increased use of debit cards has dramatically reduced the cost of processing payments – the marginal cost of making a transfer using a debit card is less than 5 per cent of processing a cheque payment. Technology has enabled retail banks to offer a wider range of services, including internet banking which gives customers the ability to examine their balances and make transfers speedily. The use of sophisticated databases means that new services can be targeted at the customer, rather than waiting for customers to enter branches.

The adoption of new technology has enabled the financial services industry to become more efficient and offer its clients a better range of products and quality of service. Many back-room and processing operations can now be carried out in cheaper locations than traditional, more expensive, financial centres, and in recent years many banks have relocated some of their information technology (IT) functions to India where labour costs are significantly cheaper. Technological advances have greatly reduced communication costs and improved the speed and capacity to act because information is rapidly transmitted from one financial centre to another, reducing the cost of executing orders and enhancing the ability of financial markets to monitor and analyze financial, political and economic developments.

Nonetheless, new technology has not always been viewed as purely advantageous by the industry. New technology can be very expensive to implement and some extremely costly mistakes have been made. For example, the London Stock Exchange had to abandon a planned paperless trading system called TAURUS in 1995 at an estimated cost of £400 million due to problems with the system. Another problem with new technology is that, while it can bring cost savings, there can be increased costs in the way of expensive IT staff. In addition, new hardware and software are very expensive. The need for backward compatibility with previous systems means that it is often very difficult for existing firms to take full advantage of the latest developments, while being less so for new entrants, who can in some cases quickly establish significant market shares.

There are also issues of security and reliability associated with new technology; cases of ‘hacking’ and people gaining access to confidential client information are big worries for many companies. In fact, data protection is now one of the key issues facing the financial services industry. New technology also increases the mobility and demands of customers who shop around for the best quotes. In sum, many financial institutions that have invested heavily in new technology find it difficult to earn an adequate return on their capital investments, especially as any advantage they may gain is usually transient, lasting only until their competitors catch up. One very important aspect of new technology is that it has changed the balance between fixed and variable costs, and in so doing has made market share an increasingly important issue. For example, new ATMs and debit payments systems are extremely costly to

backward compatibility the need for new information technology, such as computers and software, to work with older technology in order to service existing clients




install and set up, but the marginal operating costs are relatively low. This has tended to mean that firms require a large and increasing market share to cover the high initial expenditure and to reap rewards from their investment.

1.9 DeregulationGovernments have always intervened to regulate the financial services industry, but since the 1980s there has been a fundamental shift towards less regulation by many governments. This shift is known as the process of deregulation.

Government policies in the 1980s were particularly favourable for the development of the financial services industry, as deregulation in the UK was followed by deregulation on the continent. The UK government introduced a range of tax breaks for savers such as TESSAs (tax exempt special savings accounts) and personal equity plans (PEPs), and shifted the tax structure from taxes on income to taxes on expenditure, which left consumers with larger disposable incomes. While indirect taxes were increased on goods and services, financial products remained largely exempt, which increased their relative attractiveness.

The UK government adopted a privatization programme that benefited the financial services industry through advice, consultancy and underwriting fees. The programme also increased public interest in shares in general. While technology may have been the driving force enabling firms to offer a wider range of financial services, deregulation was essential in permitting financial institutions to offer the new services. There are numerous arguments in favour of and against regulation and these are worth reviewing.

One of the major arguments in favour of regulation is the need for investor protection. Investors need to be protected from misinformation which encourages them to invest in products that are unsuitable, and they need to be protected against the misuse of their funds once they have been handed over (for example, fraud). however, many in the financial services industry oppose regulation, which they argue increases costs to meet compliance. In addition, regulation can prevent the introduction of new innovative products. Another problem is that financial centres around the world find themselves in competition with one another for business, and for this reason centres are especially keen to avoid heavy-handed regulations which drive business away to other centres that adopt a more light-handed approach. This is one of the lessons to be learnt from the Eurodollar market in which US regulations clearly stimulated the development of the market.

Another problem of regulation is that too much investor protection can create a problem known as moral hazard. Moral hazard occurs when insuring against an event makes the insured-against event itself more likely to occur. For example, if governments guarantee investors’ money this may encourage investors to place their money in institutions offering the highest return because, regardless of the risks involved, investors know that their principal is safe. Overall, this can then lead investors to place too much of their funds with high-risk institutions resulting in a misallocation of savings. This factor undoubtedly played a significant part in the savings-and-loans fiasco in the USA at the end of the 1980s. In the early 1980s, the savings-and-loans business was deregulated and competition for funds led to many institutions offering high rates of interest. Most investors’ deposits were insured by the Federal Deposit Insurance Corporation (up to $250,000) and investors

deregulation the reduction or elimination of regulations designed to increase competition and reduce prices facing consumers

regulation the set of rules or laws governing the conduct of financial institutions, markets and instruments

moral hazard the existence of an insurance policy makes the insured event more likely to occur than in the absence of the insurance policy

Federal Deposit Insurance Corporation (FDIC) a US corporation that insures US bank deposits up to the value of $250,000; it was created in 1933 to maintain public confidence in the banking system

privatization the sale of state-owned enterprises to the private sector, often through the sale of shares to the public and institutions




consequently placed their funds with the highest-interest-paying institution. In a bid to meet these interest payments many savings institutions lent money to increasingly risky ventures, a large number of which subsequently failed, making those savings-and-loans institutions insolvent. The result was that the Federal Deposit Insurance Corporation was required to pay out far more than it had received in premiums. Ultimately, the US taxpayer had to foot a bill which is estimated to be close to $300 billion spread over 30 years.

It is clear that most governments need to strike a balance between regulation and the need to allow their financial services industry to develop without over-burdensome restrictions. The 1980s witnessed considerable financial deregulation. London experienced the ‘big bang’ in 1986, which involved ending the broker–jobber divide and fixed commissions for share-dealing. The reform was motivated by the desire to improve the competitiveness of London share dealing, and has been considered important in maintaining London’s competitiveness as an international financial centre.

however, although there was a general trend towards deregulation of national financial systems, there was one clear exception to this trend at the global level: the Basel Accord of 1988. During the 1980s regulators and central banks had become increasingly concerned that the process of globalization had led to increased interactions between banks from different countries, with a perceived danger that a banking crisis in one country could transmit itself to other countries. hence there was an attempt to ensure that banks had sufficient capital to absorb potential losses, which resulted in the Basel Accord of 1988. As we shall see in Chapter 17, this first initiative in global regulation inevitably encountered much criticism and the Basel II Accord came into force in 2006 to address these problems. however, Basel II proved inadequate, as shown by the global banking crisis which started in August 2007. The result has been a protracted new framework including new liquidity requirements and higher capital requirements in the Basel III Accord which is due to come fully into force by 31 March 2019. In the United States, the Dobb Frank Wall Street Reform and Consumer Protection Act of July 2011 was enacted as a direct response to the global financial crisis and represents a major move towards tighter regulation of the financial sector (see Chapters 17 and 18).

1.10 Financial innovationBy financial innovation we mean the design of new financial instruments or the packaging together of existing ones. There are two main views on why financial innovation occurs. One cynical view is that innovations are primarily designed to overcome the effects of regulations and to exploit tax loopholes, whilst the more positive view is that they are all about designing products to meet the wide variety of needs of investors and to improve the efficiency with which they can achieve those objectives. Since the 1980s we have witnessed the rapid development and widespread availability of a whole range of financial products; examples include the proliferation of new types of options and futures contracts, warrants, swaps, junk bonds, index-tracking unit trusts, exchange traded funds (ETFs) and secondary markets in third-world debt. The greater availability and wider financial product range means that firms and investors are better able to achieve their risk–return investment objectives. In addition, the wider range helps to attract new custom.

Basel Accords three agreements, emanating from the Bank for International Settlements in 1988, 2004 and 2011, that require large international banks to set aside capital reserves against potential losses equivalent to 8% of their risk-adjusted assets. In Basel III liquidity requirements and leverage ratios were added and the capital adequacy ratio increased

financial innovation the design of new financial securities and methods of delivering financial services




Box 1.1 Securitization

One of the biggest innovations in the debt markets from the 1980s to the present has been the process of securitization. In its simplest form the idea of securitization is to turn relatively illiquid assets with cash flows into a liquid asset by combining the cash flows from the illiquid assets into a security to investors. The basics of securitization can be illustrated with an example. Imagine that Bank ABC wishes to raise $1 billion to take over Bank XYZ. The problem Bank ABC has is that it does not have any spare cash. It could of course undertake a rights issue, that is, sell new shares to its existing shareholders or perhaps increase its debt burden by issuing a corporate bond. Alternatively, it could consider turning some of its illiquid assets, such as loans and mortgages which generate a cash flow to the bank, into an asset backed security (ABS). The cash flows of the ABS can be bought by investors which will then give Bank ABC the money it requires to complete the takeover of Bank XYZ. The process of securitization is illustrated in Figure 1.2.

As can be seen in Figure 1.2, Bank ABC identifies a pool of loans or mortgages on which it is currently receiving interest and principal payments and it packages them together. A master trust is set up to manage the cash flows from the loans to ensure payments are made to investors in the ABS. In return for giving up the cash flows from the loans and mortgages Bank ABC receives $1 billion cash from the sale of the ABS to fund its takeover of Bank XYZ. The process of securitization has enabled Bank ABC to turn some relatively illiquid assets into cash for operational purposes today.

The process of securitization can be used to turn existing assets such as loans and mortgages into cash but it can also be used to turn prospective future cash flows into cash today. In a famous issuance the UK rock star David Bowie raised $55 million in 1997 by selling an ABS, the cash flows for which were financed by future sales and royalties from 25 of the albums he produced prior to 1990.

Figure 1.2 The process of securitization

Master trustpools the

assetsBank ABC identifies cash flows from $1 billion of illiquid loans or mortgages

10-year ABS is created. �e ABS is backed by the cash flows from Bank ABC’s loans/mortgages and is sold to investors with an annual coupon and principal returned on maturity

$1 billion proceeds from sale of ABS can be used by Bank ABC

Investorsbuy the ABS

continued overleaf




There were a number of forces in the 1970s and 1980s that lay behind the rapid pace of financial innovations. One was the greater volatility in both goods and financial markets. The early 1970s witnessed the breakdown of the Bretton Woods system of fixed exchange rates and witnessed high exchange rate, stockmarket and interest rate volatility. Following the first oil price shock of 1973 when the price of oil was quadrupled by the OPEC cartel, many countries suffered high and volatile inflation rates. The more turbulent environment greatly increased the demand for financial products to protect investors’ and borrowers’ interests.

The 1980s witnessed the widespread introduction of highly sophisticated computers and the development of appropriate software, enabling new and more complex products to be brought to the marketplace. Deregulation and greater competition in the financial sector undoubtedly had the effect of increasing both the range and quality of financial products offered. Information flows greatly improved and this led customers to demand products that enabled them to cope with rapidly changing forces. The 1990s witnessed the rise of the internet and the ability of retail customers to buy and sell shares, access financial information, and carry out their banking online. The impact and implications of all of this are still being felt by the financial services industry.

More recently, the world of finance has been profoundly affected by the so-called ‘FinTech revolution’, which is affecting the delivery of everything from payments systems to wealth management. It has also led to the emergence of new startups in segments such as peer-to-peer lending and to crowdfunding (see Box 1.2). This combination of venture capital and technology firms is likely to further revolutionize the world of finance over the next decade. The revolution is likely to reduce costs and improve the quality of financial services because FinTech firms have less regulation to worry about, and are not burdened by legacy IT systems and expensive branch networks. In addition, FinTech firms are likely to increase the range of products available to consumers that currently do not have access to savings, credit, insurance, and other financial services, especially in developing countries. Overall, the FinTech revolution is likely to change the finance industry for existing customers and to have a much more profound effect by simply extending financial services to entirely new customers and markets.

Box 1.1 Securitization – continued

The so-called ‘Bowie Bond’ paid a rate of interest of 7.9% per annum, and the Prudential Insurance Corporation bought the entire issue. The ABS matured in 2007 and Bowie once again collected the royalties from sales of 25 of his early albums.

Securitization is a vital part of the modern financial landscape enabling banks and firms to generate cash based on their existing assets or prospective future cash flows. The construction of many commercial properties is financed by issuing ABSs based upon future cash flows likely to be generated by renting out the property over the years. Without securitization of future cash flows many projects might not go ahead, to the detriment of the economy, society and jobs.

As we shall see later in the book, securitization has been taken even further than our simple examples. This occurs when the ABS is in effect divided up into various tranches with different risk–return characteristics.




Box 1.2 The FinTech Revolution

Financial technology, commonly referred to as FinTech, is a rapidly growing industry made up of companies that use technology to make financial services more efficient and to provide new financial services and products. The industry comprises predominately new startup companies that use technology and software to challenge existing finance-related companies such as banks, insurance, brokerages, mutual funds and such like. The FinTech industry is rapidly growing and very diverse, and is in large part funded by the venture capital industry. Some identifiable areas of FinTech business include:

Payments processing – some FinTech companies concentrate on improving payments by enabling consumers to transfer money abroad into other currencies far cheaper, or to use their mobile phones to make payments, allowing small companies to accept credit and debit card payments via their mobile phones. Companies of this type include Square at Squareup.com and Stripe.com There are also companies dealing with business-to-business (B2B) payments. There has been a whole network and ecosystem set up in support of the virtual currency bitcoin.

Trading and execution – some FinTech companies such as money.net, e-trade .com and Robinhood.com enable traders to buy and sell shares, foreign exchange and other securities such as futures and options at low cost, and supply retail customers with real-time information.

Alternative funding for borrowers and startups – some companies enable borrowers to access funds directly from consumers through peer-to-peer lending. Companies in this space include lending.club which enables consumer-to-consumer lending. Then there are companies that enable startups to raise funds through crowdfunding. Sites include Crowdcube.com and FundingCircle.com which enable individuals and professional investors to invest in startup, early-stage and growth businesses through equity and debt investment options.

Infrastructure and security – with more and more payments and financial trading done online there is a need to ensure security of payments and trades. This has led to the growth of companies that can store the data, ensure financial transactions are properly recorded and take place in a secure manner, free of the dangers of hacking and malicious software such as viruses. There is a large demand for such services from existing banks, securities houses and brokerages.

Financial and wealth management – traditionally financial advisors have played an important role in helping consumers structure their personal finances and wealth management. There have been many companies set up that reduce the role of financial advisors. There are so-called Robo Advisor sites such as Learn Vest, Betterment and Nutmeg that help consumers with their portfolio allocations between cash, equity, bonds, and alternative investments, and all-in-one money management tools such as Mint and Level.

continued overleaf




1.11 Types of financial innovationsExamples from the wide range of innovations include the following:

1 Market-broadening innovations – these work to increase the liquidity of markets by attracting new investors and providing new opportunities for borrowers.

2 Risk-management innovations – these have the effect of redistributing financial risk exposure from agents that are risk averse to agents that are willing to undertake the risks.

3 Arbitraging innovations – in these, agents exploit arbitrage opportunities either within or between different markets, often to take advantage of loopholes in the regulatory or tax framework.

4 Pricing innovations – these seek to reduce the cost of achieving a specific investment objective.

5 Marketing innovations – in addition to innovative financial instruments, financial markets are also adept at finding innovative methods of selling and distributing financial products.

1.12 Emerging marketsSince the 1980s there has been a rapid rise in the significance of financial markets in most of the so-called emerging market countries. Countries in Southeast Asia and Latin America have increasingly found themselves attracting the interest of investors from the industrialized nations, this interest being very much spurred on by the rapid rates of economic growth of these countries. In more recent years, the newly independent countries of Eastern Europe that have emerged since the break-up of the Soviet bloc in the 1990s have also attracted the interest of international investors. In particular, countries such as Poland, hungary and Russia have attracted significant capital inflows. Many of these Eastern-bloc countries joined the EU in

Box 1.2 The FinTech Revolution – continued

Insurance – traditionally large insurance companies use brokers and other intermediaries to sell their products. But with the ability to get more data on individuals and to do business online there is much greater scope for insurance companies to have a more direct relationship with their customers, and for the design of products that are more tailored to the individual’s needs and with premiums better priced to the risk profile and needs of the individual. There are also enormous opportunities in the healthcare insurance sector, which is a large market in the United States and growing rapidly globally with companies such as Oscar at hiOscar.com.

Some of the major factors that restrain the growth of FinTech include regulation, reticence by corporates and institutions to adopt new technology, funding for FinTech startups and modifying consumer behaviour. however, despite these obstacles FinTech is expected to be one of the faster areas of growth in the finance industry over the next decade or so. Indeed, global FinTech financing rose fivefold over the period 2013 to 2016 to an estimated $20 billion.




Box 1.3 The growth of Islamic banking and finance

The credit crunch which started in August 2007 led many to question the foundations of the Western banking system. By contrast, Islamic banking and finance was far less severely impacted by the crisis than its Western counterpart. Islamic banking is a system of banking that is consistent with the principles of Sharia law (or Islamic law) whose primary sources are the Koran and the sayings of the Prophet Muhammad. The rules of Islamic commercial jurisprudence are known as fiqh al-mu’amalat. Fiqh al-mu’amalat focuses on what contracts are permissible and desirable (halal) and which are prohibited and undesirable (haram). A small group of Islamic scholars in each country determine whether a product is Sharia compliant. Sharia law prohibits the payment of interest (riba) on the borrowing of money and also forbids the investment of money in businesses that provide goods or services that are contrary to its principles, such as alcohol, tobacco, gambling or pornography, or companies that have too high debt levels (typically meaning more than 33 per cent of stockmarket capitalization). In addition, the use of money to finance speculation (qimar) or gambling (maysir) is prohibited, as are contracts involving ambiguity as to subject matter (gharar). There can be differences between national jurisdictions – a product deemed Sharia compliant in more liberal Malaysia may not be deemed compliant in more conservative Saudi Arabia.

In the late 20th century a number of Islamic banks were formed to offer banking services based on Sharia principles to personal and corporate entities within the Muslim community. The first experiment with modern Islamic banking started in Egypt in 1963, led by Ahmad Elnaggar who set up a form of a savings bank based upon profit sharing. In 1975 the Islamic Development Bank was set up to provide funding for member countries. Today Islamic banking has more than 300 institutions in more than 50 countries and some 250 mutual funds with over $500 billion of assets under management according to Islamic principles (see Table 1.9). Many Western banks such as Citibank, Goldman Sachs and Standard Chartered also offer Sharia-compliant products. The basic principle of Islamic banking is that profits and losses are shared (mudharabah, which means profit sharing). Other useful terms are wadiah (meaning safekeeping), murabahah (meaning cost plus) and ijarah (leasing/rent).

Table 1.9 Sharia-compliant assets (US$ billions)

YearIslamic

bankingIslamic funds Sukuk OIFI Taluk Total

2012 1,272,931 46,309 252,453 87,160 31,617 1,689,469

2013 1,201,956 52,310 279,660 85,251 30,465 1,649,282

2014 1,345,691 55,794 295,094 83,916 33,390 1,814,086

2015 1,507,398 60,258 309,849 87,272 35,394 2,000,171

2016 1,688,296 65,078 325,341 87,272 37,517 2,206,985

Note: OIFI stands for Other Islamic Financial Institutions.

Source: ICD Thomson Reuters Islamic Finance Development Report 2016, p.14

continued overleaf




Box 1.3 The growth of Islamic banking and finance – continued

Because interest cannot be charged, a typical house purchase can be financed by the bank purchasing a house on behalf of a buyer and then selling the house to the buyer at a higher price. The bank allows the buyer to pay it back in instalments under a contract known as a musharakah mutanaqisah partnership. Similarly, a car purchase can be financed by the bank buying the car, then selling it on to the buyer at a higher price and allowing payment by instalments, with the bank retaining ownership of the vehicle until the final instalment is paid. Such a contract is known as murabaha. In a business transaction an Islamic bank may lend money to the company based on a certain percentage of the company’s profits. Once the principal amount of the loan plus cost is repaid, the cost plus contract, which is known as mudarabahah, ends. A partnership or joint venture, namely muskarakah, is an arrangement whereby an entrepreneur provides labour and the bank provides financing so that both profits and losses are shared. The sharing of the capital provided by the bank and the labour by the business reflects the Islamic view that the borrower must not bear all the risk and cost of a failure. This results in a balanced distribution of income and means that the lender is not allowed to monopolize the economy. Depositors in Islamic banks keep their money in mudoraba or wakala accounts and receive a percentage of the profits rather than a given rate of interest, although most Islamic banks maintain ‘profit equalization reserves’ to ensure minimum payments even if losses are made. More recently Islamic finance has developed Sharia-compliant bonds called sukuks which have been used to finance companies and development in Islamic countries. A typical sukuk is based upon an asset-backed ijarah structure, which is an asset backed bond on a sale and leaseback arrangement that uses revenue from an asset, usually a property, to pay investors. These payments are based on rent or profits which are not considered to provide a guaranteed return because the property could fall in value, although investors invariably get their principal back. While a conventional bond is a promise to repay a loan, purchasing a sukuk constitutes partial ownership of a debt, asset, project, business or investment.

Sharia principles meant that Islamic banks did relatively well compared to their Western counterparts during the financial crisis which started in 2007. They had low amounts of leverage, little exposure to the toxic subprime mortgages and a relatively stable deposit base. The main hit to the Islamic banks was their exposure to the real estate market in the Middle East which had boomed prior to the outbreak of the crisis but was significantly hit during the downturn. There are still some problems that confront Islamic banks. One particular problem is that they cannot access the interbank market because they are not allowed to pay interest, so short-term liquidity has to be managed by other means. The use of derivatives may be sanctioned if they are used to hedge risk, but not for speculative purposes. The future development of the Islamic finance sector will depend on its ability to innovate and offer wider ranges of products and services at competitive prices so as to be able to compete with Western-based banks.




April 2004. This has, over time, led to further strengthening of their economies and also encouraged them to develop their financial systems, including measures to attract foreign investment. The emerging markets’ stockmarkets have often offered spectacular returns, but also on many occasions the falls have led to equally large losses such as during the Mexican crisis of late 1994–early 1995 and the East Asian financial crisis of 1997. During this crisis markets fell significantly; for example hong Kong fell from 16,500 to a low of around 6,500, although by early 2017 the hong Kong index had recovered to trade above 22,000. One of the lessons for investors is that overexposure to a single emerging market is a risky business, but this does not necessarily apply to exposure to a portfolio of emerging markets.

1.13 Problems concerning investment in emerging marketsAlthough there is a strong theoretical case for international portfolio diversification, there are a number of reasons why investment managers in developed countries are reluctant to invest significant amounts of money in emerging markets, and why investors are often warned to be wary of investment in such markets. These reasons include:

• Poor accounting standards. In developed financial markets there are usually strict regulations and standards regarding reporting the financial positions of companies. In many emerging markets, however, standards are often relatively poor, making it extremely difficult for investors to ascertain a clear picture of the financial worth of a company.

• Governance of companies. In developed financial markets companies are run by directors who act as agents for shareholders. In theory, at least, directors are selected on merit and can be replaced if performance is unsatisfactory. In many emerging markets, control of companies is often exerted by a board made up of founding family shareholders who are not necessarily best suited to the job.

• Information costs. In developed financial markets, most quoted companies are subject to detailed financial analysis and the costs of acquiring good-quality information are relatively low. When investing in emerging markets, however, there are language barriers and also far less dissemination of information, which means that the costs of acquiring good-quality information are relatively high.

• Political risks. In developed financial markets, governments are relatively stable and the election of the opposition to government does not necessarily have any significant influence on financial markets. In emerging markets, however, foreign investors face the risk of controls being imposed which will restrict the outflow of their investments, and often face withholding taxes (that is, taxes on dividends and interest paid to foreign investors) or the threat of such taxes. There are some tax treaties between countries that enable investors to gain a credit for the payment of such taxes so that they do not pay double taxation, but this is not always the case and the process of claiming the tax credit can be cumbersome. In extreme instances, foreign investors face the risk of expropriation of their assets and even nationalization of the enterprises they have invested in.

• Foreign exchange risk. Investment in emerging markets may result in a capital and income gain measured in the currency of the emerging market economy. however, these investments need to be converted back into the developed country’s

withholding tax a tax on investment income aimed specifically at foreign investments




currency for a comparison to be made with domestic investments. The currency change may provide a gain or loss representing an additional risk that is not present with domestic investments.

• Controls on foreign investments. In many emerging markets, governments can impose costly restrictions on how foreigners can invest and manipulate their investments. For example, foreign investors may only be allowed a certain proportion of investment in domestic companies, or allowed shares that have more limited voting rights than domestic investors.

• higher transaction costs. In developed financial markets, deregulation and greater competition have had the effect of greatly reducing brokerage commissions. In most emerging markets these costs are significantly higher, and there are also additional costs associated with foreign exchange commissions and communication for the execution of orders.

There has also been a growth of interest in what are known as frontier markets, which refers to a subset of emerging markets that have low market capitalizations, relatively low turnover and poorer liquidity conditions than other emerging markets. While there is no decisive means of classifying frontier markets as distinct from other emerging markets a country may be classified as a frontier market due to its relatively small size, its lower level of development compared to other emerging markets and also higher level of investment restrictions. The countries classified by MSCI Barra as frontier markets are Argentina, Bahrain, Bangladesh, Botswana, Bulgaria, Croatia, Cyprus, Estonia, Ghana, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Saudi Arabia, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates and Vietnam.

1.14 The futurePredicting the future is a hazardous business. Looking back over the last 50 years, many of the important events for financial markets have been shocks that were largely unforeseeable. The oil-price hike of 1973–74 meant that huge OPEC (Organization of Petroleum Exporting Countries) surpluses were placed on the international money markets, much of which was then lent on to Latin America. In 1982, a moratorium on Mexico’s debt repayments triggered the international debt crisis. By then many major international banks had heavy exposure to the Latin American countries, and were preoccupied by the crisis throughout the 1980s. The global 1987 stockmarket collapse hit trading volumes on stockmarkets overnight. The reunification of East and West Germany in 1990 led to Germany becoming a big borrower of funds on global financial markets. Similarly, the Asian financial crisis of 1997 was largely unforeseen, yet it was undoubtedly one of the most turbulent events to ever affect global financial markets. The disintegration of the Soviet empire provided new opportunities and risks as witnessed by the 1998 Russian default. Likewise, stockmarkets went into a major downswing following the 11 September 2001 attacks on the twin buildings of the World Trade Center, a single shock that was totally unforeseen. Barely any commentators predicted the size and extent of losses and seize-up of the financial system that started in August 2007. Major financial institutions such as Citigroup, American International Group, Bank of America, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac, the Royal

frontier markets countries with stockmarkets that are less developed than emerging markets




Bank of Scotland Group, halifax Bank of Scotland, Lloyds Bank and countless other financial institutions from around the world were drawn into the biggest financial crisis since the 1930s banking crisis. To some extent the future of the financial system will, for many years to come, be shaped by policy response and lessons to be learnt from the credit crunch. In 2016, UK voters took a surprising decision to exit the EU, a decision which will have ramifications for London’s position as a financial centre, and also potentially raise the importance of other European financial centres such as Frankfurt, Luxembourg, Paris, Amsterdam and Dublin that will be keen to attract any business lost by London.

Nonetheless, there are a number of trends that will undoubtedly have a major impact. One is that financial technology will continue to penetrate the home consumer market and banking business. The internet enables consumers to manage their bank accounts and make payments for goods and services directly from home. People in more and more countries will be able to trade stocks, bonds and other financial securities from their homes or mobile phones. Retail banking will remain a tough commodity business, with consumers allocating more of their money to deposit accounts and less to current accounts. On the loan side, the ability to easily search the market for the most competitive loan rates will further erode profit margins.

Technology is also likely to continue to impact heavily upon the way many financial instruments are traded. In New York and Tokyo, shares are still traded on the stock exchange floor, and futures and options contracts involve traders gathering around a pit. The plain fact is that technology makes such arrangements an anachronism and it is only a matter of time before screen-based trading becomes the norm. The experience of London is instructive in this regard. When screen-based trading was first introduced following the big bang in 1986, it was supposed to complement trading on the stock exchange floor. however, within two weeks trading on the floor ceased and screen trading became the London norm. Electronic exchanges such as the Nasdaq in the United States have tended to gain share over rivals that do not fully utilize the benefits of modern technology. Some of the fastest-growing companies are in the FinTech sector, using technology to disrupt the delivery of financial services and traditional ways of doing things in the financial services sector.

In Europe the successful introduction of monetary union in 1999 and the euro at street level in 2002 had a profound effect, with mergers between the Amsterdam, Paris, Lisbon and Brussels stock exchanges to form the Euronext exchange. Since its introduction, the euro has proven to be a sound low-inflation currency and, despite the recent Eurozone crisis involving the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain), the euro is the only currency able to rival the US dollar as a reserve currency. The euro is leading to greater demands for a truly single market in the European financial services industry, and the removal of national governments’ ability to unilaterally print money has led to a greater focus on economic reforms of social security and pension systems.

The regulatory environment in Europe is also changing rapidly in response to the 2008–10 financial crisis and the PIIGS crisis. The EU is in the process of setting up a Banking Union, which is covered in Chapter 18, with the aim of making the European regulatory framework more effective in dealing with financial crises and offering better protection for depositors. Prior to the financial crisis the EU had been keen to enhance the ability of financial firms to sell their services in other EU countries

FinTech refers to companies that use new technology solutions and innovations to disrupt the delivery of financial services through the development of applications, processes, products or business models




based on the concept of ‘mutual recognition’ and the so-called ‘passport’ principle. The concept of mutual recognition is that countries in the EU agree on the minimum standard for an insurance company or bank, and once this standard is agreed the financial institution is free to sell its services in all the EU countries. In effect, once a licence to operate is obtained in one EU country, the financial institution has a ‘passport’ to operate in every other EU state. This regulatory environment is very different from the old days when attempts to agree on full standards never got anywhere, and financial institutions required a separate licence to operate in each EU member country.

The significance of emerging market economies to both the world economy and world of finance will continue to grow over the next decade. Countries like China and India still have relatively low GDPs per capita and underdeveloped financial systems, but they have rapidly growing economies and their demands for finance and financial products will continue to grow significantly. There is no doubt that they will look to developed capital markets such as the USA, UK and Japan for sources of finance and for models on which to develop their own financial services industries. The demand for finance-related skills in both China and India can be safely predicted to continue to rise. Similarly, the Eastern-bloc economies can be expected to grow rapidly over time and they too will continue to further seek to develop their own financial sectors.

1.15 ConclusionsThe world of finance like the global economy has undergone major changes since the 1980s, culminating in the financial crisis of 2008–10, the banking crisis in the Eurozone area and more recently the decision by voters in the UK to leave the EU. Further changes and crises can be expected in the future, to quote an old adage, ‘the only constant is change’. Present-day financial institutions and the way of doing business today are likely to look very outdated in 20 years’ time as the FinTech revolution changes the way existing financial institutions do business and as new models of doing finance emerge. Nonetheless, there are some fundamental principles of finance that do not change: one is that higher return is usually associated with higher risk, and another is that financial instruments and financial institutions will only survive in a marketplace if they are able to meet clients’ needs at a competitive price. In the rest of this book we shall be looking in more detail at the role played by the financial sector of the economy, and the various financial instruments that exist.

Further readingBain, K. and howells, P. (2007) Financial Markets and Institutions, 5th edn, Financial

Times/Prentice-hall.Bodie, Z., Kane, A. and Marcus, A. (2014) Investments, 10th edn, McGraw-hill.Buckle, M. and Thompson, J. (2016) The UK Financial System: Theory and Practice,

5th edn, Manchester University Press.Valdez, S. and Molyneux, P. (2015) Introduction to Global Financial Markets, 8th edn,

Palgrave Macmillan.




Chapter 1 Revision questions

1 What are the key roles of a financial centre and to what extent does London differ as a financial centre from New York?

2 Discuss the pros and cons of the use of new technology in financial institutions.

3 What is meant by securitization?

4 Discuss what is meant by financial innovation. What are the five types of financial innovation that can occur?

5 What is meant by ‘globalization of financial markets’? Discuss the pros and cons of the globalization process in the world of finance.

6 Briefly describe five reasons why emerging markets may not prove popular with international investors.

7 What is mean by the FinTech revolution, and what are the main segments of the finance industry that the revolution is affecting?

8 In what ways is Islamic finance different from traditional finance as practised in the USA and UK?



49 5

ABS see asset backed securityAbsolute PPP 277–86Active fund management 51, 55, 232Adjustable rate mortgages 411Adverse selection 411Aggressive securities 181–2AIG see American International GroupAlgorithmic trading 198–9Allotment policy 200Alpha 185–7Alt-A mortgage 392Amaranth 58American International Group 391, 404Anchoring 237–8Announcement effect 73–4Annuities 50Arbitrage 36–7, 250–2, 300, 321–2, 380, 387

cross currency 251–2financial centre 250goods 277

Arbitrage pricing theory 190–1Arbitrageur 36, 364–6Asset backed security 15–16, 395Association of International Bond

Dealers 140Assurance 49Asymmetric information 394, 441Auction issue 33, 96

Backward compatability 12Balance sheet 218Bancassurance 50–1Banker’s acceptance 100–1 Banking Acts 449–50Banking Union 23Bank bonuses 417–18Bank run 406Banks

Commercial 44, 75–7, 97, 115, 249–50Investment 45, 97, 414

merchant 44universal 44

Bank of England Act 449 Bank run 406Barings bank 11Base rate 419Basel Accords 408, 423, 437–8, 457–61Basis risk 326Bearer form 139Behavioural finance 237–9Beta 173–4, 236, 241Bid–ask spread 32, 36, 115, 199, 228, 251,

359, 382, 448Big bang 196, 447Big Mac index 279Bills 69Bitcoin 98–100Black–Scholes option pricing formula 352–66,

369Black Monday 242Bonds 114–46

clean price 117 convertible 134corporate 134dirty price 117domestic 7, 136Eurobond 7, 136foreign 7, 136futures 323–4 government 115–17junk 135–6 price formula 116–17price volatility 121–5putable 134

Bought deal 33Bradford & Bingley 430–2Bretton Woods 10, 16, 133, 257, 306Brexit 2, 242–3Broad money supply 75–8Brokers 36, 411

INDEX



49 6 I N D E X

Bubble 6, 201–2, 242–3Building societies 45Business risk 213 Buy-back 386Buy-hold strategy 233

Call back 142Call market 34Call option see optionsCall provision 129, 133 Call risk 133Capital adequacy 42, 47, 426, 435, 444, 459Capital asset pricing model (CAPM) 172–92 Capital flight 137 Capital market 5, 35Capital market line 166–7, 178–9 CAPM see capital asset pricing modelCarry trade 289–91Cash market 35Cash reserves 443Cash settlement 312, 401CDO see collateralized debt obligationCDS see credit default swapsCentral bank 40–1, 70–5, 250Certificate of deposit 101Characteristic line 174Chartists 213–15, 231, 244Cheapest-to-deliver bond 323Chinese wall 232, 448Clearing house 309Co Co bonds 138, 140Collateral 404, 419Collateralized bond obligation 394Collateralized debt obligation 391–2, 396–7, 394, 435Collateralized loan obligation 394Commercial banks 44–5, 249 Commercial bills/paper 97, 219, 396Computerized trading 198Conduit 410Confirmation bias 238–9Continuous market 34Contracting cost 32Contractionary monetary policy 70–2, 78–9, 112 Convertible bond 134Convexity 121–2Corporate bonds 128–36 Correlation coefficient 153 Cost of carry 198Counterparty risk 308–9, 388, 397, 402, 46, 436 Coupon payment 116–17 Covariance 152–3, 162–3, 173, 175Covenants 219, 364Covered interest parity 264–6 Credit crunch 2, 19, 391, 405–38Credit default swaps 391, 397–405, 428

Credit derivative 391–8, 461Credit event 391, 397–400Credit rating 62, 97, 129–30, 136, 142, 310, 392–3, 393,

396, 427 Credit rating agency 413, 415Credit risk 129, 133Cross border lending 7–8Crowdfunding 16–17Crowding out 85 Cross rates 251–2Cuomo report 417–18Currency futures 325–7Currency swap 374–5, 380–4Current ratio 223Current yield 117–18Curvature 126–7

Day of the week effect 234Debt 28–9

coverage 223finance 196, 218–19junior 402market 5–6maturity structure 219security 148senior 402

Debenture bonds 129Debt–equity ratio 215–19Debt versus equity finance 28–9, 196, 218–19, 224Default rates 28, 43, 86, 96, 107, 309, 385, 392Default risk 44, 96–7Defensive securities 181–2, Deficit agents 3–4, 27, 30–2, 62–3Delta 360Deposit

Insurance 433 -taking institutions 43–4

Deregulation 13–4, 16, 50, 446–7Determination of interest rates 79–85Diminishing marginal utility of wealth 154Direct placement 96Discipline function 36Disintermediation 92Disposition effect 237Distant contract 312 Diversifiable risk 184, 187 Diversification 155–60Dividend 52, 63, 201, 203, 215–17, 220–1, 236

payout ratio 221pricing model 207–13, 219yield 188, 218, 221

Dividend irrelevance theorem 211Dobb-Frank Act 14, 427–8 Domestic bond 136Dominance principle 162, 167



I N D E X 497

Dornbusch model 288, 293–300Dot com bubble 201–2Double bottom 214Duration 122–7

Earningsannouncements 241–2per share 220yield 173, 221

EfficiencyAllocative 228 operational 228

Efficiency frontier 158–61, 176Efficient diversification 164 Efficient market hypothesis 35, 228–45

semi-strong form 229, 336–44strong form 229, 243weak form 228–36

Efficient portfolio 148, 180Eligible reserves 97Emerging markets 18, 21–2, 51, 60, 143, 399Endowment policies 50Equity

different types of 28–9, 149, 200–3finance 196, 218–19, 224pricing of 207–13security 149tranche 394

Estimated volume 312ETFs see Exchange Traded FundsEuro 9, 23Eurobonds 137–44Eurocommercial paper 111 Eurocurrency markets 102–10, 122–3Eurodollar 102–10Euro medium term notes 111–12Euronotes 111European Banking Union 455–6European Monetary Union 23 European option see optionsEvent risk 133Event studies 236, 239–42 Exchange rate

bid–offer spread 251definition 247determination 250–66effective 266–72forward rate 252, 263–6nominal 266–72overshooting 293–303real 266–72risk 21, 149, 263spot rate 252, 254–63turnover 247

Exchange Traded Funds 14, 53–4

Expansionary monetary policy 70–1, 112 Expectations theory 87–9 Expected return 149, 151, 153–4, 216–17Expected volatility 363–4Exposure limits 443Exotic options see optionsExternalities problem 441

Factoring agency 62Fannie Mae 412Federal Deposit Insurance Corporation (FDIC) 13–14,

107, 396, 424Federal Funds rate 419–20Federal Open Markets Committee (FOMC) 73 Federal Reserve 406Freddie Mac 412Filter rule tests 232–3Financial asset 148Financial centres 3–7Finance companies 40, 61–2Financial innovation 14–18, 54, 133, 142–3, 391, 413,

442, 447Financial institutions 40–66Financial intermediaries 3–4, 27, 30–2, 40, 43, 52

role of 62–3types of 43–65

Financial intermediation 27 Financial liabilities 29Financial markets 29, 32–55

classification participants 36–7 role of 35–6

Financial ratio analysis 219–25Financial security 28 Financial Services Act 448–9 Financial Services Authority 437Financial Services and Market Act 430Financial Stability Board 46Fines 434FinTech 16–18, 23–4, 66Firm size 188First Banking Directive 454–5 Fiscal policy 85–6, 422Fixed exchange rate 92, 247, 258–63Fixed recovery CDS 402Flexible price monetary model 286–92Flight to quality 133Floating exchange rate 257–8, 303Floating interest rate 105Floating rate note 134–5, 138, 144Foreign bond 136, 140Foreign exchange market 246–73 Forex rigging scandal 253–4Forward exchange rate 198 Forward/forward rate 322



49 8 I N D E X

Frankel model 300–3Fraud 442, 446Free cash flow 223Free float 202Frontier markets 22, 29, 32–5

Participants 36–7Fuld, Dick 409–10Funding risk 42–3Futures 306–29

bond 323–4comparison with forwards 307–8comparison with options 342–5comparison with swaps 386–7 currency 325–7exchanges 306–7 nearby contract 312short-term interest rate 306, 319–24stock index 306

Gearing 215–19General insurance 45, 49–51 Gilt edged market makers (GEMMS) 115Glass-Steagall Act 408Globalization 10–1Goods arbitrage 277, 286–7Gordon growth model 208–10

Hamburgers and PPP 198–9Head and shoulders 214–15, 231 Hedge funds 56–9Hedgers 36–7, 341, 349, 384Hedging 37, 137, 263–4, 273, 317–20, 324–6High frequency trading 198–9 Hire purchase 62Historical volatility 363–4 Holder 331, 344, 346Home country preference 387

IBFs see International banking facilitiesICE Futures Europe 35Implied volatility 363–4 Indenture 129Indifference curves 154–5 Inflation 83–5

target 260Information costs 32Insider trading 243, 441, 444 Initial margin 310, 313–15, 436, 452Initial public offering 60, 199–202, 408Insider trading 243, 441, 444Institutional investors 196, 199, 313Insurable interest 401Insurance 8, 16

Premium 31Insurance companies 45, 49–51

Interbank market 97–100Interest coverage 223Interest equalization tax 103, 137Interest rate

determination 68–75, 79–91futures 318–24long term 68, 83–5nominal 68, 83–5, 292real 68, 83–5, 292short term 68, 87–9, 92

Internal ratings based approach 425, 459International banking facilities 105International capital market 136–7 International Swaps and Derivatives Association

374, 398Intrinsic value 354–58Investment analyst 231Investment banks 45, 97, 413 Investment companies 52–3Investment trusts 52–3 Islamic finance 19–20

January effect 234–5Jensen’s alpha 186–7 Jobber 447Junk bonds 135–6

Kappa 366

Lambda 366Law of one price 277LBO see leveraged buy outLoanable funds theory 81–3Lead manager 141–2Leeson Nick 11Lehman brothers 406, 409–10, 424 Lender of last resort 110, 112, 419 Letter of credit 97, 100–1Leverage 413 Leveraged buy out 59–60 Leverage ratio 461Life assurance 29, 45Life insurance 45Libor 78, 104–8 Libor scandal 107–8 Liquid asset ratio 223Liquidation 223Liquidity 27, 31, 42, 44, 86, 115, 144, 396Liquidity coverage ratio 462Liquidity preference theory 89Liquidity premium 219 Liquidity provision 419–21Liquidity requirements 200, 443 Liquidity risk 44, 397Listing requirements 200, 442



I N D E X 49 9

Loanable funds theory 81–3 Long futures 313Long-term capital management 58

Macaulay duration 122–3Madoff, Bernard 452Management buyout 61Margin payments 310,Market capitalization 220Market-maker 36, 199, 447Market model 173–6Market portfolio 166–7, 178–9, 190Market price of risk 168, 179, 181Mark to market 401Market risk 167–9, 163–4, 175, 181, 190–1Market segmentation theory 90–1Mark to market 310, 401Master Trust 15Maturity transformation 30MBS see market backed securitiesMedium-term notes 136Merger 52, 63Minimum variance portfolio 159–60Modified duration 123–6Monetary base 74Monetary models 276, 288–303Monetary policy 41, 70–5, 91–2Monetary Policy Committee 73Money

functions of 68–9demand 73–4, 79–80, 92, 289, 293, 295

Money market 35, 95–112, 297–300Money multiplier 75–8Moody’s 130–2, 393, 404Moral hazard 13, 437Moratorium 398Mortgage backed securities 403, 413 Mortgage equity withdrawal 412Multifactor CAPM 189–90 Mutual fund 51–2, 57, 59, 441, 452Mutual recognition 24, 453, 455

Naïve diversification 164, 169Nasdaq 196–7Narrow money supply 75–8National debt 41, 86Nationalization 430–1Nearby contract 312 News 236NINJA loans 412Non-sterilized intervention 258–63Normal distribution 151–2Northern Rock 406, 430–2Note-issuing facilities (NIFs) 111Notional principal amount 377

Off-balance-sheet exposure 42, 388, 437, 449Offshore market 102 OPEC 16, 104Opening price 312Open interest 310–11, 315Open position 266Open market operations 41, 421Opening price 312Open position 266Options 330–51

American 332, 339at-the-money call 331–2currency 339–41 delta 366European 332, 345, 353exercise price exotic 348–9gamma 366growth of 331in-the-money 354–5interest rate 338–9intrinsic value 354–9kappa 366lambda 366out-of-the-money 354–5, 367premium 332–4 pricing of 352–72profit/loss profile on a call 333–4 profit/loss profile on a put 335–6 put 331–2, 334–6put–call parity 366–8rho 366stock index 337–8strategies 345–8strike price theta 366time value 354–9 turnover 331versus futures 342–5

Ordinary shares 200–1, 207, 429Over-collateralized 143Overdraft 219Overshooting 293–303Over-the-counter (OTC) market 7–8, 308–10, 398,

401, 436

Par value relation 119, 135Passive fund management 51, 55, 59, 232Passport principle 24, 453Payments mechanism 30Pension funds 55–6, 63, 91, 393People’s Bank of China 261–2Physical delivery 399Pillars 1, 2 and 3 459–60



5 0 0 I N D E X

PIMCO 129Political risks 21, 137Ponzi scheme 11Portfolio diversification 155–63Portfolio theory 147–71PPP see purchasing power parityPre-emptive rights offering 33 Preferred habitat theory 90Preference shares 200–3, 220, 429Price–earnings effect 241Price–earnings ratio 173, 188, 221–2 Price–earnings to growth ratio 222Price interest point (pip) 248Price-to-book ratio 223Piece-to- cash flow 223Price-to-liquidation ratio 223Primary dealer 420Primary gearing 215–19Primary market 33–4, 199–200Principal–agent problem 441Private equity 57, 59–60Private placements 33Privatization 200Proprietary trading 249Prospect theory 237 Prudential Regulation Authority 450–1Public bourse 197, 428, 437, 461 Public issue 96Purchasing power parity 276–87, 289, 295, 301, 303Putable bond 134Put–call parity 366–9Put option see options

Quadratic easing 120–1Quadratic programming 163Quality spread 132, 386Quantitave easing 421–2Quantity theory of money 8

Random walk 229–31Rate of return 149 Rational bubble 242–3Red herring prospects 142Recovery rate 402–3Reference entity 387Regulation of financial sector 13–14, 90, 106, 201, 387,

440–63 benefits/costs 440–2disclosure requirements 33, 443 Eurobonds 137–44European 452–6 investor protection 442licensing 442–3objectives of 442prudential 442

rationale for 440–2statutory versus self-regulation structural 442types of 442–4United Kingdom 446–51

Regulation Q 103Regulatory arbitrage 457Regulatory risk 44 Relative PPP 278Repurchase agreement (Repo) 101Retained earnings 211 Required rate of return 208–13Reserve

ratio 77requirement 77–9, 97, 428

Retail banks 44Retail clients 248–9 Retained earnings 211Return on capital employed 220–1 Reversing trade 310–11Rho 366Rights issue 34, 134, 203–4Risk 148, 151, 349

aversion 153–5, 176, 288, 406default 44, 96–7exposure 31free 149, 151, 154, 165–6, 177–8liquidity 31–2, 42, 44loving 153 management 5, 31, 48–9, 415, 460 neutral 153profile 42ratios 222–3 regulatory 44re-investment 90transformation 30–1

Risk premium 84, 105, 178–9, 189–90, 211, 387Risk weighted assets 461Riskless security 165Royal Bank of Scotland 406–7Run test 234

Sarbannes-Oxley 451Savings institutions 45Screen-based market 23, 34Second Banking Directive 455 Secondary buy out 60Secondary market 33–4, 69, 144, 206–7, 348, 380Securities Exchange Commission 48, 53, 141, 391, 451–2 Securities Investment Board 448–9Securities markets 33–5Securities market line 180–2Securitization 15–16, 92, 395, 435–6Self-Regulatory Organisation 448–9Selling group 142



I N D E X 5 01

Senior debt 402Settlement price 313Shadow banking 45–7, 66, 451Shares in issue 220Sharpe ratio 185–6Short futures 313Short selling 57, 176, 203–5 Short squeeze 204–5SIV see structured investment vehicleSingle Market 453–4Size effect 241Smart beta 55Solvency risk 397Sovereign Wealth Funds 64–5, 432, 431Special liquidity scheme 420 Special purpose vehicle/entity 395, 437–8Specific risk 148, 163–4, 175, 179, 181–2, 184–5, 191Speculator 37, 340–1, 344–5SPV see special purpose vehicleStandard and Poor’s ratings 130, 393, 404Straddle 332Strangle 332Sterilized intervention 258–63 Stock Exchanges 196–7 Stock index futures 311–19Sockmarket capitalization 5Stockmarket crash 196, 198, 242–3Stockmarket performance 206–7Stockmarkets 196–200Stock split 236Stop-loss 316Straddle 345–6Straight 138, 142Strangle 346–8Stress tests 424–6Structured investment vehicle 46, 396–7Subprime 411, 413Subprime mortgage 392, 408Sukuk 20Supervision 41–2Surplus agents 3–4, 27, 30–2, 62–3Swap 373–88

absolute advantage 377–8 basis 388buy back 386callable 388comparative advantage 378–80, 384 comparison with forward 386–7currency 374, 381–4 financial press 382forward rate 388index 388innovations in 387–8interest rate 374, 381–4notional principal amount 377, 384

plain vanilla 377, 387putable 388role of intermediary 384–5 roller coaster 388secondary market 380, 385–7scenarios 374–7 swap rates 382swap reversal 385swap sale 388swaption 388zero coupon 387

Syndicated loans 110Systematic risk 46, 148, 164–5, 175, 180–1, 191, 451

Takeover 52, 63, 207, 221, 228, 436Technology 2, 11–13TALF see Term Asset Backed Securities Loan FacilityTARP see Troubled Asset Relief ProgramTAURUS 12Technical analysis 213–15, 231, 234Technology 11–13, 17–18TED spread 105–6Tender issue 26Term Asset Backed Securities Loan Facility Term structure 68, 86–91Theta 366Tier capital 457–9 Time value 354–9Too big to fail 43, 424Tranches 96 Transaction costs 22, 90, 108, 115, 228, 232, 235 Treasury bills 69, 95–7 Treasury bonds Treynor ratio 186 Troubled Asset Relief Program 424 Type I, II, III and IV liabilities 29

Uncovered interest parity 287–91, 299 Underlying currency 339Underwriting 33, 144, 201, 204, 206, 388Underwriting group 141, 201Unit trust 51–2, 57Universal banks 44Unsystematic risk 148, 164–5, 186

Value at risk 48–9Variation margin 310, 314–15, 436Vehicle currency 248Venture capital companies 16–17, 61, 201VIX index 364–5Volatility 353, 363–4Volker rule 427–8

Warrant 134, 138, 349Wealth-management 16–17



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