Financial Market

TOPIC 1: INTRODUCTION TO FINANCIAL
MARKETS
Aim
The aim of this topic is to provide an introduction to, and framework for examining, the nature and
operation of the financial system. The two main methods of financing are distinguished along with
the different types of financial assets that are created. In addition, the relationship between the
financial system and the economic system and the role of government with respect to the financial
system are considered.
Learning objectives
After working through this topic, you should be able to:
1. Describe the main features of the financial system.
2. Distinguish between direct and indirect financing and the characteristics of each.
3. Explain the relationship between the financial system and the economic system.
4. Outline the main reasons for, and methods of, government intervention into financial markets.
2012 Topic 1 – Introduction to Financial Markets 1

O B J E C T I V E 1
After working through this section you should be able to describe the main features of the
financial system.
1.1 The financial system
To understand the nature of financial markets it is first necessary to understand the overall financial
system that comprises, inter alia, financial markets.
The main functions of a nation’s financial system are to facilitate the:
transfer of funds from surplus to deficit economic units, in primary financial markets, by the
creation of new financial assets
trade of existing financial assets in secondary financial markets
A nation’s financial system comprises surplus economic units (lenders), deficit economic units
(borrowers), financial institutions, financial markets and financial assets.
1.1.1 Surplus economic units
These are individuals or small groups (eg individual households or business firms) who have more
funds available than they require for immediate expenditure. That is, they represent savers and
potential lenders of their surplus funds.

1.1.2 Deficit economic units
These are individuals or groups (eg individual households or business firms) who require additional
funds to meet their expenditure plans. That is, they represent potential borrowers of funds.
1.1.3 Financial institutions
These are organisations whose core business involves the borrowing and lending of funds (financial
intermediation) and/or the provision of financial services to other economic units.
1.1.4 Financial assets
Financial assets, also called financial instruments, represent a claim or right that a surplus economic
unit holds over a deficit economic unit. Issued by the party raising funds, it acknowledges a financial
commitment and entitling the holder to specified future cash flows. For the party issuing the financial
assets, the assets represent a liability or obligation.
Whenever, funds are lent and borrowed, financial assets are created. Primary market financial
transactions involve an exchange as funds are exchanged for financial assets. Lenders of funds are
also buyers of financial assets and borrowers of funds are sellers of financial assets.
All financial assets have four different attributes which can provide a basis for comparison
between different types of financial assets:
return or yield
risk
liquidity
time pattern of return or cash flow
Note that expected return or yield has a positive relationship with risk and inverse relationship with
liquidity. The higher the level of risk and the lower the liquidity, the higher the return on investment
required by lenders of funds (surplus economic unites). Lenders of funds are able to satisfy their own
personal preferences by choosing various combinations of these attributes.
The financial assets that are created and exchanged can be divided into the following four broad
types:
Debt: Debt instruments represent an obligation on the part of the borrower to repay the principal
amount borrowed and interest in a specified manner over a defined period of time or when a
specified event occurs. Some examples are:
Deposits - eg bank deposits
Contractual savings- eg life insurance, superannuation

Discount securities - eg commercial bills
Fixed interest securities - eg bonds, debentures
Equity: Equity differs from debt in that it represents an ownership claim over the profits and
assets of a business. The main example is ordinary shares.
Hybrid: Hybrid financial assets comprises securities that combine features of both debt and
equity. Two examples are preference shares and convertible notes.
Derivatives: Derivative instruments are financial assets whose value is derived from another type
of financial asset. Two examples are options and futures
Whatever form financial assets take they represent a claim (or right) which a surplus economic unit
holds over a deficit economic unit. Likewise they also represent an obligation of deficit economic
units.
1.1.5 Financial markets
An economic market comprises a mechanism which brings together, not necessarily to a single
location, sellers and buyers for the purpose of exchange. Financial markets are where financial
assets are created and/or exchanged. Every nation’s financial system comprises a number of
different financial markets which can be classified in different ways for different purposes.
One type of classification is between primary and secondary financial markets. In the former, new
financial assets are created and traded in exchange for borrowed funds: eg a household (surplus
economic unit) lends funds to a corporation (deficit economic unit) in exchange for debentures (a
financial asset). In the latter, existing financial assets are traded which results in a change of
ownership but not the lending of funds: eg the holder of debentures sells his financial asset to another
person.
The term financial security is used to describe financial assets that can be traded in a secondary
market.
Another type of classification is between money markets, where funds are lent for a period of less
than one year, and capital markets, where funds are lent for one year or longer.
Other types of classification distinguish between financial markets for the different type of
financial assets that are traded. This is the basis on which we will be examining different financial
markets in Australia. Specifically, we will examine the following separate Australian financial
markets in turn:
• The Money Market (topic 3)

• The Debt-Capital Market (topic 4)
• The Foreign Exchange Market (topic 5)
• The Equity Market (topic 6)
• The Derivatives Market (topic 7)

O B J E C T I V E 2
After working through this section you should be able to distinguish between direct and
indirect financing and the characteristics of each.
1.2 Direct and indirect finance
The flow of funds in primary financial markets can either be direct from lender to borrower or
indirectly through a financial intermediary. The alternative methods of financing are illustrated in
the diagram below;
1.2.1 Direct finance
With direct finance the surplus economic units who are the ultimate lenders provide funds directly
to the deficit economic units who are the ultimate borrowers. In exchange for the funds, the deficit
economic units issue financial assets that are primary securities held by the surplus economic units
and represent a direct claim over the ultimate borrower.
In direct finance financial institutions frequently provide financial services to the parties, particularly
the borrowers. These services include financial advice, financial management and security
documentation, marketing, sales negotiation, provision and arrangement of underwriting facilities. In
providing such services financial institutions are paid commission or fees.
1.2.2 Indirect finance
Indirect financing is also known as intermediated financing because it involves financial institutions
performing the role of financial intermediary. With indirect financing, the surplus economic units,
the ultimate savers, lend their funds initially to a financial institution who then lends the funds
to the deficit economic units who are the ultimate borrowers.

The financial institution acts as a financial intermediary and performs the role of both borrower and
lender. This is the basis of the legal relationship that financial intermediaries have with surplus and
deficit economic units. In performing this role financial intermediaries earn income in the form of a
net interest margin and fees. The net interest margin represents the difference between the average
cost (interest paid) of funds and average return (interest earned) from lending.
In indirect financing, deficit economic units issue primary securities which are held by financial
intermediaries who issue secondary securities to surplus economic units. Surplus economic units do
not have a direct claim on deficit economic units.
You should not become confused between primary and secondary financial markets and
primary and secondary financial assets (securities). The terms “primary” and “secondary” are
used in different contexts for each of the above which are not related. Primary and secondary
securities are both created in primary financial markets and can be traded in secondary financial
markets.
1.2.3 Advantages of financial intermediation
In carrying out the role of intermediation financial institutions provide a number of benefits to
borrowers, lenders and the economy as a whole. The main advantages of financial intermediation
are:
• Asset value transformation: financial intermediaries are able to create secondary securities
that differ in value from the primary securities that are issued by deficit economic units. In
this way they can tap small individual savings and pool them together for the purpose of
making larger loans.
• Maturity transformation: financial intermediaries are able to borrow for different time periods
than for what they lend. In doing this they are able to match the maturity preferences of
borrowers and lenders. As a general rule, lenders require greater liquidity than borrowers are
prepared to provide.
• Credit risk reduction and diversification: financial intermediaries are able to reduce the risk
of lending to borrowers who are unable to meet their loan commitments as a result of their
expertise and knowledge. In addition, as a result of their size and diversification of loans,
they are able to spread a small percentage of bad loans across their total loan portfolio.

• Liquidity provision: Ability to convert financial assets into cash. Financial intermediaries,
due to their size and specialisation in borrowing and lending are able to provide their
customers with a high degree of liquidity eg. cheques, ATM, EFTPOS facilities.
• Increased quantity of national savings: As a result of the above advantages the existence of
indirect financing will tap a greater quantity of national savings and hence increase the
supply of funds available to finance real investment and promote economic growth.
1.2.4 Disadvantages of financial intermediation
There is no doubt that financial intermediation provides a number of advantages. However, it does
not come without cost as both borrowers and lenders must pay for the benefits they receive. This
generally means:
Increased cost of funds for borrowers
Reduced return from lending for savers.
In addition to this, there is a further disadvantage in that, as a general rule:
It is less likely for secondary financial assets to be securitised ( ie financial securities) in that
they can be traded in a secondary market.
Over recent years there has been increased reliance by large borrowers on direct rather than indirect
(intermediated) finance. Hence the term disintermediation is used to describe this process.

O B J E C T I V E 3
After working through this section you should be able to outline the main institutional and
regulatory features of the Australian financial system
1.3.1 Nature and role of financial institutions
A financial institution is a business organisation whose core business is financial intermediation

and/or the provision of financial services to other sectors of the economy.
In indirect financing, a financial institution performs the function of financial intermediation by

borrowing from surplus units and lending to deficit units. Revenue is generated by net interest
margin and fees. In direct financing, a financial institution provides financial services by performing
the function of broker, agent, financial advisor, etc. Revenue is generated by fees and commission.
Although there is a great deal of overlap between the services offered by different financial
institutions, it is common practice to categorise non-bank financial institutions on the basis of how
they raise the majority of their funds. We can identify two main types of institutions:
• Deposit taking financial institutions: They attract the savings of depositors through on-
demand deposit and term deposit accounts. They provide loans to borrowers in household and
business sectors. e.g. commercial banks, building societies and credit cooperatives.
• Non Deposit taking financial institutions: They generally do not provide laons or take
deposits but they may managed funds under contractual arrangement (superannuation) and
provide a wide range of financial services. e.g. Investment banks, general insurance
companies and superannuation funds.
1.3.2 Current Institutional features
The Australian financial system comprises a range of different types of financial institutions
providing financial intermediation or other financial services.

Total Assets (Percentage Share) of Financial Institutions
From this table a number of observations can be made concerning the institutional structure of the
Australian financial system. These include:
The dominant role of banks with the commercial banks, as a group, comprising more than 50%
of the total assets of all financial systems. During the period of regulation banks share of financial
assets fell however, following deregulation it did increase.
Both building societies and credit unions are very small in terms of percentage share of
financial assets. However, there are a large number of individual institutions with approximately
30 building societies and 320 credit unions. The decline in percentage share of financial assets
owned by building societies has been particularly due to the conversion of a number of building
societies into banks.
Life offices and superannuation funds, as a group, have experience a significant increase in the
share of financial assets they control. The percentage share of life offices has declined in recent
years while superannuation funds have represented one of the fastest growing sectors of the
financial system. This is particularly due to government wages and taxation policy.
Other form of managed funds, particularly public unit trusts, have also grown significantly as
retail investors have turned toward equity and other types of managed investments and away from
traditional forms of investment such as bank deposits.

Mortgage originators and securitisation vehicles have only become recognised as a type of
financial institution in recent years. Officially, the Reserve Bank did not collect statistics on them
until December 1996. Mortgage originators have experienced considerable recent growth in the
90’s but shrank following the Global Financial Crisis. Mortgage originators make housing loans
and then sell these loans to securitisation vehicles set up as separate entities by financial
institutions. Funds are raised through the issue of mortgage backed securities by the securitisation
vehicles.
1.3.3.1 Commercial banks
Commercial banks are the largest group of financial institutions within a financial system and
therefore they are very important in facilitating the flow of funds between savers and borrowers. The
core business of banks is often described as the gathering of savings (deposits) in order to provide
loans for investment.
The traditional image of banks as passive receivers of deposits through which they fund their various
loans and other investments has changed since deregulation (for deregulation see topic 8). For
example, banks provide a wide range of off-balance-sheet transactions such a underwriting where for
instance the bank will commit to purchase unsold share after the share were issued to the market. The
bank can also act as guarantor on some financial products such as money market bills (“bank bills”).
A wide range of non-bank financial institutions has evolved within the financial system in response
to changing market regulation and to meet particular needs of market participants.
1.3.3.2 Building societies and credit unions
The majority of building society funds are deposits from customers. Residential housing is the main
form of lending. Credit unions funds are sourced primarily from deposits of members. Housing
loans, personal loans and credit card finance is available to their members. A defining characteristic
of a credit union is the common bond of association of its members, usually based on employment,
industry or community.
1.3.3.3 Investment banks and merchant banks
Investment banks and merchant banks play an extremely important role in the provision of
innovative products and advisory services to their corporations, high-net-worth individuals and
government.
Investment and merchant banks raise funds in the capital markets, but are less inclined to provide
intermediated finance for their clients; rather, they advise their clients and assist them in obtaining
funds direct from the domestic and international money markets and capital markets.
Investment banks specialise in the provision of off-balance-sheet products and advisory services,
including operating as foreign exchange dealers, advising clients on how to raise funds in the capital
markets, mergers and acquisitions, acting as underwriters and assisting clients with the placement of

new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and advising
on corporate mergers and acquisitions, advising clients on project finance and, providing risk
management services.
1.3.3.4 Managed funds
The main types of managed funds are cash management trusts, public unit trusts, superannuation
funds (pension funds), statutory funds of life offices, common funds and friendly societies. Managed
funds may be categorised by their investment risk profile, being capital guaranteed funds, capital
stable funds, balanced growth funds, managed or capital growth funds.
Managed funds are a significant and growing sector of the financial markets due, in part, to
deregulation, ageing populations, a more affluent population and more highly educated investors. In
Australia, employers must contribute the equivalent of 9 per cent of an employee’s wage into a
superannuation account in the name of the employee. The superannuation funds receive concessional
taxation treatment.
1.3.3.5 Life insurance offices and general insurance offices
Life insurance offices are contractual savings institutions. They generate funds primarily from the
receipt of premiums paid for insurance policies written. Life insurance offices are also major
providers of superannuation savings products.
Whole-of-life insurance policies include an insurance risk component and an investment component.
The policy will accumulate a surrender value over time. A term-life policy provides life insurance
cover for a specified period. If the policyholder dies during that period, an amount is paid to the
named beneficiary.
Related insurance policies include total and permanent disablement insurance, trauma insurance,
income protection insurance and business overheads insurance. General insurance policies include
house and contents insurance. Motor vehicle insurance includes comprehensive, third party fire and
theft, third party only and compulsory third party insurance.
1.3.3.6 Finance companies and general financiers
Finance companies derive the largest proportion of their funding from the sale of debentures (Debt).
They provide loans to individuals and businesses, including lease finance, floor plan financing and
factoring. Deregulation of commercial banks has resulted in a significant decline in finance
companies. Many finance companies are now operated by manufacturers, such as car companies, to
finance sales of their product.
i.e. AGC, CBFC and ESANDA

O B J E C T I V E 4
After working through this section you should be able to explain the relationship between the
financial system and the economic system.
1.4 The financial and economic systems
In the study of economics, it is normal to treat the financial system as a component part of the larger
economic system. The economic system is seen as comprising, inter alia, real output markets (for
goods and services), resource markets and financial markets.
The role of the financial system is to facilitate the operation of the overall economic system and in
particular the output markets for goods and services.
1.4.1 The economic system
A nation’s economic system is concerned with the production and distribution of goods and services.
In performing this function, a nation’s economic performance is normally assessed in terms of the
following economic objectives:
economic growth
full employment
price stability
external balance
efficient allocation of resources
equitable distribution of income and wealth
1.4.2 The financial system and economic objectives
A nation’s financial system will affect its performance with respect to each of the economic
objectives listed above.
1.4.2.1 Economic growth
Historically, there is a well established relationship between the development of a nation’s financial
system and economic development. The establishment of a well developed financial system is seen
as a necessary prerequisite for a country to raise sufficient funds, to finance the necessary
infrastructure projects required for sustained economic development.

For developed economies, the cost and availability of funds, determined in the financial system, are
significant determinants of aggregate demand, particularly private investment demand. The level and
rate of growth of aggregate demand, in turn, has a major impact on a nation’s economic growth rate.
1.4.2.2 Full employment
The demand for resources, including labour, is derived from the demand for final goods and services.
Thus, the level of employment in the economy is directly related to aggregate demand and the rate of
economic growth. As the cost and availability of funds is a significant determinant of aggregate
demand, it is also a significant determinant of the level of employment.
1.4.2.3 Price stability
The rate of inflation is also significantly determined by the growth of aggregate demand.
Consequently, the cost and availability of funds in the financial system will have some bearing on
whether a nation is experiencing inflation or relative price stability.
A nation’s monetary policy normally involves Central Bank intervention into the financial system in
pursuit of macroeconomic objectives, particularly price stability. In Australia, at the present time, the
Reserve Bank of Australia has set an inflation target of 2 - 3% per annum for determining the
conduct of monetary policy.
1.4.2.4 External balance
External balance refers to a desirable position in terms of a nation’s international transactions, as

reflected in that country’s balance of payments, and exchange rate value of its currency. Both the
balance of payments and the exchange rate will be significantly affected by the financial system.
The cost and availability of funds will affect the level and rate of change of the export and import of
goods and services. In addition, borrowing from overseas (capital inlow) and overseas investment of
funds (capital outflow) are directly affected by conditions in financial markets both domestically and
globally.
Thus, both current and capital account transactions of a nation’s balance of payments will be
significantly determined by domestic and international financial market conditions.
As international transactions determine the demand and supply for a nation’s currency, financial
market conditions will also have a significant affect on the foreign exchange value of that nation’s
currency.
1.4.2.5 Efficient allocation of resources
An efficient allocation of resources is where a nation’s limited resources are allocated to produce that
output mix of particular goods and services that maximises the satisfaction of society. This is best

achieved by competitive markets where the allocation of resources is determined by demand and
supply for individual goods and services.
Any non-market distortions that influence the levels of demand or supply will reduce the efficient
allocation of resources. Non-market distortions can result from factors in resource markets, finance
markets or in the markets for goods and services themselves.
The efficient allocation of resources requires that factors in finance markets do not distort the pattern
of demand for individual goods and services from that which would otherwise take place. Allocative
efficiency requires that the financial system directs funds to the highest yielding forms of
expenditure. This is best achieved by competitive financial markets with a minimum of government
intervention and controls.
1.4.2.6 Equitable distribution of income and wealth
Non-market distortions that affect the cost and flow of funds not only reduce allocative efficiency
but have effects that are not spread evenly over the community. For example, ceilings on particular
interest rates means some groups receive benefits, or an effective subsidy, while other groups are
required to pay higher cost for funds than would otherwise be the case. As a result, the distribution of
income between different groups in the community is affected.
At different times, governments have intervened into finance markets for the main purpose of
altering the distribution of income to one that it views as more socially desirable or equitable.

O B J E C T I V E 5
After working through this section you should be able to outline the main reasons for, and
methods of, government intervention into finance markets.
1.5 The government and finance markets
Over the past fifty years, the Australian government and government bodies, such as the Central
Bank, have significantly altered both the extent, and methods, of intervention into financial markets.
Similar changes have been experienced in financial markets around the world.
In general terms, we can divide the past 50 years into the following three periods:
• Regulation (pre 1980’s): During this period the Australian financial system was characterised by
an extensive array of direct controls, particularly over banks.
• Deregulation (1980’s): During the first half of this decade the direct controls and other types of
government regulation were progressively removed and the financial system took on the features
of a competitive market.
• Post-deregulation (1990’s): During the first half of this decade, the role of government changed
again with a strengthening of government intervention. However, this was different in nature from
the regulations that existed in the pre-1980 period.
These three periods are outlined in more detail in the next objective.
1.5.1 Reasons for government intervention
All government policy actions are aimed at the achievement of particular objectives. In particular,
the following objectives have been important reasons for government intervention into finance
markets:
• Macroeconomic objectives of economic growth, full employment, price stability and external
balance. The previous section outlines how the financial system can affect a nation’s performance
with respect to these objectives and they have always been a major rationale for government
intervention.
• An efficient, fair and competitive financial system.
• The promotion of financial safety.
1.5.2 Methods of government intervention
There are numerous ways in which government actions can affect conditions in finance markets
either directly or indirectly. This includes the main arms of economic policy as well as direct
legislation. The main methods are:

Fiscal policy
the financing of a budget deficit or disposal of a budget surplus
individual outlay and revenue items.
Monetary policy
open market operations
reserve asset requirements.
External policy
exchange rate policy
actions affecting exports and imports
capital inflow/outflow controls.
Wages policy eg superannuation requirements.
Competition policy
eg attitude of the Australian Consumer and Competition Commission towards bank

mergers.
Consumer protection - voluntary and legislative.
Direct legislation - eg aspects of corporations law, superannuation legislation.

TOPIC 1: SUMMARY
In this introduction to finance markets the emphasis has been on the nature and characteristics of the
financial system and its relationship to the larger financial system.
The financial system comprises both primary and secondary markets, each of which performs a
different role. The primary markets are concerned with mobilising the savings of surplus economic
units and transferring the surplus funds, either by means of direct or indirect finance, to deficit
economic units in exchange for newly created financial assets. The secondary markets are concerned
with the trade of existing financial assets.
There are many different financial assets that are created and traded in financial markets. Financial
assets can be classified as debt, equity, hybrid or derivatives and can be distinguished from each
other on the basis of return, risk, liquidity and time pattern of return.
Conditions in finance markets will have a significant influence on the overall economic system and
the achievement of economic objectives have always been main reasons for explaining government
intervention into finance markets.

TOPIC 2: THE FLOW OF FUNDS A N D
DETERMINATION O F
INTEREST RATES
Aim
The aim of this topic is to provide an overview of the flow of funds within the Australian
financial system together with an examination of the nature and determinants of interest rates
(the cost of funds). The role of the different sectors of the economy in the flow of funds
between deficit and surplus units is considered. This is followed by an analysis of the nature of
interest rates including some basic interest rate calculations. The determinants of the level and
structure of interest rates are then examined.
Learning objectives
1. Identify the main features of role played by the different sectors of the economy in the
flow of funds between surplus and deficit units.
2. Explain the nature of interest rates and complete some basic interest rate calculations.
3. Outline and explain the main determinants of the level of interest rates.
4. Outline and explain the main determinants of the structure of interest rates.

TOPIC 3: THE MONEY MARKET
Aim
The aim of this topic is to introduce students to the short term debt market and provide an overview
of the basic instruments used in funds management in the short end of the yield curve. During this
course the short term market is referred to as the “Money Market” and is overnight to 12 months in
time frame. We will look at how these products are used and the pricing of these instruments in the
markets.
Learning Objectives
After working through this topic you should be able to:

1. describe the nature and functions of the money market
2. explain who are the major participants in the money market
3. describe the various products traded in the money market
4. complete calculations in the pricing of money market instruments.
5. appreciate the use of data and information
6. describe the various money market products traded in the global financial system’s eurocurrency
markets

O B J E C T I V E 1
After working through this section you should be able to describe the nature of this market
and its functions from the point of view of both deficit and surplus units.
3.1 The nature of the market
The money market is the market by which participants can buy and sell, borrow and lend money. It
is generally defined as short term in nature which means for instruments with maturities less than one
year. Borrowings and investments greater than one year in maturity are termed part of the capital or
fixed interest market.
The money market is not a physical market: i.e. there is no central place where participants gather
together to trade money. Instead it is a market that is linked by a vast network of communications
which will be described in a later section.
Throughout this topic, it is intended for the material to apply to the major money markets in the
world. In some cases there may be differences peculiar to a market. Overall the principles are the
same throughout the world.
The money markets around the world are becoming more and more integrated as a result of financial
deregulation, technological change and the increasing sophistication of market participants.

3.1.1 Functions of the money market
In its most basic form the Money Market facilitates the transfer of short-term funds from those units
which are in surplus (ie. have any excess supply of money) to those units which are in deficit (ie.
have a shortfall of money). This can be viewed as follows:
The Money Market is the mechanism by which this transfer takes place and has developed so that
this transfer has a strong degree of reliability and safety.
3.1.1.1 Other functions of the Money Market include :
the mechanism by which a country's government can raise short term funding
the primary method by which a country's monetary policy is implemented
a "determinant" of the country's interest rate structure (at least in the short term maturities)
the market for short-term international trade finance
Money is not just a medium for exchange but is also a traded commodity.
Money Market operations comprise:

1. Placing of deposits
2. Short-term borrowing
3. Sale and purchase of money market securities
3.1.2 Historical developments - why did this market evolve?
In an economy there are units which have surplus funds and those which are in deficit. Money
became an accepted means of exchange rather than a barter system because it could be used and
transferred by all parties in a village or a town. The Money Market evolved to allow the transfer of
funds between these units in an efficient way. For example, to bring together, either directly or
indirectly investors and borrowers of funds.
One of the main intermediaries of this transfer of funds are the banks which accept deposits and then
loan out these funds to borrowers.

3.1.2 Prices
As can be seen from the above example the price of borrowing money is reflected in the interest rate.
As money becomes tight we usually see interest rates rising. This will influence various decision
makers about their company’s investments. The nature and functions of interest rates were outlined
in Topic 2.
3.1.4 How do Money Market participants profit?
Borrowers of funds cannot expect to make a profit from their activities in the Money Market. How
they apply those funds will determine whether a profit is to be made. Lenders of funds will of course
make a return from their activities in the Money Market, but this has to be weighed against the
opportunity cost – the return they could have earned in some other way and which they have
foregone by investing in the Money Market. Surplus economic units and deficit economics would be
more likely to view the Money Market as a way to achieve their various objectives, rather than as a
way of making profits.
Intermediaries, on the on the other hand, participate in the Money Market in order to make a profit.
As mentioned previously the Money Market is simply the buying and selling of money and short-
term securities which is also called borrowing and investing. Using the example below, to make a
profit the bank will borrow funds (accept deposits, buy money) at a lower rate than it will lend funds
(sell money).
For example the bank may
Activity Rate of interest Total $ interest

Loan $1 million 5.00% $50,000
Accept a deposit
of $1 million 4.50% $(45,000)
Profit $5,000
(Note: positive cash flows mean money received while negative cash flows mean money paid out.)

O B J E C T I V E 2
After working through this section you should be able to identify and explain who are the
major participants in the money market.
3.2 Major participants
The major participants in the Money Market are:

The central bank e.g. Bank of England, US Federal Reserve, Reserve Bank of Australia (RBA).
The commercial (trading or money centre) banks.
Investment (or merchant) banks.
Finance companies.
Brokers.
Corporations.
Each participant has an important role to play in the operation of the market. These roles are
summarised below :
3.2.1 The central bank
In most of the developed economies around the world the central bank has an important role in
controlling/manipulating the supply of money and/or the level of interest rates. The extent of this
control differs from country to country.
The central bank implements policy, particularly monetary policy (with varying degrees of
government consultation). Government economic policy objectives include:
Economic growth
External balance
Full employment
Price stability
In achievement of these objectives, the central bank targets interest rates in the money markets via
the use of open market operations.

3.2.2 The commercial/trading banks
Commercial banks participate in the Money Market by:

accepting deposits and making loans to individuals and companies (intermediated / indirect
finance)
assisting individuals and companies to raise money through direct finance, by acting as acceptor
for bank bills (discussed later in this topic) and by providing a range of other financial services
providing a source of financing for the government, through the purchase of Government
Securities (eg. Treasury Bills)
3.2.3 Investment (or Merchant) banks
Investment banks participate in the Money Market by:

providing a range of financial services in return for fees and commissions
accepting fixed deposits and short-term loans
participating in the interbank Money Market, whereby banks manage their liquidity by lending
amongst themselves
3.2.4 Finance Companies
Finance companies participate in a variety of activities, including:

hire purchase or lease finance
investment and portfolio management
Most of these activities are long-term in nature, and therefore are part of the debt-capital market, but
they also need to participate in the Money Market in order to manage their liquidity and obtain short-
term finance.
3.2.5 Brokers
Brokers play an important role in most financial markets. They can:

match borrowers with lenders (or buyers with sellers), using their expertise and access to
information to make it easier for potential participants to locate a counterparty for a Money
Market transaction
provide the service of anonymity, allowing potential participants to remain anonymous in their
search for a counterparty, until the transaction is finalised
provide a range of other financial services
Brokers are paid fees or commissions in return for these services.

3.2.6 Corporations
Corporations play a major role in the operation of the Money Market. As both surplus and deficit
economic units, they need to both lend and borrow short-term funds. They can participate in the
Money Market by:
borrowing and investing funds in the overnight Money Market
taking advantage of overdraft facilities
placing fixed-term deposits with, and taking out fixed-term loans from, banks
(The above three activities are all examples of intermediated/indirect finance)
issuing commercial bills and promissory notes (direct finance)
All of the above activities are described further in Objective 3, where the various Money Market
products and instruments are examined in detail.
There are other sources of short-term finance available to corporations. These sources of finance are
sometimes not considered as part of the structured Money Market, but they nevertheless represent
ways of raising funds for periods of less than 12 months, and should be considered by a corporation
when it is considering the alternative sources of finance which are available to it. These include:
3.2.6.1 Trade Credit
Trade Credit can be an inexpensive source of funding and can often be used to meet at least some of
a company’s funding requirements. It simply involves delaying payment to the company’s creditors
for as long as possible – within the credit terms offered by the creditor. By the time the outstanding
invoices need to be paid, additional purchases will have been made, giving the company an ongoing
source of finance.
3.2.6.2 Accruals
As with trade credit, accruals provide the firm with a spontaneous and interest-free source of finance.
Accruals represent provisions made by the organisation before they are due and payable. Common
examples are wages and salaries, long service leave provisions and taxes provided for or collected
before they are due to be paid to the government.

3.2.6.3 Factoring/Debtor Finance
Both of these forms of finance involve the use of a firm’s accounts receivable or book debts to raise
funds. Finance companies are the major financial institutions that provide these facilities. A variety
of arrangements are possible that will allow the firm to use these assets to raise Accounts Receivable
Finance. This may involve using the book debts as security for a loan or series of loans from
financial institutions. Alternatively, the financial institution may “purchase” the firm’s debts
outright, providing the firm with an immediate cash flow in exchange for giving up the rights to
claim the debts. The amount of cash payable will be heavily discounted to reflect (a) the time value
of money, and (b) the credit risk associated with the debt.

O B J E C T I V E 3
After working through this section you should be able to describe the various products traded
in the money market. You should explain who might issue each product and who might invest
in that product.
3.3 Instruments
The range of instruments which are used to borrow and lend in the Money Market includes:
Cash Products
cash (overnight and 7-day cash)
loans (overdrafts, fixed term deposits and loans)
Discount Securities
commercial bills (bank bills and non-bank bills)
promissory notes (commercial paper)
Treasury notes
certificates of deposit
repurchase agreements
3.3.1 Cash products
Cash products are the simplest of products traded. They are based on the borrowing and lending of
cash between two parties.
Cash products are quoted on a yield basis, which is the interest rate on the loan or deposit. $5/$10
million is the usual parcel size in the professional market.
Overnight Cash (also known as 11am Cash)
deposits and loans are initially made overnight
deposits and withdrawals must be made by 11a.m. the next day. If this is not done, the
deposit is “rolled over” for another overnight period.
the rate is reset daily
7-day Cash (also known as 24-hour Cash)
the initial period of the deposit or loan is fixed for 7 days
after the initial period, the money can be repaid or withdrawn, but 24 hours notice is
required

the rate is reset daily after the initial 7-day period
3.3.1.1 Two-way pricing – cash products
In reality there are usually two prices quoted for each product in the market – a buy price and a sell
price. The price maker (usually a bank) is entitled to quote two prices and profits from the “spread”
– the difference between the prices. It is important in all markets to know which price the bank is
offering to the client.
The golden rule is that for any two prices you are shown you. as the price taker, can only deal on the
worst side of the quote – the most disadvantageous price from your point of view..
EXAMPLE
You have $10m cash to invest overnight.
To the bank you ask " what's the overnight cash doing?:"
The bank responds with "7.45-60"
What price can you invest your money at?
The bank response of 7.45 - 60 means 7.45% and 7.60% pa. This is just a short hand way of quoting.
The banks is quoting its bid price and its offer price to the investor.
As an investor you want the highest rate of interest possible so you would prefer 7.60% over 7.45%.
However, the bank is only bidding 7.45% for your cash. It is lending cash at 7.60%. The 15 points
difference is its spread and where the bank makes its profit.
The banks usually make a market in this area to the corporate or other market players. They offer a
two-way price, a price where they will bid for your funds and a price they will offer funds to you: ie.
if your company wishes to borrow money from then.
Corporations are known as the price takers in this market. From the corporation’s point of view the
credit risk is in lending to the firm or bank. They do not have a risk when they are borrowing from a
bank. Banks and other Money Market participants quote a 2 way price when asked by price takers
for a cash rate.
eg. When asking for a cash price the rate might be:
Bank A 5.70/75
As an investor what rate would you prefer?.............................................
As an investor what rate will the bank borrow?.......................................
To agree on a deal what rate do you deal at?...........................................
EXAMPLE

Your company wishes to borrow $5,000,000 overnight:
You ring 3 banks and get 3 prices.
A 5.82/85
B 5.75/80
C 5.75/77
Which bank do you choose?.............................................................
What rate do you deal at?.................................................................
How much interest would you pay?....................................................
3.3.1.2 Loans - short term requirements from companies, banks and individuals
Besides the organised markets for cash products discussed above, there is considerable flexibility
available when it comes to borrowing short-term funds from a bank. A number of variations are
available to best meet companies requirements. Two examples are:
committed loans
the line is available to draw down at all times
a commitment fee is payable
uncommitted loans
the line is available at the discretion of the bank
fees are lower on this type of loan
3.3.1.3 Bank overdrafts
A common source of short term finance for business and one of the most expensive.
The features of an overdraft are:
A credit arrangement provided by a bank allowing its customer to overdraw his or her current
account up to an agreed limit.
The interest is charged daily on debit balances only.
Deposits reduce a debit balance or increase a credit balance. Withdrawals (cheques) increase a
debit balance or decrease a credit balance.
An overdraft is repayable on demand.
Because banks must keep the funds available all the time in case they are required by the
customer, they cannot earn an optimal return on unused funds, so the interest rate charge on an

overdraft will be higher than that charged on a fully drawn advance. Indicator rate typically a
floating rate based on a published market rate, e.g. Australian prime rate Bank Bill Swap index
BBSW.
3.3.2 Discount Securities
The following products relate to a group of products know in the market as discount securities. They
a all traded in the market at a price that is less than their face value, or at a discount to the face value
of the security. Rather than receiving an explicit interest payment on the amount invested, the
investor pays a discounted amount when buying the security and receives the full face value when it
matures. The differences between the two amounts represents the return on the investment.
3.3.2.1 Commercial bills (Bills of exchange)
The definition of a Bill of Exchange: “An unconditional order in writing addressed by one person to
another, signed by the person to whom it is addressed to pay on demand or at a fixed or determined
future time a sum certain in money to or to the order of a specified person/s”.
Bills of Exchange were originally created to facilitate international trade. This type of bill is
sometimes called a “trade bill”. In recent years it is more common for a Bill of Exchange to be used
simply to borrow money, without any connection to international trade. This type of bill is referred to
as an “accommodation bill” or a Commercial Bill.
The parties involved in a bill are:

Drawer
Acceptor/guarantor/drawee
Discounter
The usual arrangement is that the drawer (who is borrowing money) essentially writes down an
instruction to the acceptor (also known as the drawee) instructing the acceptor to pay a certain

amount of money at a certain time in the future to a certain party – usually the holder of the
document (the discounter). In return for a fee, the acceptor signs the document to indicate that it is
accepting it – that it will comply with the instruction. This gives the document value and it can be
sold by the drawer to raise funds. A party buying the bill – and therefore lending money – pays a
discounted amount for the security and is known as a discounter.
When the bill matures the holder of the bill presents it to the acceptor for payment. The acceptor
pays the face value to the holder and then seeks reimbursement from the drawer. The requirement
for the drawer to reimburse the acceptor is not part of the bill itself, but it will be the subject of
separate agreement entered into by the drawer at the time that the bill is accepted. The diagram
below describes the flow of fund between the drawer, acceptor and discounter:
The discounter can hold the bill until it matures or sell it in the secondary market. If it is sold, the
seller of the bill must “endorse” the bill (which essentially means signing the back of the bill). This
incurs a “contingent liability” which may result in a liability to repay the face value of the bill if
other parties default. The first party liable to pay the face value of the bill when it matures is the
acceptor. In the event that the acceptor defaults, the drawer is the next party that is liable. In the
event that the drawer defaults, the next party liable is the last discounter to sell the bill to the current
holder (and who has therefore endorsed the bill). If that party defaults, the previous seller of the bill
is liable, and so on up the chain of parties who have previously sold the bill.
The following features generally apply to commercial bills:

Terms – 7 to 185 days.
Traded on yields. This means that the amount quoted in the market is the yield or interest rate
implied by the difference between the price and the face value.
$5 – $10 million is a market size parcel.
Banks quote 2-way prices (where the “prices” are actually yields).
Extra fees apply to borrowers:
Line fee
Acceptance fee
Endorsement fee
There are different types of commercial bills:

Non-bank Bill
Bank Accepted Bill
Bank Endorsed Bill
3.3.2.1.1 Non-bank Bill
Created by a borrower and accepted by a non bank party, then sold in the market. There is no
involvement by a bank at any stage.
3.3.2.1.2 Bank Accepted Bill (BAB)
Bank offers a “Bill Acceptance Facility” to make it easier for companies to use Commercial
Bills as a source of finance.
Bank acts as acceptor and charges a fee for acceptance.
Bank undertakes to pay holder face value of bill at maturity.
Bank accepted bills are by far the most common type of bills. The acceptance by a bank gives the
bill much greater creditworthiness because repayment is guaranteed by a bank. The creditworthiness
of the bill is based on the credit-worthiness of the acceptor, not the borrower. The acceptance fee
charged by the acceptor to the drawer will reflect the credit risk of the borrower.
3.3.2.1.3 Bank Endorsed Bill (BEB)
If a non-bank bill is bought in the market and then resold (and hence endorsed) by a bank it becomes
a Bank Endorsed Bill. Although not as creditworthy as a Bank Bill, the endorsement by a bank still
adds creditworthiness because subsequent purchasers of the bill can rely on the fact that the bill has

been endorsed by a bank and the bank will comply with the contingent liability should it be
necessary.
Both Bank Endorsed Bills and Bank Accepted Bills are referred to collectively as Bank Bills.
Which bill has the lower yield and why? Which bills has the highest price? Which bill has the
lowest price?
3.3.2.2 Promissory Notes (P/Ns, P-Notes, Commercial Paper)
Definition: “A written unconditional promise to pay a sum certain in money to the bearer at some
time in the future”.
A Promissory Note is also known as one name paper, because there is not acceptor. It is
essentially an IOU written by the borrower in favour of the holder of the note.
Promissory Notes are sold either:
at auction via tender panel
placement (market directly approached)
There are no bank fees.
Only large corporations with an excellent credit ratings are able to issue Promissory Notes.
No is endorsement is required if the note is sold in the secondary market, so traders incur no
contingent liability.
The maturity of Promissory Notes is generally 30 – 180 days.
Because Promissory Notes are riskier than Bank Accepted Bills, the yields on
P-Notes are higher than those on BABs.

3.3.2.3 Treasury Notes (T-Notes)
Treasury Notes are essentially Promissory Notes issued by the Government rather than corporations.
They are issued by the Central Bank on behalf of the government.
They are issued weekly by tender.
The maturities are 5, 13 and 26 weeks.
There is a very active secondary market. Treasury Notes are traded on the basis of yield.
Banks and non-bank financial institutions are the main purchasers and traders of Treasury
Notes.
Treasury Notes are considered to be the most liquid instrument (besides cash).
They can be used for Prime Asset Ratio purposes. This requires banks to keep a certain
proportion of their assets in prime (or liquid) assets. It will be discussed further in Topic 8.
Central Banks use Treasury Notes to conduct their open market operations. They will buy and
sell Treasury Notes in order to influence the money supply, which in turn will influence
interest rates, inflation rates and rates of economic growth.
Yields on Treasury Notes are generally lower than those on Bank Accepted Bills, because
Government securities (at least in developed countries like Australia) are considered to be free
of credit risk.
Treasury Notes can be used by banks to satisfy short term liquidity requirements.
3.3.2.4 Certificates of deposit (CD’s)
Definition: “A negotiable certificate issued by a bank to a bearer such that bank agrees to pay a sum
certain in money on a specified date.”
Certificates of Deposit are similar in principle to Promissory Notes but are issued by a bank
rather than a corporation. They are therefore more secure than Promissory Notes.
The yields on CDs are the same as those on BABs.
CDs usually have maturities of 90 - 180 days
CDs have a high credit quality (they carry the bank's rating and have the same rank as other
depositors).
CDs are negotiable which means that they are tradeable in the market. Thus a secondary
market would exist for this security.
The minimum denomination is usually $50,000.
3.3.2.5 Repurchase agreements (Repos)

A repurchase agreement is an agreement under which an asset (usually a financial asset such as
shares or bonds) will be sold and subsequently repurchased on a certain date for a certain price.
Depending on the perspective of each party to the transaction, they can be described in the following
two ways:
buy repo: an agreement to buy securities today and sell them at a predetermined future date.
Generally the income earned will be the equivalent to the market rate for loans for the
corresponding period
sell repo: an agreement to sell securities today and buy them back at a later predetermined
date. The cost would be the same as a loan for the equivalent maturity.
The party which “lends” the cash under the repo effectively receives the financial asset as security
for a loan. However, to qualify as a repo title to the asset must pass to the purchaser, rather than
merely being offered as security for a loan. Repos are used by banks to manage their liquidity, and
the RBA uses repos to implement monetary policy.

O B J E C T I V E 4
After completing this section you should be able to determine the price of the various
instruments traded in the money market. You should also be familiar with the concept of two -
way pricing.
3.4 Pricing a discount security
All the discount securities that were discussed in the previous section are priced and quoted in the
same way. Examples of such instruments include:
Treasury Notes
Commercial Bills (bank and non-bank)
Promissory Notes.
The method of pricing a discount bill can be obtained from the rearrangement of the simple interest
equation outlined in section 3.2.1.4:
FV
PV =
(1 + yt )
where t is the time the product is held (in years)
y is the yield to maturity which is the return received by the purchaser of a bill
if that bill is held until it is redeemed.
EXAMPLE
Consider a commercial bill with a face value of $70,000 and a yield of 7.5% with 30 days to maturity
FV
PV =
(1 + yt )
70,000
=
æ 30 ö
1 + (0.075)ç ÷
è 365 ø
= 69,571.14

Convention
Remember there is a difference in the interest rate year convention between different countries:
365 days in Australia, UK, Canada and Singapore.
360 days in USA, continental Europe and Japan
Accordingly the purchaser of the bill at $69,571.14 will earn interest of $428.86 over 30 days which
is equivalent to 7.5% simple interest.
The price of NCD, Commercial Bills and Promissory Notes all use the same formula.
EXAMPLE
If a company sells a $500,000 Promissory Note at a yield 8.90% for 92 days:
500,000
PV =
æ 92 ö
1 + (0.089 )ç ÷
è 365 ø
= 489,029.66
This is the proceeds of the sale of a $500,000 bill which is the money the company receives on the
sale.
These securities do not provide the holder with an explicit rate of interest payment. In order for the
holder to receive the equivalent of an interest payment these securities are sold (at price PV) for less
than their face value or redemption value (FV), this being the amount repaid by the lender on the
security maturity date.
These securities are called discount securities as they are sold at a discount to their face value. A
discount security provides interest by virtue of the fact that it is bought at a discount to its face value.
The rate of interest used to price short term discount securities in the short term money market is the
annualised simple rate of interest.
Question for Discussion
A bank offers to sell a $1,000,000 bank bill today to your company at 7.55% for 180 days.
a) How much would you invest today?
b) How much do you receive in 180 days?

3.4.1 Two - Way pricing - commercial bills
Previously we looked at two way pricing of cash. We will now look at how we quote commercial
bills. Like a cash quote, a bank quotes a bid and offer price for a discount security. A bank will
quote a two way price where they will buy and sell a security: eg. a bank bill. Two way pricing of
securities is slightly different but the concept is the same:
A bank might quote 7.65/60

This means the bank will buy a bill at a yield of 7.65%, and will sell a bill at a yield of 7.60%.
A price taker must do the opposite – sell at a yield of 7.65% or buy at a yield of 7.60%.
If a bank buys a bill they are effectively lending money. If the bank sells a bill they are
effectively borrowing money. Thus, the bank will lend at a higher rate than that at which they
will borrow, and a price taker must borrower at a higher rate than that at which they will lend.
Questions For Discussion
1. a) If you wish to sell a bill what are you doing? Raising funds or investing?
b) What rate of interest would you prefer? High or low?
c) The bank quotes 6.55/50. What rate will you get from the bank?
2. a) The bank quotes 7.00/95. If you now wish to buy a bank bill, are you raising funds or
investing?
b) What rate would you prefer?
c) What rate will you deal it?
3. You get 3 quotes:

Bank X 7.92/87
Bank Y 7.94/89
Bank Z 7.90/85
a) If you wanted to invest at which rate would you deal?
b) If you wanted to borrow funds at which rate would you deal?

O B J E C T I V E 5
After working through this section you should be able to explain the importance of
communication to trading in the market and how information is used in the financial markets.
3.5 Communication
It is extremely important for all dealers in the market to be fully informed of information which may
affect interest rates.
Try buying a share when you haven’t seen the price for a month. How do you know what is a good
price? What is fair?
Consequently, most dealing rooms will have the following equipment as the bases of their
communication and dealing systems to keep them fully informed:
Newspapers/Journals
The internet
Economic News Bulletins
Telephones
Reuters, Telerate, Bloomberg, Knight Ridder etc.
Television (BBC World, CNN News)
3.5.1 Dealing
Dealers transact the majority of their deals on the telephone. Some transactions may also occur
through such systems as Reuter’s direct dealer or via the telephone.
3.5.2 Information systems
Examples of these services include Reuters, Bridge Telerate, Bloomberg, etc. These are some of the
more commonly available on-line information services available that provide:
latest market prices

volume of deals to be dealt at a price level
financial market news
political and economic news
In some instances the service is expanded to enable banks to communicate with other banks across
the world and thus deal directly (a code is used to distinguish banks just like a telephone number).
This is more widely used in the foreign exchange market.

These systems are also available with "add-on" services such as graphics, charting and some data
manipulation capacities.
3.5.3 Interpreting Information
Dealers must be able to process lots of information quickly and assimilate the news and report it to
their customers. All dealers are expected to keep informed by reading newspapers, journals and
world news.
As most of the transactions occur over the telephone there is a great reliance on knowing the
counterparty and also knowing their capacity (authority) to deal. Telephone dealing agreements have
been accepted to a limited degree between some banks and customers but generally in the interbank
market the reliance is on "market practice". To this extent in some countries have independent
bodies associated with the financial markets such as the "Australian Financial Markets Association"
in Australia. The bodies have developed standards by which all professional market players adhere.
In previous years the market used to operate on the philosophy that "my word is my bond".
Unfortunately this is not necessarily the case in recent years and this is the reason why most dealers
in the professional market have their telephone conversations recorded.

O B J E C T I V E 6
After working through this section you should be able to describe the various money market
products traded in the global financial system’s eurocurrency markets
3.6.1 Nature of the global financial system and eurocurrency markets
In this Topic we also want to consider the money market products traded in the global financial
system. However, before we do this we will commence by considering the nature of the global
financial system and eurrocurrency markets.
3.6.1.1 The global financial system
The global financial system enables borrowers and lenders to conduct transactions in a large number
of different countries and in a large number of different currencies at interest rates and exchange
rates that are determined by global market forces. The global financial system developed from the
1970’ predominantly as a result of technological developments and deregulation of domestic
financial systems, including the movement to floating exchange rates and abolition of exchange
controls. In addition to deregulated domestic financial systems, the global financial system includes
the eurocurrency markets that had developed from the 1950s.
Thus, the global financial system comprises:
• Domestic financial systems that have deregulated and integrated into the global financial system
• The eurocurrency markets
3.6.1.2 Eurocurrency markets
The eurocurrency markets are large money and capital markets, primarily located in international
financial centres (eg London, Bahrain and Singapore) with participants comprising residents from a
number of different countries. The eurocurrency markets are dominated by international banks who
provide traditional intermediated banking services, accepting deposits and making loans, along with
the provision of other financial services.
The term eurocurrency refers to a currency that is traded outside the country of that currency. For
example, USD denominated bank deposit held in a bank outside the United States or a Yen
denominated loan made outside of Japan. Use of the term “euro”, in this context, needs to be
distinguished from the “Euro” as the currency of the 12 European Union countries that have adopted
a common currency.
The eurocurrency markets developed in London in the 1950s when UK banks started accepting
deposits and making loans denominated in USDs. The Soviet Union and other Eastern European
countries had held large deposits in US banks. However, as a result of political tensions between the

USA and the USSR, these funds were transferred to banks in London. The international banks who
were holding these funds responded by making loans denominated in USDs. The name eurodollar
was given to the market to distinguish it from the USD domestic financial markets.
The market rapidly expanded to include:
• Other currencies and locations. The growth of the market was particularly due to it escaping the
regulations of the countries whose currencies were traded. For example, there were periods of
time when the US government imposed controls on the outflow of funds from the US. However,
USDs held outside the US escaped these controls and the eurocurrency markets were essentially
unregulated markets during a period of regulation. With the deregulation of domestic financial
markets, the eurocurrency markets have continued to develop and grow essentially as a result of
the financial services and narrower spreads provided by the international banks involved.
• Securitised international debt such as discount securities and bonds. From the 1970s, the role of
intermediated finance came under pressure in the euromarkets as a result of:
o Economic and political pressures – eg high loan exposures to developing countries.
o In direct finance, surplus economic units have access to anonymous bearer securities such as tax
free eurobonds, they can obtain credit diversification away from bank risk, and they receive
higher returns than received on bank deposits
o Deficit economic units obtain lower cost funding on more flexible terms, access to a wider
source of funds and are frequently subject to less scrutiny
o Financial institutions became arrangers, underwriters, etc, and received fee income rather than a
net interest margin
3.6.2 Products traded in the short term eurocurrency markets

As outlined above, the eurocurrency markets are similar to financial markets forming part of a
domestic financial system in that:
• There is both intermediated and direct finance.
• Over recent time direct finance has become relatively more important – that is, the markets have
experienced disintermediation and securitisation.
3.6.2.1 Intermediated products
Short term bank advance
The main form of eurocurrency loan that is traded in the global money market is the short term bank
advance, typically for a minimum amount of US$1m – US$5m. The short term facility, less than one
year, can be extended to a medium term loan by including a revolving facility. Normally, short term
advances are repaid by a lump sum payment at a specified time.

The interest rate is set in terms of marker rates such as LIBOR or SIBOR which are quoted for a
wide range of maturities. Both these marker rates assume a 360 day year and therefore they must be
multiplied by 365/360 for the purpose of direct comparison with Australian rates.
Standby facilities
Standby facilities are a line of short term credit that a borrower can draw upon, if needed, during the
term of the facility. Standby facilites represent a backup facility that can be drawn against in periods
of tight liquidity. Although they are normally negotiated for periods of 12-24 months they can be
arranged for shorter periods. They comprise two separate charges:
a commitment fee for making the facility available

an interest charge on drawn funds, based on a marker rate
The interest charge is likely to be higher than a standard eurocurrency loan as the facility will only be
drawn upon in times of liquidity pressure.
3.6.2.2 Direct products
As with domestic financial markets, the short term securities issued in the euromarkets are discount
securities. The main types are euronote issuance facilities, eurocommercial paper and medium term
notes.
Euronote issuance facilities (NIF)
NIFs are a short term bearer promissory note drawn by the borrower in its own name. The main
features are:
They are normally issued in the name of the borrower in denominations of 100,000 –$500,000
USD
Usually they are issued with a facility to provide continuity of finance over a period of years, even
though the notes themselves have a term of between 30 – 180 days
They are underwritten, typically by a syndicate of banks who agree to purchase those notes not
sold in the market below a certain interest rate.
They are sold at a discount by a tender process with LIBOR being the most commonly used
marker rate.
Eurocommercial paper (ECP)
ECP developed as an alternative to notes in the late 1980s. ECP, while similar to notes, differs in the
following two main ways:

ECP programmes are not underwritten. The risk that the issue is not fully subscribed is normally
hedged by a standby facility.
ECP is issued through a select panel of dealers who either take the paper themselves or place it
profitably. Unlike NIFs, they are not sold by tender.
Notes and paper that are denominated in AUD have been mainly sold in Hong Kong and Singapore
using the Australian bank bill rate as the marker rate.
Medium term notes (MTN)
These are debt obligations that do not have a uniform maturity, nor do they have a need to be fully
drawn when they are issued. They are normally issued with maturities of between 9 months and 5
years and tend to be capital market rather than money market securities. Frequently MTNs have the
same features as bonds with interest paid by means of coupon payments.
MTNs can be issued with a mix of maturities, a range of currency denominations and with fixed and
floating interest rates. They can be issued in small denominations to appeal to retail market
participants and larger denominations for institutional investors.

TOPIC 3: SUMMARY
This topic has covered the various short term instruments in the debt market. It has highlighted the
uses and the issuers of the various products. The money market is a relatively unregulated market
with many players interacting daily. Volumes are large and transactions are carried out quickly. It
definitely pays to know what you are doing.
Different size corporations usually access different forms of short term finance and it is important to
recognise this aspect during the course. On the other hand investors are looking for short term debt
as liquid investments and are always pricing these products in terms of their risk, return, liquidity and
duration.
These short term instruments are traded in domestic financial systems and in the eurocurrency
markets that comprise part of the global financial system.

TOPIC 5: THE FOREIGN
EXCHANGE MARKET
Aim
The aim of this topic is to explain the nature and operation of the foreign exchange market along
with the main determinants of the foreign exchange value of a currency. When a resident of one
country enters into an economic transaction with a resident from another country, trading in the
foreign exchange markets results. The topic examines the major groups of participants and trading
practices in the market, the main types of instruments traded and, how trading in foreign exchange
markets establishes the value of currencies.
Learning objectives
1. Describe the nature of the foreign exchange market
2. Read and quote foreign exchanges prices
3. Explain why the foreign exchange markets exists
4. Outline the nature of globalisation and explain the reasons for off-shore borrowing
5. Describe the role of the major players in the market
6. Calculate the spot and forward market prices and cross rates
7. Demonstrate an ability to maintain a foreign exchange trading position.
8. Explain how the interaction of supply and demand determines the foreign exchange value of a
currency
9. Provide a brief history of the exchange rate systems adopted by Australia since the early 1970s,
and outline the problems associated with the fixed exchange rates.
10. Explain how the following factors can affect the foreign exchange value of a currency:
relative inflation rates and purchasing power parity

relative economic growth rates
relative interest rates
commodity prices
international speculation and investment
expected movements in exchange rates
official intervention into the foreign exchange market.

O B J E C T I V E 1
After working through this section you should be able to describe the nature of the foreign
exchange market
5.1 Nature of the foreign exchange market
Foreign Exchange is simply about the exchanging of one currency for another. There is no mystery
or tricks to the exchange. If you want to buy a loaf of bread you can exchange money for it – so too
with currencies. If you want Malaysian Ringgits or Singapore Dollars and you only have Australian
dollars then you can go to a shop and literally buy Malaysian Ringgits or Singapore dollars at a price
and hand over the correct amount of Australian dollars.
The only thing that is slightly different about buying other currencies is that the value of one
currency can be expressed in terms of another currency, and vice versa. For example, you can walk
into a shop and ask the price of a loaf of bread. The answer you get is the value of bread in terms of
dollars. You could also, in theory, walk into a shop and ask how much bread you can get for $1. The
answer you would get (half a loaf, say) is the value of a dollar in terms of bread. Although this
doesn’t often happen with bread, it happens all the time with currencies. We will return to the
various methods of quoting the value of currencies below.
There is no physical marketplace for wholesale foreign exchange – a location where large volumes
of currencies are exchanged. All you need is a phone and authority to trade and a deal can be done.
In recent year the technology has evolved and the use of electronic broking system has become the
norm, few deals are now negotiated via the phone. The ICAP and Reuter 300 are two of the most
popular broking system. These new system centraliseS the order book and match orders, enhancing
efficiency and transparency of prices.
Due to time zones differences trading can take place 24 hours a day almost 7 days a week. The
market place consists of a telecommunications network and a range of information systems which
provide a mechanism for the exchange of currencies around the world.
The retail market where small volumes are handled - less than $25,000 - is often at a shop front; at an
exchange bureau, such as a bank or Thomas Cook travel shop.
5.1.1 What is Foreign Exchange?
Foreign exchange is the exchanging of one currency for another. Unlike the other markets examined
in this course, the forex market is not a capital market, in that it is not used to raise funds. It exists to
allow for the exchange of currencies. After a transaction, there is no further obligation (eg. debt or
equity obligations) on the part of the parties to the transaction.

5.1.2 What is a Foreign Exchange rate?
A foreign exchange rate is the price or value of one currency expressed in term of another currency.
For example:
1 AUD = 1.1839 USD
1 USD = 0.8446 AUD
The above equations are two different ways of expressing the same exchange rate. In the first
example, the price of 1 Australian Dollar, in terms of US Dollars, is 1.1839. It would cost
US$1.1839, to buy A$1. In the second example, the price of 1 US Dollar is 0.8446 Australian
Dollars. It would cost A$0.8446 to buy US$1. This is the same rate of exchange, expressed two
different ways, because 0.8446 is the reciprocal of 0.8446.
The above exchange rate would normally be quoted in one of the following formats:
AUD/USD = 1.1839
USD/AUD = 0.8446
In each case, the exchange rate is the price of the first-named currency in terms of the second-name
currency. So the first example is the price of an Australian Dollar, in terms of US Dollars, and the
second example is the price of a US Dollar in terms of Australian Dollars. More formally:
• Base currency – the first named currency in an FX quote that is expressed as one unit in terms
of the second currency. In the AUD/USD example the base currency is the AUD and is
expressed as 1AUD will be bought/sold for the amount of USD that will be given in the
quote.
• Terms currency – the second named currency in the quote, that is, the USD.
5.1.3 Foreign Exchange terminology
5.1.3.1 Depreciation/Appreciation/Devaluation/Revaluation
Consider again the above exchange rate. If we check the AUD/USD exchange rate the next day, we
might find that it has changed to the following:
AUD/USD = 1.1815
The price of an Australian Dollar has decreased from 1.1839 to 1.1815 US Dollars. It has
depreciated against the US Dollar. Logically, this means the US Dollar must have increased in
value, or appreciated against the Australian Dollar. We can check this by taking the reciprocal of
the above number:

USD/AUD = 1/1.1815 = 0.8464
The US Dollar has indeed increased in value, or appreciated against the Australian Dollar.
The terms Depreciation and Appreciation are used to indicate a change in the value of a floating
currency, in response to market forces. If the government decides to decrease the value of a fixed or
pegged currency, we call this a devaluation and if it decides to increase the value of such a currency
we call this a revaluation.
5.1.3.2 Direct and indirect quotation
An exchange rate which gives the value of a unit of foreign currency in terms of the local currency is
referred to as a direct quote. An exchange rate which gives the value of a unit of local currency in
terms of a foreign currency is referred to as an indirect quote. In the examples used earlier:
AUD/USD = 1.1839
USD/AUD = 0.8446
the first quote is an indirect quote from the point of view of a resident of Australia, and the
second quote is a direct quote from the point of view of a resident of Australia.
The convention in the former members of the British Empire, such as Australia and New Zealand, is
to use indirect quotes. This is why the first of the above quotes looks more familiar to us. The
convention in most countries of the world is to use direct quotes. Foreign exchange quotes in
Malaysia and Hong Kong are usually expressed as follows:
USD/MYR = 3.0008
USD/HKD = 7.8012
5.1.3.3 Commodity and Terms currencies
A foreign exchange quote such as AUD/USD = 1.1839 can be classified as an indirect quote in
Australia and a direct quote in the USA. However, neither classification makes sense from the point
of view of a resident of Japan. It is perhaps more useful to classify the first-named currency as the
commodity currency and the second-named currency as the term currency. Thus, an exchange rate
is the price of a unit of the commodity currency in terms of the terms currency.
5.1.3.4 Jargon
Foreign exchange dealers have developed a short-hand jargon which they use when asking for and
giving foreign exchange quotations. In jargon speak, if the Australian/US Dollar exchange rate is the
following:
AUD/USD = 1.1839

this is described as "the Aussie is 1.1839". Other examples might be "the Kiwi is 7521" and the
"Cable" is 1.721. The US Dollar is known simply as the "dollar" or the “big dollar” depending where
in the world you are dealing.
In the above quote, the first 2 digits after the decimal point are known as the “big figure”. Dealers
will often assume that the person they are dealing with knows the big figure, and might simply say
that “the Aussie is at 39”. The last two digits – the “39” – are sometimes referred to as the pips or the
basis points.
5.1.4 Quotation of exchange rates
5.1.4.1 Two-way pricing
In all financial markets there will be a two way price – a price at which the commodity can be bought
and a price at which the commodity can be sold, whether the commodity is a share, a bank bill or
currency.
Like any purchase of an asset there is a price at which you can buy and a different price at which you
can sell. Think about the price of your car or textbook. The price you paid for it will probably not be
the price which you can sell it, regardless of wear and tear. Most of the time you will get less for
selling your car than you paid to buy it. It is what as known as the dealer’s margin, or spread.
In currency markets banks quote two-way prices and are called price makers. Banks, brokers and
financial institutions all quote a two-way price. It is part of their job and responsibility in the market.
Corporations do not quote two way prices – they are price takers. They must take the price the bank
gives them. The corporation has a choice of dealing or not dealing at that price.
5.1.4.2 Bid, offer and spread
There always appears some confusion over the bid and offer of a price that a bank quotes. The
bid/offer is always from the price makers’ point of view.
The bid is the first price which is the price the bank wants to buy the commodity currency and the
offer is the price the bank wants to sell the commodity currency. The difference between the bid and
the offer is often called the spread. It represents the profit the bank will make if it can buy and sell
the currency simultaneously. The bank like any trader wishes to buy the currency lower than it will
sell the currency. The foreign exchange market, unlike many other markets, does not charge a
commission. All costs are in the spread so the bank is careful in watching the smallest movement in
the market to monitor this spread.
Example of bid and offer rates in the foreign exchange market:
Spot USD/AUD
Bid Offer Spread

Quoting bank 0.8436 0.8446 10 pips
buy USD sell USD
sell AUD buy AUD
Calling bank sell USD buy USD
buy AUD sell AUD
EXAMPLES
a) A corporation might ring up a bank and ask for a price to buy $1 million USD in exchange of
AUD. The bank might answer "I will sell $1 million USD at .8446”. You as the corporate can
say "Yes that's done. I buy $1 million USD at .8446 " or "No nothing there". Then you can ring
up another bank and look for a better quote.
EXAMPLES
a) A quote from a dealer for the Aussie Euro spot rate, AUD/EUR 0.7846 - 0.7856 means:
the dealer will buy 1 AUD for 0.7846 EUR
the dealer will sell 1 AUD for 0.7856 EUR
For successful trading the rule is to buy the commodity currency cheaply or low and selling it
at a higher price.
b) When you ask a bank for their price for 1 Euro, he bank might answer "46/56". Now what do
you do? 46 and 56 are the basis points which are added to the “big figure” to determine the
actual exchange rate. The bank is assuming that you know the big figure.
Because the convention in Australia is that the AUD is the commodity currency, 46 represents
the price at which the bank will buy the AUD (and hence sell Euro) and 56 represents the price
at which the bank will sell AUD (and hence buy Euro).
Once you know the convention you would say "at 46 I buy $1 USD" (which means that the
bank is selling to you 1 USD and buying AUD) or you might say “at 56 I sell $1 USD” (which
means that the bank will buy 1 USD from you and sell AUD).
5.1.4.3 Calling bank and quoting bank
Corporations are not the only ones who phone banks and ask for foreign exchange quotes. Banks can
also call other banks.
Quoting bank quotes a 2-way price
Calling bank asks for a 2-way price

The quoting bank is the price maker and is quoting the bid/offer from their point of view. The calling
bank is the price taker who asks for the price. The price-taker trades at the most disadvantageous
price, but has the advantage of deciding whether or not proceed at the price quoted.

O B J E C T I V E 2
After working through this section you should be able to explain why the foreign exchange
market exists
This section explains the main reasons why people, companies and government trade foreign
exchange.
5.2 Why trade Foreign Exchange?
Whenever there is an economic transaction between a resident in one country and a resident in
another, there is a need for currency exchange.
For international trade (importing and exporting)
For capital movements (off-shore borrowing and investing)
The world’s foreign exchange market serves to link each country’s payment system because each
country has a different legal tender.
The foreign exchange market is the place where (or rather, the mechanism by which) entities can
exchange their currencies to conduct international transactions.
5.2.1 Other reasons for trading forex
Economic units also use the market for other reasons which can be described as:
Hedging
Speculation
Arbitrage
5.2.1.1 Hedging
Hedging refers to the use of various financial products (eg. derivatives such as forward contracts,
options, futures) to insure or protect an individual against unfavourable movements in the future
prices and variations in wealth. The objective is to reduce variation (ie. risk) in financial outcomes.
This often involves paying a price (ie. incurring a small reduction in the expected return). This is
consistent with the direct relationship between risk and return discussed in Topic 1 – if there is less
risk, there is often less return. Hedgers are happy to pay this price in order to reduce risk.
For example, an exporter of goods will be paid in foreign currency in 3 months time. He knows what
the exchange rate is now, and can estimate his profit on the export deal, but he doesn’t know what
the exchange rate will be in 3 months time. He is exposed to foreign exchange risk. He can hedge
this risk by entering into a forward foreign exchange transaction (discussed in more detail below).

This involves entering into a contract now to exchange currency at a set exchange rate in the future.
He effectively locks in the rate that he will get in 3 months, and eliminates the foreign exchange risk.
Because risk means variation, both positive and negative, he also eliminates the opportunity to make
a profit out of exchange rate movements, but exporters are usually focussed on making a profit from
their exporting, rather than foreign exchange movements, and would usually prefer certainty rather
than variation.
The exporter in the above example will probably pay a small price for the elimination of risk if he
enters into the transaction with a licensed foreign exchange dealer (which he almost certainly will).
He must deal on the disadvantageous side of the dealer’s bid-ask spread, and will receive a slightly
worse exchange than the expected or average exchange rate he would receive if he waited until he
received his export income and subjected himself to foreign exchange risk in the spot market.
5.2.1.2 Speculation
In many ways speculation can be seen as the opposite of hedging. A hedger will normally incur a
small price in return for the reduction or elimination of risk. A speculator voluntarily takes on risk in
the expectation of making a profit in the future if market conditions turn out the way he expects. Of
course, the presence of risk means that the speculator will make a loss if market conditions turn out
differently.
For example, a speculator who thinks a particular currency will appreciate in the future will buy that
currency. If the currency does appreciate, he can then “close out” his position by selling the currency
at a higher price, thus making a profit. If he thinks a currency will depreciate in the future, he will
sell that currency. (If he doesn’t have any to sell, this is referred to as “short-selling”, incurring a
negative bank balance in that currency). If the currency does depreciate, he can close out his position
by buying the currency at a lower price, thus making a profit.
A person who enters into a forward foreign exchange transaction to reduce or eliminate the risk of an
exposed position, as in the above example in 5.2.1.1 is described as a hedger. A person who enters
into a forward foreign exchange transaction without an existing exposure to foreign exchange risk is
in fact speculating. He will have to buy (or sell) the currency in the spot market in order to perform
under the forward contract. He will make a profit if he can buy more cheaply (or sell at a higher
price) in the spot market than the price at which he deals under the forward contract.
The use of financial markets for hedging and speculation is discussed further in Topic 7 –
Derivatives.
5.2.1.3 Arbitrage
This means making a risk-free profit by buying and selling an identical commodity in different
markets simultaneously in order to take advantage of different prices in different markets. This can

occur in almost any market, and is a powerful force in ensuring that prices for the same commodity
stay very close to each other in different markets.
EXAMPLE
Exchange rate arbitrage:
Suppose you rang two banks and received the following quotes:
Bank Location AUD/USD Quote

Bank A Sydney 1.1050/60
Bank B New York 1.1065/75
Because the spreads “overlap” (the offer rate of Bank A is less than the bid rate of Bank B) you
could make an arbitrage profit by undertaking the following transactions:
Buy AUD @ 1.1060 from Bank A in Sydney
Sell AUD @ 1.1065 to Bank B in New York
Many others would see the same opportunity and seek to take advantage of it. The forces of supply
and demand would cause the exchange rates to adjust until there is no further arbitrage profit to be
made (or the rates would become so close that an arbitrage profit would be insufficient to cover the
transaction costs of the arbitrage transaction).
EXAMPLE
Triangular arbitrage:
Suppose you receive the following quotes on the following exchange rates:
AUD/USD 1.1050/60
USD/GBP 0.6253/65
GBP/AUD 1.5002/26
The third exchange rate is referred to as a “cross rate” because it does not involve the US Dollar. The
calculation of cross rates is discussed below. Because the above cross rate is NOT correctly
calculated based on the other 2 exchange rates, you could make an arbitrage profit by undertaking
the following transactions:
Sell AUD 1 m. for USD @ 1.1050. Proceeds = USD 1,105,000.

Sell the USD 1,105,000 for GBP @ 0.6253. Proceeds = GBP 690,956.50.
Sell the GBP 690,956 for AUD @ 1.5002. Proceeds = AUD 1,036,572.94.
This results in a profit of AUD 36,572.94. Once again, many others would also attempt to take
advantage of this arbitrage opportunity, resulting in a change to some or all of the above rates and the
elimination of the arbitrage opportunity.

O B J E C T I V E 3
After working through this section you should be able to explain the reasons for off-shore
borrowing and to outline the nature of globalisation.
Globalisation is defined as the international integration of economic markets including financial

markets. The globalisation of the Australian financial system has meant:
Increasing reliance on offshore financial markets by Australian corporations seeking to raise

funds
An increase in foreign ownership of Australian equities
Australian managed funds have increased the proportion of funds invested overseas
All of the top 10 largest Australian companies listed on the ASX are also listed on overseas
exchanges with BHP listed on 7 foreign exchanges
The Australian dollar is the world fourth most frequently traded currency with over 60% of trades
occurring offshore.
A wide range of international financial services providers have entered the Australian market and
now compete with Australian providers to offer services to local users.
The points above illustrate how the Australian financial system has become integrated into the global
financial system with substantial increases in both overseas borrowing and overseas investment.
However, offshore borrowing by Australian residents greatly exceeds overseas investment with net
overseas funding a function of the current account deficit. That is, Australia is a net user of overseas
funds.
As a consequence, the rest of this section will focus on offshore borrowing, particularly by the
Australian corporate sector.
5.3.1 Reasons for borrowing overseas
There are four main reasons for raising funds offshore; lower interest rates, the availability of funds,
risk management and establishing a profile in global financial markets. These will be examined in
turn.
5.3.1.1 Lower interest rates.
One of the main determinants of the source of corporate borrowing is the cost of funds as indicated
by the interest rate. Many Australian corporations have expected to take advantage of lower overseas

rates of interest, relative to Australia, by raising funds offshore. However, the cost of funds
denominated in a foreign currency depends on both the interest rate and movements in the exchange
rate.
Many Australian economic units took out foreign currency loans in the latter half of the 1980s when
Australian interest rates were relatively much higher. In particular, Swiss currency loans were taken
out at much lower interest rates than if the funds had been borrowed domestically. However, the
AUD depreciated by an unexpectedly large amount that, in many cases, more than offset the interest
rate differential. Thus, the “effective” interest rate or cost of funds turned out to be much higher than
the domestic cost of funds.
However, despite the above, it may still be cheaper for an Australian corporate to borrow offshore,
with forward cover, as a result of:
the Eurocurrency markets are free of domestic regulations, which tends to reduce costs, and may
provide suppliers of loanable funds with lower tax rates.
the international markets are wholesale markets operating on narrower spreads which provides
lower borrowing rates.
the availability of funds (see below). This is a reason for borrowing off-shore in its own right, but
is also a contributing factor to the reduced cost of funds in off-shore markets.
5.3.1.2 Availability of funds
The cost of funds is not unrelated to the availability of funds and the euromarkets are very large in
comparison to Australian domestic financial markets. Thus, large scale corporate borrowing is likely
to achieve lower cost of funds and more flexible funding arrangements if it is undertaken in
international finance markets.
When an Australian corporate requires a vast quantity of funds for a large scale investment project, it
may be necessary to borrow offshore because the funding requirements may be beyond the capacity
of Australian domestic finance markets.
5.3.1.3 Risk management
Australian corporations with international operations are likely to have offshore assets or assets
denominated in foreign currency. This exposes the firm to exchange rate risk and by borrowing
overseas, in the same currency, they are able to take out a natural hedge against adverse currency
movements.
5.3.1.4 Establishing a Profile
If an Australian corporate is intending, at some time in the future, to borrow large scale funds in the
eurobond market, it is appropriate to establish a profile and develop a well-known presence in

international markets. This can be achieved by accessing the short term eurocurrency markets
initially and achieving recognition, and a good credit rating, as a participant in international finance
markets.

O B J E C T I V E 4
After working through this section you should be able to describe the role of the major
participants in the foreign exchange market
5.4.1 Dealers
Dealers are licensed by the Australian Securities and Investments Commission (ASIC) to deal in
foreign exchange. Dealer will hold an Australian Financial Services licence. They make a market by
quoting 2-way foreign exchange rates. Dealers are usually banks, but as a result of deregulation,
corporations can also become licensed forex dealers. To become a licensed dealer, a corporation
must have:
at least $10 million in issued capital,
a properly equipped dealing room,
properly trained dealing staff, and
adequate risk management systems and controls.
Dealers will carry out the following functions and activities:
trade on their own account to make a profit for their shareholders (speculating and arbitraging)
supply liquidity in the market
service their customers.
5.4.2 Corporations
Corporations (other than those who are licensed dealers) will act as price-takers as clients of dealers.
The will use the foreign exchange market and the services of dealers to:
conduct international transactions
hedge
speculate
identify and take advantage of arbitrage transactions.
The extent to which speculation is permitted is a matter of policy determined by the Board of
Directors. In some corporations speculation is expressly forbidden. In others, intra-day speculation is
permitted but trading staff are not permitted to carry an exposed position overnight.

Because price-takers always take the most disadvantageous side of a foreign exchange quote,
arbitrage opportunities are rare.
5.4.3 Brokers
Brokers provide a similar service in forex markets that they provide in other financial markets. They
can:
match potential buyers and sellers,
provide the service of anonymity,
provide financial services such as financial advice, documentation of transactions, etc.
Brokers are paid fees and commissions for their services.
5.4.4 Central banks
Central banks carry out two distinct functions in the foreign exchange market. They:
act as the banker for the government, carrying out foreign exchange transactions on behalf of the
government whenever the governments enters into an international transactions
intervene in the foreign exchange market to influence the value of the domestic currency.
Different countries have different policies in the latter area, depending on their system of exchange
rate determination. For example, central banks will have quite different roles depending on whether
the country has a fixed exchange rate of a floating exchange rate. The central bank of Australia (the
RBA) carries out the following activities in the forex market:
monitoring the currency
“smoothing” – buying or selling the currency as required to ensure that transitions from one
exchange rate to another are smooth and not volatile
“testing” – buying or selling in order to force the market to re-evaluate the currency and ensure
that the value of the currency reflects economic fundamentals rather than market sentiment.
The RBA’s policy is not to target a particular exchange rate – merely to ensure that the currency is
“correctly” valued and that there is minimal volatility.
The central bank or monetary authority of countries with a fixed exchange rate will be forced to buy
or sell the currency (sometimes in large amounts) in order to keep the currency at its target value.

O B J E C T I V E 5
After working through this section you should be able to identify the various types of foreign
exchange transactions and be able to calculate spot rates, forward rates and cross rates.
5.5 Types of FX transactions
Unlike other financial markets, which have a variety of financial instruments that are traded, there is
only one type of instrument traded in the forex market – a contract to buy or sell one currency for
another. The only thing that varies between contracts is the date on which the exchange will occur.
This section looks at different types of foreign exchange contracts, as well as how to calculate
forward exchange rates.
5.5.1 Spot rate
The most often quoted and discussed rate is known as the spot rate. This is the rate for a currency
which is settled in two business days time. This allows banks and corporations to confirm and settle
the deals in an orderly fashion. Confirmations and instructions should be issued between parties and
the settlement should proceed without a problem.
If you deal on Monday the spot date is Wednesday, if you deal on Thursday the spot date is Monday.
If there is a public holiday in the country of either participate to a transaction that will delay the
settlement date by another day.
5.5.2 Short dates
5.5.2.1 “TOD” contracts
The exchange rate that a dealer quotes is determined on the settlement date of the deal. If you want
currency delivered to your bank account today – and that depends on time zones – then it is a same
day deal or a “tod” contract (which is short for “today”).
5.5.2.2 “TOM” contracts
You can also enter into a “tom” contract, which means that settlement takes place tomorrow (or the
next business day if there is an intervening weekend or public holiday.
The exchange rates for short-dated contracts are adjusted for the interest rate differentials between the
two countries because the deal is settled early. For example, if I am selling AUD for USD under a
TOD contract, I will be giving up some AUD interest, because I will relinquish my AUD at least 2
days earlier than I would under a spot contract, but I will be gaining the benefit some extra USD
interest, because I will be getting my USD at least 2 days earlier than I would under a spot contract.

The actual calculation of TOD and TOM rates is not required as part of this subject, but calculation
of forward rates is discussed below.
5.5.3 Forward FX transactions
A deal that is settled three or more business days in the future is known as a forward transaction.
Because the maturity is not “spot” then the dealer must once again adjust the price of the deal. This is
determined by the interest rate differential between the two countries.
The settlement period quoted is the period of time after the “spot” settlement date before the forward
transaction is settled. For example, if a 1-month forward contract is agreed to on 9 April 2013, the
settlement date will be 11 May 2013.
5.5.3.1 Quotation of forward rates
Rather than quoting the actual forward rate, dealers will quote “forward points”. These are the
number of basis points which must be added to (or subtracted from) the spot rates to determine the
outright forward rates.
EXAMPLE
Suppose the AUD/USD spot rate is 1.1446/56, and the various forward points over the next 6 months
are as follows:
1 month 14/13
2 month 29/27
3 month 43/40
6 month 84/80
In case, the forward points must be added to (or subtracted from) the spot rate to determine the
outright forward rate. For the 1-month forward points, 14 basis points must be added to (or
subtracted from) the spot bid rate of 1.1446, 13 basis points must be added to (or subtracted from)
the spot offer rate of 1.1456.
Whether the forward points should be added or subtracted depends on the relationship between the
numbers in the forward point quote. Notice that the spot is always “low-high” ie. the bid rate is
always lower than the offer rate.
The forward points could also be “low-high”, or they could be “high-low” (as in the above example).
If the forward points are “low-high”, they should be added to the spot rate. If they are “high-
low”, they should be subtracted. In the above example, the forward points should be subtracted
from the spot rate, which will result in the following outright forward rates:
1 month 0.8432/43

2 month 0.8417/29
3 month 0.8403/16
6 month 0.8362/76
EXAMPLE
Suppose the USD/JPY spot rate is 110.25/40, and the 1-month forward point quote is 10/12. In this
case the forward quote is “low-high” and hence should be added to the spot rate. The outright
forward rate would be 110.35/52.
Another way to remember whether to add or subtract the forward points is to ensure that the spread is
wider in the forward market. This is because there is more risk, and less liquidity, in the forward
market, and the price maker will want to ensure that the spread is wider in the forward market to
ensure that it is compensated for this increased risk and reduced liquidity. If you calculate the
outright forward rates and you find that the spread has narrowed, you have added when you should
have subtracted or vice versa.
The relationship between the numbers in the forward rate quote, and hence whether the forward
points should be added to or subtracted from the spot rate (and hence whether the commodity
currency is trading at a premium or a discount in the forward market) is determined by the interest
rate differential between the two countries concerned. This is discussed in more detail in the
following section.
5.5.3.2 Calculation of forward rates
The general formula to calculate a forward rate is:
é 1 + rterms t ù
f comm / terms = S comm / terms ê ú
ë1 + rcomm t û
f comm / terms = the forward rate for the commodity currency
S comm / terms = the spot rate for the commodity currency
rterms = the interest rate in the terms currency for the forward period
rcomm = the interest rate in the commodity currency for the forward period
t = the time period.
Because the interest rate is expressed as an annual figure, the time period must be the number of
years. However, forward margins beyond 12 months are extremely rare, so the time period will
usually be a fraction of a year.

For example, suppose the AUD/USD spot rate is 0.8446, the interest rate in Australia is 5.50% and
the interest rate in the USA is 4.75%. The 180-day forward rate for the AUD would be:
é1 + .0475(180 / 365) ù
f AUD / USD = .8446 ê ú
ë1 + .0550(180 / 365) û
= .8416
It should be noted that in the USA the 360 day convention is used while Australia uses the 365 day
count. Therefore the time period (t) should be 180/360 for the USA and 180/365 for Australia.
However, for purposes of simplicity and consistency we will use the 365 day year for all countries.
(In this course, students are not expected to know which countries adopt the 360 day convention and
which use the 365 day count).
The formula for calculating the forward rate illustrates that the forward rate is determined by the spot
rate adjusted for the difference in interest rates between the two countries. The country with the
higher interest rates having its forward rate trading at a discount. In the above example, interest rates
in Australia are higher than those in the USA, so the Australian dollar will be trading at a discount in
the forward market, with the outright forward rate being 0.8416. This removes an arbitrage
opportunity whereby investors could borrow funds in USA that has lower interest rates, convert the
funds into AUD’s at the spot rate and invest the proceeds in Australia at higher interest rates at
higher interest rates and protect themselves from a falling AUD by taking out forward cover.
This does not necessarily mean that the Australian dollar is expected to depreciate in the future. This
depends on the underlying reason for high interest rates in Australia, and this will be discussed in
more detail below.
5.5.4 The FX swap
An FX swap is the simultaneous purchase of a currency in the spot market and sale of the same
currency in the forward market, or vice versa. A swap does not create a net exchange position but it
does create mismatched cash flows. They are primarily used as a funding mechanism or to adjust
cash flow mismatches. For example, an importer or exporter with a rolling series of foreign exchange
exposures can use a series of FX swaps to hedge the risk of each transaction.
FX swaps are very common in the foreign exchange market. Slightly more than 50% of foreign
exchange transactions consist of FX swaps. When one adds the number of outright forward
transactions (about 15%) it can be seen that forward contracts play a crucial role in this market.
When one is contemplating a swap, the underlying spot rate is irrelevant. The only thing that is
important is the difference between the spot rate and the forward rate: ie. the forward points. This is
why the forward points are quoted rather than the outright forward rate, because it is much more
useful for planning FX swaps. For this reason, forward points are often referred to as swap points.
5.5.5 Cross rates

If there are, say, 200 different currencies in the world, there are 19,900 different possible exchange
rates. It would be impractical to quote all of these possible exchange rates. Hence all currencies are
quoted in terms of the US Dollar, and then it is possible to calculate the exchange rate between any
two currencies using the rates which are quoted in terms of the US Dollar. The resulting exchange
rate is the effective rate which would be achieved if one currency was converted to US Dollars, and
the resulting number of US Dollars was converted to the other currency.
The resulting exchange rate is called a cross rate. A cross-rate is an exchange rate in which neither of
the currencies quoted is the US Dollar.
The easiest way to calculate a cross rate is to apply the chain rule. This involves multiplying the
exchange rates, and can be used as long as the following conditions are satisfied:
(a) The commodity currency in the desired cross rate must be the commodity currency in the
relevant USD exchange rate.
(b) The terms currency in the desired cross rate must be the terms currency in the relevant USD
exchange rate.
(c) The USD must be terms currency in one exchange rate and the commodity currency in the
other, so that it will drop out of the resulting calculation.
If the USD exchange rates are not quoted this way, one or both of them must be converted so that
they are expressed this way. This is demonstrated below.
5.5.5.1 Cross rates without bid/offer spreads
The chain rule is very simple to apply if we don’t have to worry about bid/offer spreads. If we wish
to compute the AUD/EUR rate, given the AUD/USD rate and the USD/EUR rate in the market.
(Notice that the AUD is the commodity currency in both the desired cross rate and the relevant USD
exchange rate, and that the EUR is the terms currency in both the desired cross rate and the relevant
USD exchange rate, with the USD taking the remaining places in the original quoted rates.) As long
as this is the case, then we just multiply the quoted rates.
EXAMPLE
AUD/USD = 1.1246
USD/CNY = 0.1547
AUD/CNY = 1.1246 ´ 0.1547 = 0.1740
If we were given the CNY/USD exchange rate, we would have to take the reciprocal to determine the
USD/CNY exchange rate, which is what we need to apply the chain rule. Note that the CNY stands
for the Chinese Renminbi Yuan.

5.5.5.2 Cross rates with bid/offer spreads
The calculation is slightly more complicated if we have a bid and offer price for each exchange rate.
We still need the quoted exchange rates to be in the same format as described above. Then we
perform separate calculations for the bid and offer price of the cross rate.
EXAMPLE
AUD/USD = 1.1446/56
USD/CNY = 0.1547/55
As long as the exchange rates are expressed this way, the bids multiplied together will give the bid
for the cross rate, and the offers multiplied together will give the offer for the cross rate. Thus:
AUD/CNY = 1.1446 ´ 0.1547 / 1.1456 ´ 0.1555 = 0.1771/ 0.1781
If one (or both) of the exchange rates we are given is not in the correct form, we need to convert it
(or them) by taking the reciprocal of both sides of the quote and reversing the order to ensure that
the offer is higher than the bid. Thus:
EUR/USD = 1.2539/49
1 1
\USD/EUR = / = 0.7969/75
1.2549 1.2539

O B J E C T I V E 6
After working through this section you should be able to demonstrate an ability to maintain a
foreign exchange trading position
5.6 Exchange position
A dealer has an open position in a commodity when the dealer stands to make a profit or loss
consequent upon a movement in the price of the commodity. This general assertion can be applied to
a foreign exchange dealer. If a dealer has bought more of a currency than he has sold he is said to be
“long” the currency. If a dealer has lent more money than he has in his account he is “short” the
currency. We say the dealer has an FX exposure.
5.6.1 Net foreign exchange position terminology
Net exchange position: Total foreign currency bought – total sold.
Long position: More foreign currency bought than sold
Short position: More foreign currency sold than bought
Square position: Total bought = total sold
If currency dealers start from a square position, then when they are long in one currency they should
be short in another. Dealers keep account of their positions by recording the amount of commodity
currency traded in a blotter.
5.6.2 Using a blotter
The table below shows a stylised blotter, which a dealer may use to keep a record of his trading
positions.
Transaction (A$ m) Position

Buy 20 +20 Up 20
Buy 10 +30 Up 30
sell 5 +25 Up 25
sell 15 +10 Up 10
sell 15 -5 Down 5
sell 10 -15 Down 15
buy 15 0 Square
Depending on expected movements in the currency market the dealer may prefer to be short or long
the commodity currency.

5.6.3 Cash flows and T accounts
A blotter tells you of your position at any point in time. However this doesn't tell you whether you
made a profit after all that trading. Keeping T accounts and cash flows are one method for working
this out.
In a T account positive cash flows are set down on the left of the T and negative flows are set down
on the right of the T. In currency transactions, the origins of cash flows can be summarised as:
positive flows arise from (1) buying currency and (2) borrowing currency
negative flows arise from (1) selling currency and (2) lending currency
These accounts can be done by hand or more usually by the Treasury system or spreadsheets.
These accounts can be viewed as a simple bank account and one bank account is kept for each
currency. It is possible for business to keep foreign currency bank accounts in Australia. This can be
helpful when you are dealing with a large number of small transactions in one foreign currency in
your business.
EXAMPLE
Suppose you enter into 3 transactions
1. buy 2m AUD at AUD/EUR 1.5620
2. sell 5m AUD at AUD/EUR 1.5625
Then to square this AUD position you would buy 6m AUD. The rate for this transaction would
determine whether you had made a profit or a loss. If the exchange rate when you close out your
position is AUD/EUR 1.5615, you would sell EUR 9,369,000.
AUD EUR
+2,000,000 -3,124,000
-5,000,000 +7,812,500
-3,000,000 +4,689,000
+6,000,000 -9,369,000
0 8,500
Your final position is a profit of EUR 8,500. (It stands to reason that you would have made a profit,
because the 2 transactions by which you bought AUD were at a lower exchange rate (a lower price
for the commodity currency – the AUD) than the 2 transactions by which you sold AUD.
O B J E C T I V E 7

After working through this section you should be able to provide a brief history of the
exchange rate systems adopted by Australia since the early 1970s, and outline the problems
associated with pre-float regimes.
5.7 Early systems of exchange rate determination
5.7.1 The gold standard
As international transactions became more common during the late 1800s, it became necessary to
establish a stable system of exchange rate determination. This led to the establishment of the gold
standard. Each country’s exchange rate was linked to the price of gold: ie. gold was set at a fixed
price in each currency. The exchange rate between currencies was therefore also fixed.
This system was very stable until World War I. The economic disruption caused by the war and its
after effects placed a great deal of strain on the gold standard. Various countries attempted in various
ways to reintroduce the gold standard, but by World War II the system was close to collapse.
5.7.2 The Bretton-Woods system
In 1944, at an international monetary conference held at Bretton Woods in the United States, a new
international monetary system involving an adjustable-peg system of exchange rates was agreed to.
This system, which emphasised relatively fixed exchange rates, was managed through the
International Monetary Fund (IMF). Each country’s currency was fixed, or rather pegged, to the US
Dollar, and the US Dollar was fixed in terms of the price of gold. Countries were able to periodically
readjust their peg, revaluing or devaluing their currency as required, in response to economic factors.
This system was quote stable for many years, but there were some fundamental problems associated
with it and these problems came to a head in the early 1970s when the system broke down.
5.7.3 Movement to floating exchange rate systems
In August 1971 the system of pegged exchange rates was thrown into chaos when the United States
government suspended the USD convertibility into gold. With the link between the USD and gold
severed, the USD was effectively floating with its value determined by market forces. In March
1973, the currencies of the other major economies were also floated. Australia, however, adopted a
range of different methods of determining its exchange rate until it floated the AUD in December
1983.
In the period from 1971 - 74, the AUD was tied in value to the USD. This meant that the AUD was
effectively floating against all other currencies not tied to the USD. This was considered to be too
restrictive to the appropriate movement of the AUD and in September 1974, the AUD was tied to
trade weighted basket of currencies. In many ways, this was a continuation of the adjustable peg
system with the value of the AUD pegged to some benchmark. In November 1976, the value of the
AUD was adjusted on a daily basis but still set in terms of the trade weighted basket of currencies

(TWI traded weighted index). The value of the AUD was still officially set but frequently adjusted in
line with market forces.
Source :RBA, http://www.rba.gov.au/mkt-operations/foreign-exchg-mkt.html
In December 1983, Australia joined most of the other developed economies and adopted a floating,
market determined exchange rate. There are two types of floating exchange rate systems – a “clean”
float and a “dirty” float. A clean float occurs when the currency is allowed to float freely in response
to market forces, without any intervention by the Central Bank. In a dirty float, the Central Bank
intervenes in order to attempt to have some influence over the value of the currency – eg. for
smoothing and testing purposes. Most countries which have a floating exchange rate, including
Australia, have a so-called dirty float.
5.7.4 Problems with fixed exchange rates
When exchange rates are not determined by market forces but officially set, there are a number of
problems that arise. The only way to maintain the fixed rate is for the Central Bank to continually
intervene by buying and selling large quantities of the country’s currency to increase the level of

demand or supply. If the exchange rate is set at a non-equilibrium level, resulting problems can
include the following:
A country cannot continue to buy its own currency as it will run down its holdings of international
reserves and not be able to pay for imports. Continual sales of domestic will result in a build-up of
foreign reserves and this will mean that a country will experience a lower standard of living than
it otherwise could.
A country will experience either an overall balance of payments surplus or deficit. Surpluses and
deficits in the balance of payments will affect a country’s volume of money and be a potential
source of monetary instability.
Officially set exchange rates that lag behind the market can encourage speculation as future
exchange rate movements can be easy to predict. The most common non-equilibrium fixed rate is
one that is too high. The Central Bank will be forced to buy massive amounts of domestic
currency, running down its foreign reserves. Currency speculators can often predict roughly when
these reserves will run low, necessitating a devaluation. They will sell the currency short, with the
intention of buying it back cheaply when the value of the currency falls, resulting in large profits.
This short-selling places even more downward pressure on the currency, bringing about the
predicted devaluation even sooner. In November 1976 the AUD was devalued by 17.5%,
generating massive speculative profits. One of the major causes of the recent Asian currency crisis
was a series of speculative attacks on weak currencies which the subject of artificially high
exchange rates. The Thai baht was the first such currency to be successfully attacked, followed by
others as the crisis spread from country to country.

O B J E C T I V E 8
After working through this section you should be able to explain how the interaction of supply
and demand determines the foreign exchange value of a currency.
5.8 The equilibrium exchange rate
In previous sections of this topic we considered currency trading in the foreign exchange market and
the practices adopted by dealers in quoting two way prices. Currency trading is undertaken by a
range of individuals, businesses and governments who all have their own reasons for wanting to buy
or sell foreign currency.
“The” foreign exchange market comprises a vast global network of physical locations linked together
by sophisticated telecommunications systems. Each currency has a large number of buyers and
sellers whose collective actions represent the demand and supply conditions in the foreign exchange
market. The prices quoted by dealers are determined by demand and supply conditions throughout
“the” market.
As with any good or service that is sold in a competitive market, the equilibrium price is determined
by the interaction of supply and demand. We will consider each of these forces in the context of the
foreign exchange market for the Australian dollar (AUD)
5.8.1 Demand for a currency
The demand for the AUD is the result of economic units selling foreign currency and buying the
AUD. An increase in demand for the AUD will result from:
an increase in the export of Australian produced goods and services
an increase in capital inflow (borrowing from overseas or investments from overseas)
The demand for the AUD is inversely related to the price of the AUD as a fall in price of the AUD
will lower Australian prices in world markets and increase the demand for Australian exports. This is
illustrated in the diagram below:
Exchange
D
2012 Topic 1 – Introduction to Financial Markets Quantity of AUD 73
5.8.2 Supply of a currency
The supply of the AUD is the result of economic units selling the AUD and buying a foreign
currency. An increase in supply of the AUD will result from:
an increase in the import of goods and services into Australia
an increase in capital outflow ( overseas investment/lending)
The supply of the AUD is directly related to the price of the AUD as an increase in price of the AUD
means overseas prices become relatively cheaper and increases the demand, by Australian residents,
for imported goods and services. This is illustrated in the diagram below:
Exchange
Quantity of AUD
5.8.3 The foreign exchange market
The foreign exchange market brings together the forces of supply and demand with the equilibrium
price being the unique price (exchange rate) where the demand for the AUD exactly equals the
supply of the AUD. This is illustrated in the diagram below:
Exchange
.70
.60
.50
D
The equilibrium price for the AUD, in terms of the USD isQuantity
.60 where demand and supply exactly
of AUD
equal each other.

Any price other than the equilibrium price is not sustainable as there will either be excess demand or
supply in the market which will move the exchange rate towards equilibrium. For example, if the
AUD/USD were at .70 there would be excess supply of the AUD in foreign exchange markets –
more would be supplied at that price than would be demanded. Dealers will reduce the price of the
AUD, in terms of the USD, in order to reduce this excess supply, and move the exchange rate back to
equilibrium. If the AUD/USD were at .50 there would be an excess demand for the AUD – more
would be demanded at that price than would be supplied. Demanders of AUD would “bid up” the
price of the AUD in an attempt to satisfy this excess demand, moving the exchange rate back to
equilibrium.
Like the Loanable Funds theory of the determination of interest rates, this is a simple, but useful
theory. If a change is postulated which might change the exchange rate, with this model it is simply a
matter of determining what change, if any, will take place in the position of the demand and supply
curves shown above. This will lead to a change in the equilibrium exchange rate, which will result
from the interaction of the new demand and supply curves. Such changes are discussed in more
detail in the next section.

O B J E C T I V E 9
After working through this section you should be able to explain the main determinants of the
foreign exchange value of a country’s currency
5.9 Determination of the foreign exchange value of a currency
The previous section established that the foreign exchange value of a currency, in a competitive
market, is determined by the interaction of supply and demand for the currency concerned. Thus, any
event that affects the value of international transactions for a particular country has implications for
the exchange rate. The main explanations for exchange rate movements seek to identify major causes
of changes in the value of a country’s international transactions. These explanations are discussed in
turn from the perspective of the AUD.
5.9.1 Relative inflation rates and purchasing power parity
Assume Australia has higher inflation than the rest of the world. The effects of this will be:
A decrease in demand for exports as Australian prices become less competitive on world markets.
There will therefore be less demand for the AUD and the demand curve will shift to the left.
An increase in demand for imports as overseas goods become relatively cheaper on the Australian
domestic market. There will therefore be increased supply of the AUD and the supply curve will
shift to the right.
The above two effects will result in a fall in the value of the AUD as illustrated below.
Exchange
S1 S2
ER1
ER2
D2 D1
Quantity of AUD
What is happening is that the fall in the value of AUD (from ER1 to ER2) is reducing Australia’s
prices relative to the rest of the world and offsetting the price effect of inflation.

This view of the determination of the exchange rate assumes the maintenance of purchasing power
parity between currencies. The theory of purchasing power parity is based on the “law of one price”.
It contends that:
“Market forces will eventually force adjustments to exchange rates to provide parity of purchasing
power (ie. comparable goods cost the same) between currencies”.
The purchasing power parity theory is based on traded goods. Goods which are cheaper in one
country than another (ie. which display a violation of purchasing power parity) will be bought where
they are cheap, transported and sold where they are more expensive. Either the prices of the goods
will equalise, in response to supply and demand, or the exchange rate will adjust because of the
importing and exporting, resulting in an equalisation of the effective price of the goods. However,
not all goods are traded, and there is a time lag before changes in the price of traded goods are passed
on to non-traded goods.
A weaker form of the purchasing power parity theory is often used, which contents that inflation
rates, rather than actual prices of goods, will tend to equalise because of interdependence between
the exchange rate and inflation rates.
5.9.2 Relative economic growth rates
Assume that Australia experiences higher economic growth than its major trading partners. Income
and aggregate demand, including demand for imported goods and services, will be growing at a
faster rate. To pay for increases in imports there will be an increase in the supply of AUD in the
foreign exchange market. This is illustrated in the diagram below:
Exchange
S1 S2
ER1
ER2
D1
Quantity of AUD
The AUD has fallen from ER1 to ER2.
However, if the higher growth involves investment projects financed through offshore borrowing by
Australian companies, the increase in capital inflow means an offsetting increase in demand for the
AUD. This is illustrated in the diagram below:

Exchange
S1
ER2
ER1
D1 D2
Quantity of AUD
Superimposing these two effects yields the following diagram.
Exchange
Rate
S1 S2
ER1
D1 D2
Quantity of AUD
In the above case, the supply effect is to reduce the price of the AUD while the demand effect is to
increase the price of AUD. The net effect will depend on the strength of each of these separate
factors and the slope (elasticity) of the demand and supply curves. It cannot easily be determined in
advance.
5.9.3 Relative interest rates
The relationship between the effect of differing interest rate movements on exchange rates provides
contrasting views which are outlined below in terms of Australia experiencing higher interest rates
than the rest of the world.
The traditional view was that the higher interest rates in Australia would encourage capital inflow
and discourage capital outflow. This would result from overseas investors placing funds in Australia,
to take advantage of the higher returns, and Australians investing a greater proportion of funds in the

domestic financial markets. The effects of this are illustrated below with the AUD increasing from
ER1 to ER2.
Exchange
S2 S1
ER2
ER1
D1 D2
Quantity of AUD
The previous view does not accord with what happens in the foreign exchange market. as empirical
evidence suggests an alternative view. That is, a country experiencing higher interest rates is also
likely to be experiencing a fall in the value of its currency.
The explanation for the alternative view is based on inflation and the difference between real and
nominal interest rates. Nominal interest rates are the quoted observable interest rates which include
the effects of inflation. In order to determine the real interest rate – the interest rate that actually
results in an increase in purchasing power over and above the inflation rate – it is necessary to
subtract the inflation rate from the nominal rate to determine the real interest rate. (This is an
approximation which is sufficiently close for the purposes of this analysis.)
It is assumed (it is usually a reasonable assumption) that real interest rates are constant between
countries. If this were not the case, there would be arbitrage opportunities created and capital would
quickly flow to those countries with the highest real rates, thus bringing real rates into alignment. If
real rates are constant, a country experiencing higher nominal interest rates must also be
experiencing higher inflation. As explained in Section 5.8.1, higher inflation will result in a
depreciating currency.
5.9.4 Commodity prices
A commodity is essentially anything that is bought or sold. In this context, we are talking about the
commodities that Australia exports – chiefly minerals and agricultural products. Because Australia is
a large commodity exporter, the value of its exports, and hence the level of demand for the AUD, is
significantly influenced by world-wide commodity prices.
If Australian exports become more expensive because of inflation, overseas importers of our
goods will turn to other countries, and the value of our exports will fall, along with demand for,

and the value of, the AUD. However, if our exports become more expensive because of an
increase in commodity prices, importers cannot turn to other suppliers because commodity
prices are a world-wide phenomenon. They will continue importing commodities from
Australia, and the total value of our exports, and hence demand for the AUD, and hence the
value of AUD, will all increase.
5.9.5 International speculation and investment
Notwithstanding the various theoretical causes of changes in the value of the AUD, its change in
value can be influenced by international speculation and mainly driven by investment. When the US
economy, the world’s largest, is weak capital tends to flow into stronger economy, such as Australia.
When there is bad economic news in the US, as there has been since the early 2000’s, this usually
results in a retreat of capital from the US, and the AUD benefits as a result. Hence the steady decline
in the USD over the last 10 years, as the Australian economy becomes more attractive for investment
compared to that of the US. Severely hit by the GFC the US dollar has recently lost such value
compare to the Australian dollar that the two currencies are now trading around parity (1 to 1).
There is no formal link, but generally non-US economies “suffer” when the US economy and the
USD are strong, and they benefit when the USD falters.
5.9.6 Exchange rate expectations
Exchange rate expectations are a major cause of actual exchange rate movements. If market
participants, including speculators, have formed expectations about future exchange rate movements
then they will take action which will have a self-fulfilling effect.
For example, if market participants expect the future value of the AUD to fall, they will sell the
AUD, increase its supply in the foreign exchange market, which will cause a fall in its value. If they
expect the value of AUD to increase, they will buy the AUD, increasing demand for the currency and
helping to bring about an appreciation.
5.9.7 Official intervention
In addition to the above factors, official (government or central bank) intervention into foreign
exchange markets can exert a significant influence on the value of that country’s currency. In
Australia, official intervention is through the activities of the Reserve Bank, buying and selling the
AUD in trade with banks and a select number of non-bank authorised FX dealers. Since the
December 1983 float of the AUD, there has been two distinct periods of official intervention
Dec. 1983 - mid 1986: minimum intervention (“clean float”).
Mid. 1986 - current: significant intervention (“dirty float”).
The reasons for Reserve Bank intervention since mid 1986 have been

To try and understand the nature and strength of forces in the market
To buy and sell currency to meet the needs of its clients particularly government
offset short term instability
The Reserve Bank has stressed that its role in intervening is to “buy time” for market participants to
reassess their judgement and to provide a settling influence on the market. It is not to target a
particular exchange rate.

TOPIC 5: SUMMARY
The foreign exchange market serves to link domestic payments systems into a global payments
system. Whenever a resident in one country has an economic transaction with a resident in another
country there is a need for currency exchange. An exchange rate is the value of one currency in terms
of another currency with the two main forms of FX transaction being on a spot and forward basis.
Forward exchange rates are determined by interest rate differentials given that both exchange rates
and interest rates are determined by expectations.
In the spot market dealers buy low, at their bid quote, and sell high, at their offer quote.
The foreign exchange market is a highly competitive market comprising a vast network of different
locations linked together by telecommunications. It is only from 1973, that the world major
currencies were floated and from December 1983 that the Australian dollar was floated. In the
competitive FX market the foreign exchange values of currencies are determined by the demand for,
and supply of, particular currencies.
There are a number of explanations of the determinants of the foreign exchange value of a currency
including relative inflation rates, relative growth rates, relative interest rates, expectations and
official intervention.

TOPIC 5: THE FOREIGN
EXCHANGE MARKET
Aim
The aim of this topic is to explain the nature and operation of the foreign exchange market along
with the main determinants of the foreign exchange value of a currency. When a resident of one
country enters into an economic transaction with a resident from another country, trading in the
foreign exchange markets results. The topic examines the major groups of participants and trading
practices in the market, the main types of instruments traded and, how trading in foreign exchange
markets establishes the value of currencies.
Learning objectives
11. Describe the nature of the foreign exchange market
12. Read and quote foreign exchanges prices
13. Explain why the foreign exchange markets exists
14. Outline the nature of globalisation and explain the reasons for off-shore borrowing
15. Describe the role of the major players in the market
16. Calculate the spot and forward market prices and cross rates
17. Demonstrate an ability to maintain a foreign exchange trading position.
18. Explain how the interaction of supply and demand determines the foreign exchange value of a
currency
19. Provide a brief history of the exchange rate systems adopted by Australia since the early 1970s,
and outline the problems associated with the fixed exchange rates.
20. Explain how the following factors can affect the foreign exchange value of a currency:
relative inflation rates and purchasing power parity

relative economic growth rates
relative interest rates
commodity prices
international speculation and investment
expected movements in exchange rates
official intervention into the foreign exchange market.

O B J E C T I V E 1
After working through this section you should be able to describe the nature of the foreign
exchange market
5.1 Nature of the foreign exchange market
Foreign Exchange is simply about the exchanging of one currency for another. There is no mystery
or tricks to the exchange. If you want to buy a loaf of bread you can exchange money for it – so too
with currencies. If you want Malaysian Ringgits or Singapore Dollars and you only have Australian
dollars then you can go to a shop and literally buy Malaysian Ringgits or Singapore dollars at a price
and hand over the correct amount of Australian dollars.
The only thing that is slightly different about buying other currencies is that the value of one
currency can be expressed in terms of another currency, and vice versa. For example, you can walk
into a shop and ask the price of a loaf of bread. The answer you get is the value of bread in terms of
dollars. You could also, in theory, walk into a shop and ask how much bread you can get for $1. The
answer you would get (half a loaf, say) is the value of a dollar in terms of bread. Although this
doesn’t often happen with bread, it happens all the time with currencies. We will return to the
various methods of quoting the value of currencies below.
There is no physical marketplace for wholesale foreign exchange – a location where large volumes
of currencies are exchanged. All you need is a phone and authority to trade and a deal can be done.
In recent year the technology has evolved and the use of electronic broking system has become the
norm, few deals are now negotiated via the phone. The ICAP and Reuter 300 are two of the most
popular broking system. These new system centraliseS the order book and match orders, enhancing
efficiency and transparency of prices.
Due to time zones differences trading can take place 24 hours a day almost 7 days a week. The
market place consists of a telecommunications network and a range of information systems which
provide a mechanism for the exchange of currencies around the world.
The retail market where small volumes are handled - less than $25,000 - is often at a shop front; at an
exchange bureau, such as a bank or Thomas Cook travel shop.
5.1.1 What is Foreign Exchange?
Foreign exchange is the exchanging of one currency for another. Unlike the other markets examined
in this course, the forex market is not a capital market, in that it is not used to raise funds. It exists to
allow for the exchange of currencies. After a transaction, there is no further obligation (eg. debt or
equity obligations) on the part of the parties to the transaction.

5.1.2 What is a Foreign Exchange rate?
A foreign exchange rate is the price or value of one currency expressed in term of another currency.
For example:
1 AUD = 1.1839 USD
1 USD = 0.8446 AUD
The above equations are two different ways of expressing the same exchange rate. In the first
example, the price of 1 Australian Dollar, in terms of US Dollars, is 1.1839. It would cost
US$1.1839, to buy A$1. In the second example, the price of 1 US Dollar is 0.8446 Australian
Dollars. It would cost A$0.8446 to buy US$1. This is the same rate of exchange, expressed two
different ways, because 0.8446 is the reciprocal of 0.8446.
The above exchange rate would normally be quoted in one of the following formats:
AUD/USD = 1.1839
USD/AUD = 0.8446
In each case, the exchange rate is the price of the first-named currency in terms of the second-name
currency. So the first example is the price of an Australian Dollar, in terms of US Dollars, and the
second example is the price of a US Dollar in terms of Australian Dollars. More formally:
• Base currency – the first named currency in an FX quote that is expressed as one unit in terms
of the second currency. In the AUD/USD example the base currency is the AUD and is
expressed as 1AUD will be bought/sold for the amount of USD that will be given in the
quote.
• Terms currency – the second named currency in the quote, that is, the USD.
5.1.3 Foreign Exchange terminology
5.1.3.1 Depreciation/Appreciation/Devaluation/Revaluation
Consider again the above exchange rate. If we check the AUD/USD exchange rate the next day, we
might find that it has changed to the following:
AUD/USD = 1.1815
The price of an Australian Dollar has decreased from 1.1839 to 1.1815 US Dollars. It has
depreciated against the US Dollar. Logically, this means the US Dollar must have increased in
value, or appreciated against the Australian Dollar. We can check this by taking the reciprocal of
the above number:

USD/AUD = 1/1.1815 = 0.8464
The US Dollar has indeed increased in value, or appreciated against the Australian Dollar.
The terms Depreciation and Appreciation are used to indicate a change in the value of a floating
currency, in response to market forces. If the government decides to decrease the value of a fixed or
pegged currency, we call this a devaluation and if it decides to increase the value of such a currency
we call this a revaluation.
5.1.3.2 Direct and indirect quotation
An exchange rate which gives the value of a unit of foreign currency in terms of the local currency is
referred to as a direct quote. An exchange rate which gives the value of a unit of local currency in
terms of a foreign currency is referred to as an indirect quote. In the examples used earlier:
AUD/USD = 1.1839
USD/AUD = 0.8446
the first quote is an indirect quote from the point of view of a resident of Australia, and the
second quote is a direct quote from the point of view of a resident of Australia.
The convention in the former members of the British Empire, such as Australia and New Zealand, is
to use indirect quotes. This is why the first of the above quotes looks more familiar to us. The
convention in most countries of the world is to use direct quotes. Foreign exchange quotes in
Malaysia and Hong Kong are usually expressed as follows:
USD/MYR = 3.0008
USD/HKD = 7.8012
5.1.3.3 Commodity and Terms currencies
A foreign exchange quote such as AUD/USD = 1.1839 can be classified as an indirect quote in
Australia and a direct quote in the USA. However, neither classification makes sense from the point
of view of a resident of Japan. It is perhaps more useful to classify the first-named currency as the
commodity currency and the second-named currency as the term currency. Thus, an exchange rate
is the price of a unit of the commodity currency in terms of the terms currency.
5.1.3.4 Jargon
Foreign exchange dealers have developed a short-hand jargon which they use when asking for and
giving foreign exchange quotations. In jargon speak, if the Australian/US Dollar exchange rate is the
following:
AUD/USD = 1.1839

this is described as "the Aussie is 1.1839". Other examples might be "the Kiwi is 7521" and the
"Cable" is 1.721. The US Dollar is known simply as the "dollar" or the “big dollar” depending where
in the world you are dealing.
In the above quote, the first 2 digits after the decimal point are known as the “big figure”. Dealers
will often assume that the person they are dealing with knows the big figure, and might simply say
that “the Aussie is at 39”. The last two digits – the “39” – are sometimes referred to as the pips or the
basis points.
5.1.4 Quotation of exchange rates
5.1.4.1 Two-way pricing
In all financial markets there will be a two way price – a price at which the commodity can be bought
and a price at which the commodity can be sold, whether the commodity is a share, a bank bill or
currency.
Like any purchase of an asset there is a price at which you can buy and a different price at which you
can sell. Think about the price of your car or textbook. The price you paid for it will probably not be
the price which you can sell it, regardless of wear and tear. Most of the time you will get less for
selling your car than you paid to buy it. It is what as known as the dealer’s margin, or spread.
In currency markets banks quote two-way prices and are called price makers. Banks, brokers and
financial institutions all quote a two-way price. It is part of their job and responsibility in the market.
Corporations do not quote two way prices – they are price takers. They must take the price the bank
gives them. The corporation has a choice of dealing or not dealing at that price.
5.1.4.2 Bid, offer and spread
There always appears some confusion over the bid and offer of a price that a bank quotes. The
bid/offer is always from the price makers’ point of view.
The bid is the first price which is the price the bank wants to buy the commodity currency and the
offer is the price the bank wants to sell the commodity currency. The difference between the bid and
the offer is often called the spread. It represents the profit the bank will make if it can buy and sell
the currency simultaneously. The bank like any trader wishes to buy the currency lower than it will
sell the currency. The foreign exchange market, unlike many other markets, does not charge a
commission. All costs are in the spread so the bank is careful in watching the smallest movement in
the market to monitor this spread.
Example of bid and offer rates in the foreign exchange market:
Spot USD/AUD
Bid Offer Spread

Quoting bank 0.8436 0.8446 10 pips
buy USD sell USD
sell AUD buy AUD
Calling bank sell USD buy USD
buy AUD sell AUD
EXAMPLES
c) A corporation might ring up a bank and ask for a price to buy $1 million USD in exchange of
AUD. The bank might answer "I will sell $1 million USD at .8446”. You as the corporate can
say "Yes that's done. I buy $1 million USD at .8446 " or "No nothing there". Then you can ring
up another bank and look for a better quote.
EXAMPLES
b) A quote from a dealer for the Aussie Euro spot rate, AUD/EUR 0.7846 - 0.7856 means:
the dealer will buy 1 AUD for 0.7846 EUR
the dealer will sell 1 AUD for 0.7856 EUR
For successful trading the rule is to buy the commodity currency cheaply or low and selling it
at a higher price.
d) When you ask a bank for their price for 1 Euro, he bank might answer "46/56". Now what do
you do? 46 and 56 are the basis points which are added to the “big figure” to determine the
actual exchange rate. The bank is assuming that you know the big figure.
Because the convention in Australia is that the AUD is the commodity currency, 46 represents
the price at which the bank will buy the AUD (and hence sell Euro) and 56 represents the price
at which the bank will sell AUD (and hence buy Euro).
Once you know the convention you would say "at 46 I buy $1 USD" (which means that the
bank is selling to you 1 USD and buying AUD) or you might say “at 56 I sell $1 USD” (which
means that the bank will buy 1 USD from you and sell AUD).
5.1.4.3 Calling bank and quoting bank
Corporations are not the only ones who phone banks and ask for foreign exchange quotes. Banks can
also call other banks.
Quoting bank quotes a 2-way price
Calling bank asks for a 2-way price

The quoting bank is the price maker and is quoting the bid/offer from their point of view. The calling
bank is the price taker who asks for the price. The price-taker trades at the most disadvantageous
price, but has the advantage of deciding whether or not proceed at the price quoted.

O B J E C T I V E 2
After working through this section you should be able to explain why the foreign exchange
market exists
This section explains the main reasons why people, companies and government trade foreign
exchange.
5.2 Why trade Foreign Exchange?
Whenever there is an economic transaction between a resident in one country and a resident in
another, there is a need for currency exchange.
For international trade (importing and exporting)
For capital movements (off-shore borrowing and investing)
The world’s foreign exchange market serves to link each country’s payment system because each
country has a different legal tender.
The foreign exchange market is the place where (or rather, the mechanism by which) entities can
exchange their currencies to conduct international transactions.
5.2.1 Other reasons for trading forex
Economic units also use the market for other reasons which can be described as:
Hedging
Speculation
Arbitrage
5.2.1.1 Hedging
Hedging refers to the use of various financial products (eg. derivatives such as forward contracts,
options, futures) to insure or protect an individual against unfavourable movements in the future
prices and variations in wealth. The objective is to reduce variation (ie. risk) in financial outcomes.
This often involves paying a price (ie. incurring a small reduction in the expected return). This is
consistent with the direct relationship between risk and return discussed in Topic 1 – if there is less
risk, there is often less return. Hedgers are happy to pay this price in order to reduce risk.
For example, an exporter of goods will be paid in foreign currency in 3 months time. He knows what
the exchange rate is now, and can estimate his profit on the export deal, but he doesn’t know what
the exchange rate will be in 3 months time. He is exposed to foreign exchange risk. He can hedge
this risk by entering into a forward foreign exchange transaction (discussed in more detail below).

This involves entering into a contract now to exchange currency at a set exchange rate in the future.
He effectively locks in the rate that he will get in 3 months, and eliminates the foreign exchange risk.
Because risk means variation, both positive and negative, he also eliminates the opportunity to make
a profit out of exchange rate movements, but exporters are usually focussed on making a profit from
their exporting, rather than foreign exchange movements, and would usually prefer certainty rather
than variation.
The exporter in the above example will probably pay a small price for the elimination of risk if he
enters into the transaction with a licensed foreign exchange dealer (which he almost certainly will).
He must deal on the disadvantageous side of the dealer’s bid-ask spread, and will receive a slightly
worse exchange than the expected or average exchange rate he would receive if he waited until he
received his export income and subjected himself to foreign exchange risk in the spot market.
5.2.1.2 Speculation
In many ways speculation can be seen as the opposite of hedging. A hedger will normally incur a
small price in return for the reduction or elimination of risk. A speculator voluntarily takes on risk in
the expectation of making a profit in the future if market conditions turn out the way he expects. Of
course, the presence of risk means that the speculator will make a loss if market conditions turn out
differently.
For example, a speculator who thinks a particular currency will appreciate in the future will buy that
currency. If the currency does appreciate, he can then “close out” his position by selling the currency
at a higher price, thus making a profit. If he thinks a currency will depreciate in the future, he will
sell that currency. (If he doesn’t have any to sell, this is referred to as “short-selling”, incurring a
negative bank balance in that currency). If the currency does depreciate, he can close out his position
by buying the currency at a lower price, thus making a profit.
A person who enters into a forward foreign exchange transaction to reduce or eliminate the risk of an
exposed position, as in the above example in 5.2.1.1 is described as a hedger. A person who enters
into a forward foreign exchange transaction without an existing exposure to foreign exchange risk is
in fact speculating. He will have to buy (or sell) the currency in the spot market in order to perform
under the forward contract. He will make a profit if he can buy more cheaply (or sell at a higher
price) in the spot market than the price at which he deals under the forward contract.
The use of financial markets for hedging and speculation is discussed further in Topic 7 –
Derivatives.
5.2.1.3 Arbitrage
This means making a risk-free profit by buying and selling an identical commodity in different
markets simultaneously in order to take advantage of different prices in different markets. This can

occur in almost any market, and is a powerful force in ensuring that prices for the same commodity
stay very close to each other in different markets.
EXAMPLE
Exchange rate arbitrage:
Suppose you rang two banks and received the following quotes:
Bank Location AUD/USD Quote

Bank A Sydney 1.1050/60
Bank B New York 1.1065/75
Because the spreads “overlap” (the offer rate of Bank A is less than the bid rate of Bank B) you
could make an arbitrage profit by undertaking the following transactions:
Buy AUD @ 1.1060 from Bank A in Sydney
Sell AUD @ 1.1065 to Bank B in New York
Many others would see the same opportunity and seek to take advantage of it. The forces of supply
and demand would cause the exchange rates to adjust until there is no further arbitrage profit to be
made (or the rates would become so close that an arbitrage profit would be insufficient to cover the
transaction costs of the arbitrage transaction).
EXAMPLE
Triangular arbitrage:
Suppose you receive the following quotes on the following exchange rates:
AUD/USD 1.1050/60
USD/GBP 0.6253/65
GBP/AUD 1.5002/26
The third exchange rate is referred to as a “cross rate” because it does not involve the US Dollar. The
calculation of cross rates is discussed below. Because the above cross rate is NOT correctly
calculated based on the other 2 exchange rates, you could make an arbitrage profit by undertaking
the following transactions:
Sell AUD 1 m. for USD @ 1.1050. Proceeds = USD 1,105,000.

Sell the USD 1,105,000 for GBP @ 0.6253. Proceeds = GBP 690,956.50.
Sell the GBP 690,956 for AUD @ 1.5002. Proceeds = AUD 1,036,572.94.
This results in a profit of AUD 36,572.94. Once again, many others would also attempt to take
advantage of this arbitrage opportunity, resulting in a change to some or all of the above rates and the
elimination of the arbitrage opportunity.

O B J E C T I V E 3
After working through this section you should be able to explain the reasons for off-shore
borrowing and to outline the nature of globalisation.
Globalisation is defined as the international integration of economic markets including financial

markets. The globalisation of the Australian financial system has meant:

funds
The Australian dollar is the world fourth most frequently traded currency with over 60% of trades
occurring offshore.
now compete with Australian providers to offer services to local users.
The points above illustrate how the Australian financial system has become integrated into the global
financial system with substantial increases in both overseas borrowing and overseas investment.
However, offshore borrowing by Australian residents greatly exceeds overseas investment with net
overseas funding a function of the current account deficit. That is, Australia is a net user of overseas
funds.
As a consequence, the rest of this section will focus on offshore borrowing, particularly by the
Australian corporate sector.
5.3.1 Reasons for borrowing overseas
There are four main reasons for raising funds offshore; lower interest rates, the availability of funds,
risk management and establishing a profile in global financial markets. These will be examined in
turn.
5.3.1.1 Lower interest rates.
One of the main determinants of the source of corporate borrowing is the cost of funds as indicated
by the interest rate. Many Australian corporations have expected to take advantage of lower overseas

rates of interest, relative to Australia, by raising funds offshore. However, the cost of funds
denominated in a foreign currency depends on both the interest rate and movements in the exchange
rate.
Many Australian economic units took out foreign currency loans in the latter half of the 1980s when
Australian interest rates were relatively much higher. In particular, Swiss currency loans were taken
out at much lower interest rates than if the funds had been borrowed domestically. However, the
AUD depreciated by an unexpectedly large amount that, in many cases, more than offset the interest
rate differential. Thus, the “effective” interest rate or cost of funds turned out to be much higher than
the domestic cost of funds.
However, despite the above, it may still be cheaper for an Australian corporate to borrow offshore,
with forward cover, as a result of:
the Eurocurrency markets are free of domestic regulations, which tends to reduce costs, and may
provide suppliers of loanable funds with lower tax rates.
the international markets are wholesale markets operating on narrower spreads which provides
lower borrowing rates.
the availability of funds (see below). This is a reason for borrowing off-shore in its own right, but
is also a contributing factor to the reduced cost of funds in off-shore markets.
5.3.1.2 Availability of funds
The cost of funds is not unrelated to the availability of funds and the euromarkets are very large in
comparison to Australian domestic financial markets. Thus, large scale corporate borrowing is likely
to achieve lower cost of funds and more flexible funding arrangements if it is undertaken in
international finance markets.
When an Australian corporate requires a vast quantity of funds for a large scale investment project, it
may be necessary to borrow offshore because the funding requirements may be beyond the capacity
of Australian domestic finance markets.
5.3.1.3 Risk management
Australian corporations with international operations are likely to have offshore assets or assets
denominated in foreign currency. This exposes the firm to exchange rate risk and by borrowing
overseas, in the same currency, they are able to take out a natural hedge against adverse currency
movements.
5.3.1.4 Establishing a Profile
If an Australian corporate is intending, at some time in the future, to borrow large scale funds in the
eurobond market, it is appropriate to establish a profile and develop a well-known presence in

international markets. This can be achieved by accessing the short term eurocurrency markets
initially and achieving recognition, and a good credit rating, as a participant in international finance
markets.

O B J E C T I V E 4
After working through this section you should be able to describe the role of the major
participants in the foreign exchange market
5.4.1 Dealers
Dealers are licensed by the Australian Securities and Investments Commission (ASIC) to deal in
foreign exchange. Dealer will hold an Australian Financial Services licence. They make a market by
quoting 2-way foreign exchange rates. Dealers are usually banks, but as a result of deregulation,
corporations can also become licensed forex dealers. To become a licensed dealer, a corporation
must have:
at least $10 million in issued capital,
a properly equipped dealing room,
properly trained dealing staff, and
adequate risk management systems and controls.
Dealers will carry out the following functions and activities:
trade on their own account to make a profit for their shareholders (speculating and arbitraging)
supply liquidity in the market
service their customers.
5.4.2 Corporations
Corporations (other than those who are licensed dealers) will act as price-takers as clients of dealers.
The will use the foreign exchange market and the services of dealers to:
conduct international transactions
hedge
speculate
identify and take advantage of arbitrage transactions.
The extent to which speculation is permitted is a matter of policy determined by the Board of
Directors. In some corporations speculation is expressly forbidden. In others, intra-day speculation is
permitted but trading staff are not permitted to carry an exposed position overnight.

Because price-takers always take the most disadvantageous side of a foreign exchange quote,
arbitrage opportunities are rare.
5.4.3 Brokers
Brokers provide a similar service in forex markets that they provide in other financial markets. They
can:
match potential buyers and sellers,
provide the service of anonymity,
provide financial services such as financial advice, documentation of transactions, etc.
Brokers are paid fees and commissions for their services.
5.4.4 Central banks
Central banks carry out two distinct functions in the foreign exchange market. They:
act as the banker for the government, carrying out foreign exchange transactions on behalf of the
government whenever the governments enters into an international transactions
intervene in the foreign exchange market to influence the value of the domestic currency.
Different countries have different policies in the latter area, depending on their system of exchange
rate determination. For example, central banks will have quite different roles depending on whether
the country has a fixed exchange rate of a floating exchange rate. The central bank of Australia (the
RBA) carries out the following activities in the forex market:
monitoring the currency
“smoothing” – buying or selling the currency as required to ensure that transitions from one
exchange rate to another are smooth and not volatile
“testing” – buying or selling in order to force the market to re-evaluate the currency and ensure
that the value of the currency reflects economic fundamentals rather than market sentiment.
The RBA’s policy is not to target a particular exchange rate – merely to ensure that the currency is
“correctly” valued and that there is minimal volatility.
The central bank or monetary authority of countries with a fixed exchange rate will be forced to buy
or sell the currency (sometimes in large amounts) in order to keep the currency at its target value.

O B J E C T I V E 5
After working through this section you should be able to identify the various types of foreign
exchange transactions and be able to calculate spot rates, forward rates and cross rates.
5.5 Types of FX transactions
Unlike other financial markets, which have a variety of financial instruments that are traded, there is
only one type of instrument traded in the forex market – a contract to buy or sell one currency for
another. The only thing that varies between contracts is the date on which the exchange will occur.
This section looks at different types of foreign exchange contracts, as well as how to calculate
forward exchange rates.
5.5.1 Spot rate
The most often quoted and discussed rate is known as the spot rate. This is the rate for a currency
which is settled in two business days time. This allows banks and corporations to confirm and settle
the deals in an orderly fashion. Confirmations and instructions should be issued between parties and
the settlement should proceed without a problem.
If you deal on Monday the spot date is Wednesday, if you deal on Thursday the spot date is Monday.
If there is a public holiday in the country of either participate to a transaction that will delay the
settlement date by another day.
5.5.2 Short dates
5.5.2.1 “TOD” contracts
The exchange rate that a dealer quotes is determined on the settlement date of the deal. If you want
currency delivered to your bank account today – and that depends on time zones – then it is a same
day deal or a “tod” contract (which is short for “today”).
5.5.2.2 “TOM” contracts
You can also enter into a “tom” contract, which means that settlement takes place tomorrow (or the
next business day if there is an intervening weekend or public holiday.
The exchange rates for short-dated contracts are adjusted for the interest rate differentials between the
two countries because the deal is settled early. For example, if I am selling AUD for USD under a
TOD contract, I will be giving up some AUD interest, because I will relinquish my AUD at least 2
days earlier than I would under a spot contract, but I will be gaining the benefit some extra USD
interest, because I will be getting my USD at least 2 days earlier than I would under a spot contract.

The actual calculation of TOD and TOM rates is not required as part of this subject, but calculation
of forward rates is discussed below.
5.5.3 Forward FX transactions
A deal that is settled three or more business days in the future is known as a forward transaction.
Because the maturity is not “spot” then the dealer must once again adjust the price of the deal. This is
determined by the interest rate differential between the two countries.
The settlement period quoted is the period of time after the “spot” settlement date before the forward
transaction is settled. For example, if a 1-month forward contract is agreed to on 9 April 2013, the
settlement date will be 11 May 2013.
5.5.3.1 Quotation of forward rates
Rather than quoting the actual forward rate, dealers will quote “forward points”. These are the
number of basis points which must be added to (or subtracted from) the spot rates to determine the
outright forward rates.
EXAMPLE
Suppose the AUD/USD spot rate is 1.1446/56, and the various forward points over the next 6 months
are as follows:
1 month 14/13
2 month 29/27
3 month 43/40
6 month 84/80
In case, the forward points must be added to (or subtracted from) the spot rate to determine the
outright forward rate. For the 1-month forward points, 14 basis points must be added to (or
subtracted from) the spot bid rate of 1.1446, 13 basis points must be added to (or subtracted from)
the spot offer rate of 1.1456.
Whether the forward points should be added or subtracted depends on the relationship between the
numbers in the forward point quote. Notice that the spot is always “low-high” ie. the bid rate is
always lower than the offer rate.
The forward points could also be “low-high”, or they could be “high-low” (as in the above example).
If the forward points are “low-high”, they should be added to the spot rate. If they are “high-
low”, they should be subtracted. In the above example, the forward points should be subtracted
from the spot rate, which will result in the following outright forward rates:
1 month 0.8432/43

2 month 0.8417/29
3 month 0.8403/16
6 month 0.8362/76
EXAMPLE
Suppose the USD/JPY spot rate is 110.25/40, and the 1-month forward point quote is 10/12. In this
case the forward quote is “low-high” and hence should be added to the spot rate. The outright
forward rate would be 110.35/52.
Another way to remember whether to add or subtract the forward points is to ensure that the spread is
wider in the forward market. This is because there is more risk, and less liquidity, in the forward
market, and the price maker will want to ensure that the spread is wider in the forward market to
ensure that it is compensated for this increased risk and reduced liquidity. If you calculate the
outright forward rates and you find that the spread has narrowed, you have added when you should
have subtracted or vice versa.
The relationship between the numbers in the forward rate quote, and hence whether the forward
points should be added to or subtracted from the spot rate (and hence whether the commodity
currency is trading at a premium or a discount in the forward market) is determined by the interest
rate differential between the two countries concerned. This is discussed in more detail in the
following section.
5.5.3.2 Calculation of forward rates
The general formula to calculate a forward rate is:
é 1 + rterms t ù
f comm / terms = S comm / terms ê ú
ë1 + rcomm t û
f comm / terms = the forward rate for the commodity currency
S comm / terms = the spot rate for the commodity currency
rterms = the interest rate in the terms currency for the forward period
rcomm = the interest rate in the commodity currency for the forward period
t = the time period.
Because the interest rate is expressed as an annual figure, the time period must be the number of
years. However, forward margins beyond 12 months are extremely rare, so the time period will
usually be a fraction of a year.

For example, suppose the AUD/USD spot rate is 0.8446, the interest rate in Australia is 5.50% and
the interest rate in the USA is 4.75%. The 180-day forward rate for the AUD would be:
é1 + .0475(180 / 365) ù
f AUD / USD = .8446 ê ú
ë1 + .0550(180 / 365) û
= .8416
It should be noted that in the USA the 360 day convention is used while Australia uses the 365 day
count. Therefore the time period (t) should be 180/360 for the USA and 180/365 for Australia.
However, for purposes of simplicity and consistency we will use the 365 day year for all countries.
(In this course, students are not expected to know which countries adopt the 360 day convention and
which use the 365 day count).
The formula for calculating the forward rate illustrates that the forward rate is determined by the spot
rate adjusted for the difference in interest rates between the two countries. The country with the
higher interest rates having its forward rate trading at a discount. In the above example, interest rates
in Australia are higher than those in the USA, so the Australian dollar will be trading at a discount in
the forward market, with the outright forward rate being 0.8416. This removes an arbitrage
opportunity whereby investors could borrow funds in USA that has lower interest rates, convert the
funds into AUD’s at the spot rate and invest the proceeds in Australia at higher interest rates at
higher interest rates and protect themselves from a falling AUD by taking out forward cover.
This does not necessarily mean that the Australian dollar is expected to depreciate in the future. This
depends on the underlying reason for high interest rates in Australia, and this will be discussed in
more detail below.
5.5.4 The FX swap
An FX swap is the simultaneous purchase of a currency in the spot market and sale of the same
currency in the forward market, or vice versa. A swap does not create a net exchange position but it
does create mismatched cash flows. They are primarily used as a funding mechanism or to adjust
cash flow mismatches. For example, an importer or exporter with a rolling series of foreign exchange
exposures can use a series of FX swaps to hedge the risk of each transaction.
FX swaps are very common in the foreign exchange market. Slightly more than 50% of foreign
exchange transactions consist of FX swaps. When one adds the number of outright forward
transactions (about 15%) it can be seen that forward contracts play a crucial role in this market.
When one is contemplating a swap, the underlying spot rate is irrelevant. The only thing that is
important is the difference between the spot rate and the forward rate: ie. the forward points. This is
why the forward points are quoted rather than the outright forward rate, because it is much more
useful for planning FX swaps. For this reason, forward points are often referred to as swap points.
5.5.5 Cross rates

If there are, say, 200 different currencies in the world, there are 19,900 different possible exchange
rates. It would be impractical to quote all of these possible exchange rates. Hence all currencies are
quoted in terms of the US Dollar, and then it is possible to calculate the exchange rate between any
two currencies using the rates which are quoted in terms of the US Dollar. The resulting exchange
rate is the effective rate which would be achieved if one currency was converted to US Dollars, and
the resulting number of US Dollars was converted to the other currency.
The resulting exchange rate is called a cross rate. A cross-rate is an exchange rate in which neither of
the currencies quoted is the US Dollar.
The easiest way to calculate a cross rate is to apply the chain rule. This involves multiplying the
exchange rates, and can be used as long as the following conditions are satisfied:
(d) The commodity currency in the desired cross rate must be the commodity currency in the
relevant USD exchange rate.
(e) The terms currency in the desired cross rate must be the terms currency in the relevant USD
exchange rate.
(f) The USD must be terms currency in one exchange rate and the commodity currency in the
other, so that it will drop out of the resulting calculation.
If the USD exchange rates are not quoted this way, one or both of them must be converted so that
they are expressed this way. This is demonstrated below.
5.5.5.1 Cross rates without bid/offer spreads
The chain rule is very simple to apply if we don’t have to worry about bid/offer spreads. If we wish
to compute the AUD/EUR rate, given the AUD/USD rate and the USD/EUR rate in the market.
(Notice that the AUD is the commodity currency in both the desired cross rate and the relevant USD
exchange rate, and that the EUR is the terms currency in both the desired cross rate and the relevant
USD exchange rate, with the USD taking the remaining places in the original quoted rates.) As long
as this is the case, then we just multiply the quoted rates.
EXAMPLE
AUD/USD = 1.1246
USD/CNY = 0.1547
AUD/CNY = 1.1246 ´ 0.1547 = 0.1740
If we were given the CNY/USD exchange rate, we would have to take the reciprocal to determine the
USD/CNY exchange rate, which is what we need to apply the chain rule. Note that the CNY stands
for the Chinese Renminbi Yuan.

5.5.5.2 Cross rates with bid/offer spreads
The calculation is slightly more complicated if we have a bid and offer price for each exchange rate.
We still need the quoted exchange rates to be in the same format as described above. Then we
perform separate calculations for the bid and offer price of the cross rate.
EXAMPLE
AUD/USD = 1.1446/56
USD/CNY = 0.1547/55
As long as the exchange rates are expressed this way, the bids multiplied together will give the bid
for the cross rate, and the offers multiplied together will give the offer for the cross rate. Thus:
AUD/CNY = 1.1446 ´ 0.1547 / 1.1456 ´ 0.1555 = 0.1771/ 0.1781
If one (or both) of the exchange rates we are given is not in the correct form, we need to convert it
(or them) by taking the reciprocal of both sides of the quote and reversing the order to ensure that
the offer is higher than the bid. Thus:
EUR/USD = 1.2539/49
1 1
\USD/EUR = / = 0.7969/75
1.2549 1.2539

O B J E C T I V E 6
After working through this section you should be able to demonstrate an ability to maintain a
foreign exchange trading position
5.6 Exchange position
A dealer has an open position in a commodity when the dealer stands to make a profit or loss
consequent upon a movement in the price of the commodity. This general assertion can be applied to
a foreign exchange dealer. If a dealer has bought more of a currency than he has sold he is said to be
“long” the currency. If a dealer has lent more money than he has in his account he is “short” the
currency. We say the dealer has an FX exposure.
5.6.1 Net foreign exchange position terminology
Net exchange position: Total foreign currency bought – total sold.
Long position: More foreign currency bought than sold
Short position: More foreign currency sold than bought
Square position: Total bought = total sold
If currency dealers start from a square position, then when they are long in one currency they should
be short in another. Dealers keep account of their positions by recording the amount of commodity
currency traded in a blotter.
5.6.2 Using a blotter
The table below shows a stylised blotter, which a dealer may use to keep a record of his trading
positions.
Transaction (A$ m) Position

Buy 20 +20 Up 20
Buy 10 +30 Up 30
sell 5 +25 Up 25
sell 15 +10 Up 10
sell 15 -5 Down 5
sell 10 -15 Down 15
buy 15 0 Square
Depending on expected movements in the currency market the dealer may prefer to be short or long
the commodity currency.

5.6.3 Cash flows and T accounts
A blotter tells you of your position at any point in time. However this doesn't tell you whether you
made a profit after all that trading. Keeping T accounts and cash flows are one method for working
this out.
In a T account positive cash flows are set down on the left of the T and negative flows are set down
on the right of the T. In currency transactions, the origins of cash flows can be summarised as:
positive flows arise from (1) buying currency and (2) borrowing currency
negative flows arise from (1) selling currency and (2) lending currency
These accounts can be done by hand or more usually by the Treasury system or spreadsheets.
These accounts can be viewed as a simple bank account and one bank account is kept for each
currency. It is possible for business to keep foreign currency bank accounts in Australia. This can be
helpful when you are dealing with a large number of small transactions in one foreign currency in
your business.
EXAMPLE
Suppose you enter into 3 transactions
4. buy 2m AUD at AUD/EUR 1.5620
Then to square this AUD position you would buy 6m AUD. The rate for this transaction would
determine whether you had made a profit or a loss. If the exchange rate when you close out your
position is AUD/EUR 1.5615, you would sell EUR 9,369,000.
AUD EUR
+2,000,000 -3,124,000
-5,000,000 +7,812,500
-3,000,000 +4,689,000
+6,000,000 -9,369,000
0 8,500
Your final position is a profit of EUR 8,500. (It stands to reason that you would have made a profit,
because the 2 transactions by which you bought AUD were at a lower exchange rate (a lower price
for the commodity currency – the AUD) than the 2 transactions by which you sold AUD.
O B J E C T I V E 7

After working through this section you should be able to provide a brief history of the
exchange rate systems adopted by Australia since the early 1970s, and outline the problems
associated with pre-float regimes.
5.7 Early systems of exchange rate determination
5.7.1 The gold standard
As international transactions became more common during the late 1800s, it became necessary to
establish a stable system of exchange rate determination. This led to the establishment of the gold
standard. Each country’s exchange rate was linked to the price of gold: ie. gold was set at a fixed
price in each currency. The exchange rate between currencies was therefore also fixed.
This system was very stable until World War I. The economic disruption caused by the war and its
after effects placed a great deal of strain on the gold standard. Various countries attempted in various
ways to reintroduce the gold standard, but by World War II the system was close to collapse.
5.7.2 The Bretton-Woods system
In 1944, at an international monetary conference held at Bretton Woods in the United States, a new
international monetary system involving an adjustable-peg system of exchange rates was agreed to.
This system, which emphasised relatively fixed exchange rates, was managed through the
International Monetary Fund (IMF). Each country’s currency was fixed, or rather pegged, to the US
Dollar, and the US Dollar was fixed in terms of the price of gold. Countries were able to periodically
readjust their peg, revaluing or devaluing their currency as required, in response to economic factors.
This system was quote stable for many years, but there were some fundamental problems associated
with it and these problems came to a head in the early 1970s when the system broke down.
5.7.3 Movement to floating exchange rate systems
In August 1971 the system of pegged exchange rates was thrown into chaos when the United States
government suspended the USD convertibility into gold. With the link between the USD and gold
severed, the USD was effectively floating with its value determined by market forces. In March
1973, the currencies of the other major economies were also floated. Australia, however, adopted a
range of different methods of determining its exchange rate until it floated the AUD in December
1983.
In the period from 1971 - 74, the AUD was tied in value to the USD. This meant that the AUD was
effectively floating against all other currencies not tied to the USD. This was considered to be too
restrictive to the appropriate movement of the AUD and in September 1974, the AUD was tied to
trade weighted basket of currencies. In many ways, this was a continuation of the adjustable peg
system with the value of the AUD pegged to some benchmark. In November 1976, the value of the
AUD was adjusted on a daily basis but still set in terms of the trade weighted basket of currencies

(TWI traded weighted index). The value of the AUD was still officially set but frequently adjusted in
line with market forces.
Source :RBA, http://www.rba.gov.au/mkt-operations/foreign-exchg-mkt.html
In December 1983, Australia joined most of the other developed economies and adopted a floating,
market determined exchange rate. There are two types of floating exchange rate systems – a “clean”
float and a “dirty” float. A clean float occurs when the currency is allowed to float freely in response
to market forces, without any intervention by the Central Bank. In a dirty float, the Central Bank
intervenes in order to attempt to have some influence over the value of the currency – eg. for
smoothing and testing purposes. Most countries which have a floating exchange rate, including
Australia, have a so-called dirty float.
5.7.4 Problems with fixed exchange rates
When exchange rates are not determined by market forces but officially set, there are a number of
problems that arise. The only way to maintain the fixed rate is for the Central Bank to continually
intervene by buying and selling large quantities of the country’s currency to increase the level of

demand or supply. If the exchange rate is set at a non-equilibrium level, resulting problems can
include the following:
A country cannot continue to buy its own currency as it will run down its holdings of international
reserves and not be able to pay for imports. Continual sales of domestic will result in a build-up of
foreign reserves and this will mean that a country will experience a lower standard of living than
it otherwise could.
A country will experience either an overall balance of payments surplus or deficit. Surpluses and
deficits in the balance of payments will affect a country’s volume of money and be a potential
source of monetary instability.
Officially set exchange rates that lag behind the market can encourage speculation as future
exchange rate movements can be easy to predict. The most common non-equilibrium fixed rate is
one that is too high. The Central Bank will be forced to buy massive amounts of domestic
currency, running down its foreign reserves. Currency speculators can often predict roughly when
these reserves will run low, necessitating a devaluation. They will sell the currency short, with the
intention of buying it back cheaply when the value of the currency falls, resulting in large profits.
This short-selling places even more downward pressure on the currency, bringing about the
predicted devaluation even sooner. In November 1976 the AUD was devalued by 17.5%,
generating massive speculative profits. One of the major causes of the recent Asian currency crisis
was a series of speculative attacks on weak currencies which the subject of artificially high
exchange rates. The Thai baht was the first such currency to be successfully attacked, followed by
others as the crisis spread from country to country.

O B J E C T I V E 8
After working through this section you should be able to explain how the interaction of supply
and demand determines the foreign exchange value of a currency.
5.8 The equilibrium exchange rate
In previous sections of this topic we considered currency trading in the foreign exchange market and
the practices adopted by dealers in quoting two way prices. Currency trading is undertaken by a
range of individuals, businesses and governments who all have their own reasons for wanting to buy
or sell foreign currency.
“The” foreign exchange market comprises a vast global network of physical locations linked together
by sophisticated telecommunications systems. Each currency has a large number of buyers and
sellers whose collective actions represent the demand and supply conditions in the foreign exchange
market. The prices quoted by dealers are determined by demand and supply conditions throughout
“the” market.
As with any good or service that is sold in a competitive market, the equilibrium price is determined
by the interaction of supply and demand. We will consider each of these forces in the context of the
foreign exchange market for the Australian dollar (AUD)
5.8.1 Demand for a currency
The demand for the AUD is the result of economic units selling foreign currency and buying the
AUD. An increase in demand for the AUD will result from:
an increase in the export of Australian produced goods and services
an increase in capital inflow (borrowing from overseas or investments from overseas)
The demand for the AUD is inversely related to the price of the AUD as a fall in price of the AUD
will lower Australian prices in world markets and increase the demand for Australian exports. This is
illustrated in the diagram below:
Exchange
D
2012 Topic 1 – Introduction to Financial Markets Quantity of AUD 110
5.8.2 Supply of a currency
The supply of the AUD is the result of economic units selling the AUD and buying a foreign
currency. An increase in supply of the AUD will result from:
an increase in the import of goods and services into Australia
an increase in capital outflow ( overseas investment/lending)
The supply of the AUD is directly related to the price of the AUD as an increase in price of the AUD
means overseas prices become relatively cheaper and increases the demand, by Australian residents,
for imported goods and services. This is illustrated in the diagram below:
Exchange
Quantity of AUD
5.8.3 The foreign exchange market
The foreign exchange market brings together the forces of supply and demand with the equilibrium
price being the unique price (exchange rate) where the demand for the AUD exactly equals the
supply of the AUD. This is illustrated in the diagram below:
Exchange
.70
.60
.50
D
The equilibrium price for the AUD, in terms of the USD isQuantity
.60 where demand and supply exactly
of AUD
equal each other.

Any price other than the equilibrium price is not sustainable as there will either be excess demand or
supply in the market which will move the exchange rate towards equilibrium. For example, if the
AUD/USD were at .70 there would be excess supply of the AUD in foreign exchange markets –
more would be supplied at that price than would be demanded. Dealers will reduce the price of the
AUD, in terms of the USD, in order to reduce this excess supply, and move the exchange rate back to
equilibrium. If the AUD/USD were at .50 there would be an excess demand for the AUD – more
would be demanded at that price than would be supplied. Demanders of AUD would “bid up” the
price of the AUD in an attempt to satisfy this excess demand, moving the exchange rate back to
equilibrium.
Like the Loanable Funds theory of the determination of interest rates, this is a simple, but useful
theory. If a change is postulated which might change the exchange rate, with this model it is simply a
matter of determining what change, if any, will take place in the position of the demand and supply
curves shown above. This will lead to a change in the equilibrium exchange rate, which will result
from the interaction of the new demand and supply curves. Such changes are discussed in more
detail in the next section.

O B J E C T I V E 9
After working through this section you should be able to explain the main determinants of the
foreign exchange value of a country’s currency
5.9 Determination of the foreign exchange value of a currency
The previous section established that the foreign exchange value of a currency, in a competitive
market, is determined by the interaction of supply and demand for the currency concerned. Thus, any
event that affects the value of international transactions for a particular country has implications for
the exchange rate. The main explanations for exchange rate movements seek to identify major causes
of changes in the value of a country’s international transactions. These explanations are discussed in
turn from the perspective of the AUD.
5.9.1 Relative inflation rates and purchasing power parity
Assume Australia has higher inflation than the rest of the world. The effects of this will be:
A decrease in demand for exports as Australian prices become less competitive on world markets.
There will therefore be less demand for the AUD and the demand curve will shift to the left.
An increase in demand for imports as overseas goods become relatively cheaper on the Australian
domestic market. There will therefore be increased supply of the AUD and the supply curve will
shift to the right.
The above two effects will result in a fall in the value of the AUD as illustrated below.
Exchange
S1 S2
ER1
ER2
D2 D1
Quantity of AUD
What is happening is that the fall in the value of AUD (from ER1 to ER2) is reducing Australia’s
prices relative to the rest of the world and offsetting the price effect of inflation.

This view of the determination of the exchange rate assumes the maintenance of purchasing power
parity between currencies. The theory of purchasing power parity is based on the “law of one price”.
It contends that:
“Market forces will eventually force adjustments to exchange rates to provide parity of purchasing
power (ie. comparable goods cost the same) between currencies”.
The purchasing power parity theory is based on traded goods. Goods which are cheaper in one
country than another (ie. which display a violation of purchasing power parity) will be bought where
they are cheap, transported and sold where they are more expensive. Either the prices of the goods
will equalise, in response to supply and demand, or the exchange rate will adjust because of the
importing and exporting, resulting in an equalisation of the effective price of the goods. However,
not all goods are traded, and there is a time lag before changes in the price of traded goods are passed
on to non-traded goods.
A weaker form of the purchasing power parity theory is often used, which contents that inflation
rates, rather than actual prices of goods, will tend to equalise because of interdependence between
the exchange rate and inflation rates.
5.9.2 Relative economic growth rates
Assume that Australia experiences higher economic growth than its major trading partners. Income
and aggregate demand, including demand for imported goods and services, will be growing at a
faster rate. To pay for increases in imports there will be an increase in the supply of AUD in the
foreign exchange market. This is illustrated in the diagram below:
Exchange
S1 S2
ER1
ER2
D1
Quantity of AUD
The AUD has fallen from ER1 to ER2.
However, if the higher growth involves investment projects financed through offshore borrowing by
Australian companies, the increase in capital inflow means an offsetting increase in demand for the
AUD. This is illustrated in the diagram below:

Exchange
S1
ER2
ER1
D1 D2
Quantity of AUD
Superimposing these two effects yields the following diagram.
Exchange
Rate
S1 S2
ER1
D1 D2
Quantity of AUD
In the above case, the supply effect is to reduce the price of the AUD while the demand effect is to
increase the price of AUD. The net effect will depend on the strength of each of these separate
factors and the slope (elasticity) of the demand and supply curves. It cannot easily be determined in
advance.
5.9.3 Relative interest rates
The relationship between the effect of differing interest rate movements on exchange rates provides
contrasting views which are outlined below in terms of Australia experiencing higher interest rates
than the rest of the world.
The traditional view was that the higher interest rates in Australia would encourage capital inflow
and discourage capital outflow. This would result from overseas investors placing funds in Australia,
to take advantage of the higher returns, and Australians investing a greater proportion of funds in the

domestic financial markets. The effects of this are illustrated below with the AUD increasing from
ER1 to ER2.
Exchange
S2 S1
ER2
ER1
D1 D2
Quantity of AUD
The previous view does not accord with what happens in the foreign exchange market. as empirical
evidence suggests an alternative view. That is, a country experiencing higher interest rates is also
likely to be experiencing a fall in the value of its currency.
The explanation for the alternative view is based on inflation and the difference between real and
nominal interest rates. Nominal interest rates are the quoted observable interest rates which include
the effects of inflation. In order to determine the real interest rate – the interest rate that actually
results in an increase in purchasing power over and above the inflation rate – it is necessary to
subtract the inflation rate from the nominal rate to determine the real interest rate. (This is an
approximation which is sufficiently close for the purposes of this analysis.)
It is assumed (it is usually a reasonable assumption) that real interest rates are constant between
countries. If this were not the case, there would be arbitrage opportunities created and capital would
quickly flow to those countries with the highest real rates, thus bringing real rates into alignment. If
real rates are constant, a country experiencing higher nominal interest rates must also be
experiencing higher inflation. As explained in Section 5.8.1, higher inflation will result in a
depreciating currency.
5.9.4 Commodity prices
A commodity is essentially anything that is bought or sold. In this context, we are talking about the
commodities that Australia exports – chiefly minerals and agricultural products. Because Australia is
a large commodity exporter, the value of its exports, and hence the level of demand for the AUD, is
significantly influenced by world-wide commodity prices.
If Australian exports become more expensive because of inflation, overseas importers of our
goods will turn to other countries, and the value of our exports will fall, along with demand for,

and the value of, the AUD. However, if our exports become more expensive because of an
increase in commodity prices, importers cannot turn to other suppliers because commodity
prices are a world-wide phenomenon. They will continue importing commodities from
Australia, and the total value of our exports, and hence demand for the AUD, and hence the
value of AUD, will all increase.
5.9.5 International speculation and investment
Notwithstanding the various theoretical causes of changes in the value of the AUD, its change in
value can be influenced by international speculation and mainly driven by investment. When the US
economy, the world’s largest, is weak capital tends to flow into stronger economy, such as Australia.
When there is bad economic news in the US, as there has been since the early 2000’s, this usually
results in a retreat of capital from the US, and the AUD benefits as a result. Hence the steady decline
in the USD over the last 10 years, as the Australian economy becomes more attractive for investment
compared to that of the US. Severely hit by the GFC the US dollar has recently lost such value
compare to the Australian dollar that the two currencies are now trading around parity (1 to 1).
There is no formal link, but generally non-US economies “suffer” when the US economy and the
USD are strong, and they benefit when the USD falters.
5.9.6 Exchange rate expectations
Exchange rate expectations are a major cause of actual exchange rate movements. If market
participants, including speculators, have formed expectations about future exchange rate movements
then they will take action which will have a self-fulfilling effect.
For example, if market participants expect the future value of the AUD to fall, they will sell the
AUD, increase its supply in the foreign exchange market, which will cause a fall in its value. If they
expect the value of AUD to increase, they will buy the AUD, increasing demand for the currency and
helping to bring about an appreciation.
5.9.7 Official intervention
In addition to the above factors, official (government or central bank) intervention into foreign
exchange markets can exert a significant influence on the value of that country’s currency. In
Australia, official intervention is through the activities of the Reserve Bank, buying and selling the
AUD in trade with banks and a select number of non-bank authorised FX dealers. Since the
December 1983 float of the AUD, there has been two distinct periods of official intervention
Dec. 1983 - mid 1986: minimum intervention (“clean float”).
Mid. 1986 - current: significant intervention (“dirty float”).
The reasons for Reserve Bank intervention since mid 1986 have been

To try and understand the nature and strength of forces in the market
To buy and sell currency to meet the needs of its clients particularly government
offset short term instability
The Reserve Bank has stressed that its role in intervening is to “buy time” for market participants to
reassess their judgement and to provide a settling influence on the market. It is not to target a
particular exchange rate.

TOPIC 5: SUMMARY
The foreign exchange market serves to link domestic payments systems into a global payments
system. Whenever a resident in one country has an economic transaction with a resident in another
country there is a need for currency exchange. An exchange rate is the value of one currency in terms
of another currency with the two main forms of FX transaction being on a spot and forward basis.
Forward exchange rates are determined by interest rate differentials given that both exchange rates
and interest rates are determined by expectations.
In the spot market dealers buy low, at their bid quote, and sell high, at their offer quote.
The foreign exchange market is a highly competitive market comprising a vast network of different
locations linked together by telecommunications. It is only from 1973, that the world major
currencies were floated and from December 1983 that the Australian dollar was floated. In the
competitive FX market the foreign exchange values of currencies are determined by the demand for,
and supply of, particular currencies.
There are a number of explanations of the determinants of the foreign exchange value of a currency
including relative inflation rates, relative growth rates, relative interest rates, expectations and
official intervention.

TOPIC 6: THE EQUITY-CAPITAL MARKET
Aim
The aim of this topic is to give you a working knowledge of the equity markets.
The equity market allows individuals and organisations to invest directly in companies and receive a
share of distributions of the company. The equity market also provides a forum for new companies to
raise capital from investors that may not have access to invest in a company otherwise. The topic
examines different type of products issued in this market and the different reasons for investing in
companies through the equity system. Time will also be spent in considering how to value a share
and make an investment decision.
Objectives
At the end of this topic students should be able to:
1. Explain the nature of the equity market.
2. Outline the various participants in the equities market.
3. Describe the concept of a company and the reason for becoming a public company.
4. Explain the reasons and methods for raising equity.
5. Describe the types of securities issued by companies.
6. Examine the various methods companies use to distribute their earnings.
7. Explain the role of Australian Securities Exchange and how it regulates the market.
8. Outline measures of share market performance.
9. Describe different methods of analysis of share prices.

O B J E C T I V E 1
After working through this section you should be able to describe the nature of the equity
market and its place in the financial markets around the world.
6.1 What is equity?
Equity involves ownership and is the permanent capital of a business. If you have an equity
investment, you own part of an asset, for example a house or a company. When you buy an ordinary
share in a company you become an owner of that business, even if it is a minute ownership share,
and share in the profits and losses of that company.
6.1.1 Equity versus debt
Equity differs from debt in that the following ways:
Debt securities are normally issued for a defined period of time whereas ordinary shares are
perpetuities.
Debt securities represent a contractual claim over borrowers, who must repay interest and
principal or they will be in breach of contract. Equity securities represent a residual claim –
they own the profits and net assets that remain after contractual obligations have been met.
Debt-holders normally receive a fixed rate of interest, whereas the return received by equity-
holders is much more variable. Debt-holders face less risk, and therefore receive a lower rate of
return. The risk faced by equity-holders is usually much greater, and their expected return is
also greater. The capital contributed to a business by equity-holders is sometimes referred to as
“risk capital”, because investors have no guarantee of any return on their investment, or its
repayment.
6.1.2 Nature of the equity market
As discussed in the previous topics, debt securities are traded by professional dealers in over the
counter markets whereas the market for equity securities is organised on a central exchange. In
Australia that central exchange is called the Australian Securities Exchange (ASX).
Most of the financial markets examined in this course are predominantly wholesale markets. The
equity market is quite different. The central exchange enables small investors to participate easily
and cheaply, and hence the equity market serves both retail and wholesale investors.
The equity market is a highly visible market in developed countries around the world. The
performance of these markets is given a lot of media attention by the press and financial writers.
Equity trading goes on 24 hours a day (during the working week) in different exchanges in different
time zones around the world.

O B J E C T I V E 2
After working through this section you should be able to understand the various participants
in the equities market and their role in developing an efficient market.
6.2 Participants
Participants in the equity-capital market can be divided into four main groups:
1. Brokers
2. Investors:
Private investors
Institutional investors
Overseas investors
3. ASX or stock exchange
4. Corporations:
6.2.1 Brokers
Brokers are licensed participants through whom orders are placed in the market. Brokers are paid on
commission which can be negotiated between the client and themselves. Brokerage will be charged
on each different transaction and an order to buy and sell shares in two different companies is
considered two different transactions. Brokers also provide advice, research, cash management
facilities, etc.
6.2.2 Shareholders
Traditionally, individuals have been the major holders of company shares but during the 1960s
insurance and superannuation companies started buying into the market. Now the majority of shares
are held by unit trust companies and superannuation funds. By the end of 2000 over 50% of adult
Australians owned shares directly or indirectly through share unit trust or superannuation funds.
6.2.3 The Stock Exchange – See Section 6.7
6.2.4 Corporations – See Section 6.4

O B J E C T I V E 3
After working through this section you should understand the advantages of forming a
company and the reasons for companies listing on the stock exchange.
6.3 What is a company?
Corporations differ from other forms of business organisations in the following ways:
A company is a separate legal entity from its owners (the shareholders).
Ownership claims are widely dispersed amongst a large number of shareholders.
Owners do not normally have the right to participate in the day to day operation and
management of the business.
The liabilities of owners is normally ‘limited’: ie. they have limited liability.
6.3.1 Classification of company by liability
There are various classifications of a company, based on the type of liability which is faced by the
owners of the company:
• By shares
Typically, members are usually shareholders and their liability is limited to the nominal (nominal
capital is defined as the capital with which the company was incorporated) value of their shares plus
any unpaid amount on their shares.
As an example, say you buy BHP shares at $10 for 100 shares, then your liability is limited so
that if BHP were to be sued, it is limited to the $10 paid. This is sometimes conducted differently
when you don’t fully pay for shares when the company floats. If $5 was paid and $5 was then
owed on the shares, then the remaining amount must be contributed should it be called upon.
• By guarantee
Within these companies, members can place a guarantee on the company which may only be
enforced on the winding up of the company and is not an asset of the company which may be
charged during its life. These companies have no share capital unlike companies limited by shares.
Non-Profit organisations do sometimes use this method.
• Liability is contributory specified in memo.of association. eg. Sports Club.
• By share and guarantee

Member has liability as both a shareholder and a guarantor.

• No liability
Members donot incur liability even if there are unpaid share amount, eg. mining company.
Unlimited liability
It is defined in Australia in the corporations act as a company whose members have no limit placed on
their individual liability to contribute to the debts of the company. Members are thus fully liable for
all debts. eg. accountants and legal firms.
6.3.2 Advantages of a corporate form of business organisation
Take on large projects as large amounts of funds can be raised relatively cheaply.
Spread business and financial risk amongst a large number of people and institutions.
Separation of ownership and control enables specialist managers to be hired.
Enables continuity of business activities.
6.3.3 Types of companies
It is also possible to classify companies based on the size of the company and the way in which it
raises equity finance:
Proprietary company
Public company
Listed public company
6.3.3.1 Proprietary Company
A proprietary company is essentially a private company.
It has a minimum of 2 owners signing the documentation to create the company.
The number of shareholders must be less than 50.
Private companies are usually used to operate small- to medium-sized businesses.
Shares in private companies are traded privately or held.
6.3.3.2 Public company
Five owners are necessary to sign the documentation to create a public company.

The number of shareholders is greater than 50.
A prospectus is required in order to invite the public to subscribe to shares in a public

company.
6.3.3.3 Listed public company
If a public company seeks additional equity finance it can seek listing on the stock exchange.
In order to do so it must satisfy the stock exchange’s listing requirements. It’s shares are then
publicly traded on the stock exchange.
These requirements include a minimum of $1 m. in issued capital and a minimum of 500

shareholders.
Although there are 1.5 million registered companies in Australia, there are only about 1900
listed on the stock exchange. However, the vast majority of share transactions involve these
1900 companies, and hence trading in these shares constitutes the bulk of the equity market.
6.3.4 Floating a company and listing rules
“Floating” means a new issue of shares is offered to the public through a prospectus with the
aim of listing the company on ASX. It is also referred to as an Initial Public Offer (IPO).
The company must apply to ASX for approval and conform with the Corporations Law and the
ASX’s listing regulations.
The advantages of going public are known to be:
Liquidity and increased share price,
Management and employee motivation,
Enhanced image/prestige,
Access to alternative sources of capital,
Ancillary benefits.
O B J E C T I V E 4

After working through this section you should be able to explain various methods for raising
new capital for a firm
6.4. Methods of raising capital
There are several ways in which companies can issue shares in order to raise equity capital, each of
which has advantages and disadvantages.
6.4.1 Private Placement of new shares
This involves inviting a large investor (typically an institutional investor such as a superannuation
fund) to buy a large parcel of newly-issued shares. The advantages of this method of raising equity
capital include the following:
It is arguably the least expensive of the methods available. Because shares are not being
offered to the public at large, there is no need for a prospectus, which is a document providing
information to prospective investors about the company, its future prospects and what it
intends to do with the funds it is planning to raise. Prospectuses can be very expensive
documents to produce. There are other savings in terms of administrative expenses, because
there is no need to communicate with a large number of prospective investors and process a
large number of subscriptions.
The process can be completed very quickly – often within a few days – whereas other methods
of issuing equity can take weeks or months to complete.
Because private placements can be completed quickly, the subscription price obtained by the
company is usually higher than with other methods of issuing shares. There is no need to
heavily discount the subscription price to ensure that the market price doesn’t fall below the
subscription price before the deal can be completed.
There are two main disadvantages associated with private placements:
Because the subscription price will be discounted to some extent (to induce the prospective
investor to buy the shares) they may be tempted to sell the shares immediately at a profit. To
prevent this from occurring, there are often restrictions on how quickly the shares can be sold
on the open market. This means that there a lack of liquidity in the short term from the point of
view of the investor.
Because new shares are being created and offered to persons other than the existing
shareholders, the proportional shareholding of the existing shareholders will be diluted by the
process. They will own a smaller proportion of the company than they did before the
placement took place. For this reason, private placements are restricted to 10% of the
company’s issued capital in any one year.

6.4.2 Public offer
This involves inviting the public at large to subscribe to shares. This can be used to float the
company or to raise additional equity capital after the company has been floated. The main
advantage of a public issue is that more capital can be raised than with other methods of raising
equity capital. However, there are a number of disadvantages:
It can be costly, because a prospectus needs to be produced and distributed to potential

investors, and there are other administrative expenses associated with advertising,
communicating with and processing applications for shares from potential investors.
The process can take some time, with some public issues taking several months to complete.
Because public issues can take some time to complete, the subscription price obtained by the
company often needs to be heavily discounted to ensure that the market price doesn’t fall
below the subscription price before the deal can be completed.
Public issues also involve offering newly created shares to new shareholders, thus diluting the
proportional shareholding of existing shareholders. Public issues must be approved by existing
shareholders and the ASX.
6.4.3 Rights issue/Pro-rate issue
This involves granting existing shareholders the right to buy new shares at a discounted price. The
rights are granted on a pro-rata basis, whereby the number of rights they receive are proportional to
their existing shareholding. For example, a “1 for 10” rights issue means that, for every 10 shares
held by existing shareholders, they have the right to buy 1 new share.
Rights Issues involve many of the disadvantages associated with public issues. They are costly, take
a long time to complete, and the subscription price is often heavily discounted. The main advantage
of a Rights Issue is that if the shareholders exercise their rights to buy new shares, their proportional
shareholding will be maintained – it will not be diluted.
A right to buy new shares can be renouncable or non renouncable. A renouncable right can be taken
up or sold in the secondary market. If it is sold, the buyer of the right then has the right to buy new
shares at the predetermined price, and the seller of the right simply retains his existing shares. A non-
renouncable right cannot be sold separately from the shares. If it is not taken up, it simply lapses.
Most rights issues are renouncable, which is in the interests of the shareholders.

O B J E C T I V E 5
After working through this section you should be able to describe the various types of security
issued by a company.
6.5 Equity instruments
Equity instruments issued by companies could include one or more of the following.
Ordinary shares
Preference shares
Convertible notes
Options
Warrants
The last three instruments are not technically equity instruments, but they give the investor access to
the equity market and need to be covered in any discussion of instruments traded in the equity
market.
6.5.1 Ordinary shares
The most common instrument traded in the Equity Market is an Ordinary Share. An Ordinary Share
is more than a financial asset giving the holder of the assets claims to future cash flows – it
represents partial ownership of a company. Each shareholder owns part of the company, in
proportion to the number of shares held.
As discussed earlier, the nature of the claim held by the investor is fundamentally different when
comparing debt and equity. A debt-holder has a contractual claim on future cash flows – the
company is legally required under a contract to make interest and principal payments as and when
they fall due, and if it defaults this claim is enforceable under the law. Equity-holders, on the other
hand, have a residual claim – they, collectively, own the company and the profits that remain after all
contractual claims have been met, but there is no legal requirement for the company to pay dividends
at a particular rate or even to pay dividends at all. The payment of dividends is at the discretion of
management, and the dividend decision will take into account such things as whether a profit has
been made, whether there is cash available to pay the dividends, and the company’s dividend policy.
Other rights that accrue to equity holders include the right to vote at General Meetings of the
company, and thereby to have some influence over the activities of the company. This influence is
usually limited to major policy decisions and the election of a Board of Directors. It is impractical for
the shareholders of large companies to control the day-to-day activities of the company. This control
is delegated to the Board of Directors, who in turn hires specialist managers to manage the day-to-
day activities of the company.

One of the features of an ordinary share, and one of the attractions of the company structure as a way
of doing business, is the fact that under most circumstances the liability of the shareholders for the
debts of the company is limited – limited to the unpaid value, if any, of the shares. If the shares are
fully paid (which is usually the case for shares listed on the ASX) there is no further liability on the
part of shareholders should the company get into financial difficulties.
Ordinary Shares are irredeemable – they do not mature at some point in the future in the manner of
debt instruments. (Although under certain circumstances it is possible for a company to buy back
some of their shares, this does not after the fact that when the shares are issued they are irredeemable
securities.)
6.5.2 Preference shares
Preference Shares are similar in some ways to Ordinary Shares, but there are fundamental
differences. Preference shareholders, as the name implies, receive preferential ranking in the
payment of dividends (and distribution of the net assets of the company should it be liquidated).
They still rank behind debt-holders, but rank ahead of ordinary shareholders. Because of this
preferential ranking they are subject to less risk than ordinary shareholders. They also normally
receive a fixed dividend, whereas the dividends paid to ordinary shareholders can be highly variable.
Like convertible bonds (discussed below) Preference Shares are referred to as hybrid securities,
because they have features of both debt and equity. They are technically equity, and preference
dividends are paid out of after-tax profits, whereas interest payments to debt-holders are tax-
deductible. However, their preferential ranking, reduced risk and (in most instances) fixed dividends
mean that Preference Shares have many features which are similar to debt.
Some of the features of Preference Shares are highly flexible, in order to meet the needs of the
company and the likely investors. For instance:
If the shares are Cumulative Preference Shares, this means that if there is any shortfall in the
dividend payable to preference shareholders because of insufficient profits or cash to pay the
dividend in full, the shareholders must receive any dividends they have missed out on in future
years before dividends can be paid to ordinary shareholders. If the shares are Non-Cumulative,
there is no need to make up any shortfall in dividends in subsequent years.
If the shares are Participating Preference Shares, the means that the shareholders “participate”
in extra profits, along with ordinary shareholders. In this case they can receive more than the
prescribed fixed dividend if the profits of the company are higher than expected. Non-
Participating Preference Shares can never be paid more than the fixed dividend, no matter
how much profit the company makes.
If the shares are Redeemable Preference Shares, the shareholder may have the right to sell the
shares back to the company (redeem the shares) at a specified price, under certain conditions,
or the company may have the right to buy the shares from the shareholder, at a specified price,
under certain conditions. The fact that such shares are redeemable in the same manner as debt

securities is another reason for the fact that they are known as hybrid securities. If the shares
are Non-Redeemable, no such right of sale or purchase exists.
6.5.3 Convertible bonds
These bonds are convertible into shares, at the option of the bond-holder, at a fixed price on or before
a fixed date in the future. This is the reason why convertible bonds give investors access to the equity
market and can be used by companies to issue equity (when and if the bonds are converted).
Convertible bonds are another example of a hybrid security, in that they have features of both debt
and equity securities. Until such time as the bonds are converted into equity, they are, strictly
speaking, debt. However, the value of such bonds depends not only on their value as a debt security
(ie. the present value of future cash flows as a debt security) but is also greatly influenced by the
value of the underlying shares. As the shares increase in value, there is a greater likelihood that the
bonds can be converted into shares at a profit. Indeed, variations in the value of the underlying shares
generally dominate as a determinant of the value of the bonds.
Convertible bonds are usually unsecured, and are often referred to as convertible notes. (A note is
common term for a bond which is unsecured). Because the option to convert to equity is valuable
from the point of view of the investor, companies can usually issue convertible bonds with a lower
coupon rate than would be required for “straight” bonds.
6.5.4 Share options
These give the holder the right but not the obligation to take up shares in a company at a preset price
on or before a particular date. The holder of the option is not obliged to subsequently purchase the
shares. His decision whether or not to purchase the shares at the preset price will depend on the value
of the shares in the market at the time they are to be purchased. Share options are just one type of
option contract – options in general are covered in more detail in Topic 7.
Equity capital can be raised through the premium paid for the option and as well as through the
exercise price if and when the options are exercised. If they are not exercised the premium is a “free”
source of income for the company. However, if they are exercised the new shareholders will most
likely be obtaining new shares at a discounted price, and the proportional shareholding of existing
shareholders is diluted. Share options are often included in the remuneration package for senior
executives to give them an incentive to make decisions which will increase the value of the
company’s shares.
Share options can also be issued over the shares of another company. In this case, if the option is
exercised the seller (or writer) of the option must already own the shares or obtain them from the
share market. These options are usually traded on the stock exchange and are referred to as Exchange
Traded Options (ETOs).

6.5.5 Warrants
A warrant is a type of option that is normally issued over shares. However, the exact meaning of what
constitutes a warrant differs from country to country and often within a country. In Australia, the term
warrant usually refers to options issued by approved third parties. That is, they are options issued by
an investor approved by ASIC, (normally registered banks) over a company’s shares rather than
issued by the company itself.

O B J E C T I V E 6
After working through this section you should be able to examine the various methods
companies use to distribute their wealth.
6.6 Distribution of Earnings
The main ways in which companies distribute their earnings to shareholders are:
Dividends
Bonus dividends
Bonus shares
6.6.1 Dividends
The payment of dividends is the most significant method by which companies distributed earnings to
shareholders. Dividends are expressed as a number of cents per share. Whether or not a dividend is to
be paid, and the size of that dividend, is at the discretion of management – it is generally believed that
shareholders may not make objective decisions that are in the best interest of the company in this area.
Shareholders are often given the option to reinvest the dividends and receive new shares instead of
cash – the main advantage is the avoidance of brokerage fees and stamp duty.
Dividend decisions are based on three factors:
Whether a profit has been made.
Whether there is cash available to pay dividends. Sometimes a book profit does not necessarily
imply that cash is available.
Management dividend policy. For example, management may have a set retention ratio to
finance future acquisition of assets and expansion of the company’s operations.
Dividends can be described in different ways:
Interim dividends may be paid half-way through the financial year, based on an estimate of what
the profit will be for the entire year.
Final dividends are paid after the profit for the financial year has been determined.
Dividends can be “fully franked”, “partially franked” or “unfranked”. These terms refer to
Australia’s dividend imputation system. Prior to the introduction of this system in the late 1980s,
company profits were effectively taxed twice – once when the profit was earned by the
company and again when the dividends were received by the shareholders. The dividend

imputation system is designed to prevent this double taxation. If the company has paid tax on
the profits out of which dividends are paid, the dividends are “franked” and carry “imputation
credits” which allow the shareholder to reduce the tax that they would otherwise pay by the
amount of the tax paid by the company. If tax has not been paid by the company (eg. they are
tax-exempt, or have avoided tax by carrying forward tax losses) the dividends will be
unfranked. If the dividends are partly paid from taxed profits and partly paid from untaxed
profits, the dividends will be partially franked.
6.6.2 Bonus dividends
Companies and shareholders would prefer to minimise variation from year to year in the payments
of dividends. Variation or volatility is referred to in finance as risk. Shareholders would prefer to
minimise risk, given the level of return, and companies are able to pay a lower level of return if they
can minimise risk. For this reason, if a company has a particularly profitable year and seeks to pay
extra dividends to shareholders, they will often pay a “bonus dividend” rather than increasing the
regular dividend. Although the net effect is the same, this gives the impression that the regular
dividend is less volatile, and omitting the bonus dividend the following year is less likely to be
construed as bad news than a reduction in the (temporarily increased) regular dividend would be.
6.6.2 Bonus shares
Sometimes a company will issue additional shares to existing shareholders, free of charge. These are
similar to rights issues except no subscription price is paid by the shareholder. They will be issued
on a pro-rata basis: eg. 1 bonus share for every 5 existing shares.
Whether or not bonus shares are of value to shareholders is a matter of conjecture. Because they
increase the number of shares without adding value to the company, the value of the company is
spread over a larger number of shares – it is diluted – and the value of each share should drop
accordingly. In theory, the wealth of shareholders will not change. However, bonus shares could be
seen as advantageous for the following reasons:
The market sometimes reacts favourably to the issue of bonus shares, interpreting it as good
news. This is particular the case if it is believed that dividends will continue to be paid at the
same rate on the increased number of shares. As a result, the value of all shares can increase.
Sometimes it is the intention to reduce the value of the shares. Reducing the value of
individual shares makes them more accessible to small investors and reduces the size of the
dividend which needs to be paid on each share. This is the rationale behind “share splits”
where each existing share is split into a number of new shares to keep the value of each share
at a reasonable level.

O B J E C T I V E 7
After working through this section you should be able to explain the role of the Australian
Stock Exchange (ASX) and how it regulates the share market.
6.7 The Australian Stock Exchange
6.7.1 History of the ASX
The first companies were created in England in the late 1500s to finance trading expeditions. Shares in
these companies were traded informally, often in coffee houses in London. In the late 1700s, the most
frequently-used coffee house became the world’s first stock exchange.
As Australia was developed during the early 1800s, there was a need for stock exchanges to enable
trading of company shares. The first stock exchange was established in Sydney in the 1830s, and over
the next century stock exchanges developed in all capital cities and many regional centres. In the 1930s
the stock exchanges in each capital city formed an association to ensure consistency of standards, listing
rules, etc., and the other stock exchanges closed down as trading of shares was centralised with the
exchange in each capital city.
In 1987, the 6 stock exchanges merged to become the Australian Stock Exchange – a mutual
organisation consisting of the stock brokers licensed to trade on the exchange. In October 1998 the
ASX demutualised and became a listed company with its shares traded on its own exchange. It
became the first stock exchange in the world to list itself. In 2006 the ASX merged with the Sydney
Futures exchange with the name of the merged company being the Australian Securities Exchange.
However, both markets operate separately.
6.7.2 Functions and objectives of the ASX
The functions of the ASX are to:
Facilitate the issue of shares in the primary market.
Provide a secondary market for the trading of company shares.
Regulate the stock-broking industry.
An underlying objective of the ASX in carrying out these functions is to ensure that the market for
shares is efficient, fair, honest, competitive and informed.
The ASX strives to achieve this objective by implementing and enforcing a wide range of listing
requirements and rules governing the operation of the exchange. In order for a company to become a
listed company it must satisfy a range of listing requirements, including at least $1 million in issued
capital and at least 500 shareholders. The Initial Public Offer (IPO) or “float” of a company is

designed to satisfy these requirements in particular. Companies will liaise closely with the ASX at
the time of their IPO to ensure that they comply with all of the ASX’s requirements.
Once a company has been listed it must continue to comply with the ASX’s rules and requirements.
Perhaps the most significant of these is the disclosure requirements. Companies must provide the
market with semi-annual financial statements, and they must inform the market immediately if
anything occurs which will materially affect the finances of the company or the value of its shares.
The company must also inform the market immediately if it enters into a transaction with a member
of its Board of Directors, or if a member of the Board of Directors buys or sells shares in the
company.
The ASX can temporarily suspend, or delist, companies which violate its listing rules, and it can fine,
censure or cancel the license of a stockbroker who violates its operating rules.
Because the ASX is listed on its own stock exchange, there is a potential conflict of interest in terms
of enforcement of compliance with its own rules. For this reason, the Australian Securities and
Investment Commission (ASIC) has the special rule of policing the ASX’s compliance with its own
rules.
6.7.3 Trading on the ASX
There are two different methods by which trading can be conducted on a stock exchange – floor
trading (also known as open outcry) and screen trading.
Floor trading involves licensed stock brokers gathering on the floor of the exchange and conducting
transactions, on behalf of their clients, face-to-face. They usually wear brightly coloured jackets to
identify themselves, and they have their own system of hand signals, combined with shouted
instructions, in order to communicate with each other despite the noise and commotion. The floor of
a stock exchange can be a very colourful and noisy place, but it is arguably not an efficient way to
conduct transactions.
Screen trading allows stock brokers to enter orders to buy or sell on computer screens in their offices.
The system matches the highest bids with the lowest offers, and executes the transactions in an
orderly fashion. The ASX introduced screen trading in 1987.
Most stock exchanges in the world have moved to screen trading, but not all. The largest stock
exchange in the world, the New York Stock Exchange (commonly referred to as “Wall Street”) uses a
combination of floor trading and screen trading. Transactions during the “trading hours” of the
exchange occur via floor trading, but “after hours trading” takes place via screen trading. Futures
exchanges around the world (discussed in Topic 7) have been slower to switch across the screen
trading. The largest futures exchange in Australia – the Sydney Futures Exchange – uses screen
trading.
6.7.4 CLICK XT and CHESS

CLICK XT is the Stock Exchange’s integrated Trading System, which is the screen-based trading
system used by the ASX. It allows stock brokers to enter orders to buy or sell 24 hours a day, but
overnight it ranks the orders. When the exchanges opens at 10.00am the next day, the highest bids
and the lowest offers are matched and the transactions are executed. For this reason, a significant
proportion of transactions occur in the first few minutes of the trading day, and the value of shares
can vary sharply when the exchange opens.
CHESS is the Clearing House Electronic Sub-register System. This system transfers ownership of
shares when a trade occurs and keeps track of which investors own shares in which company.
Australia no longer uses paper share certificates – records are kept electronically. The CHESS
system sends out statements to investors when their shareholding in a company changes as a result of
a trade, and it can provide companies with a list of shareholders at any time, which is necessary for
the payment of dividends or the offer of bonus shares or a rights issue.

O B J E C T I V E 8
After working through this section you should be able to outline various measures of
performance of the share market in general.
6.8 Measures of Share Market Performance
6.8.1 Turnover of shares
One way to measure the “performance” of the share market is to measures the total number of shares
or the total value of shares which change hands. The larger the turnover the more liquid the market.
If there is a high turnover of shares, and a high proportion of a country’s residents own shares, this
tends to indicate that the market in general has confidence that the share market is fair and honest.
6.8.2 Share price indices
The “performance” of a share market can also mean the increase in the value of the shares in the
market. A share price index is designed to measure the change in the value of shares in the market
overall, over a period of time. There are many different indices used to measure the performance of
each market.
The indices with which the layman is most familiar are those which are used to approximate the
change in value of all shares in the market. A subset of shares is selected which is designed to
represent the market as a whole. Most of these indices are value-weighted, which means that the
contribution that each stock makes toward the value of the index is weighted to reflect the value of
the stock in the market overall. For example, if Telstra represents 10% of the market overall, it
should carry a 10% weighting in any market index.
The index which is most often used to represent the Australian share market is the All Ordinaries
Index (AOI), which includes the 500 largest companies out of the (approximately) 1400 listed
companies. In 2000, the ASX outsourced the calculation of its share price indices to Standard and
Poor’s and the AOI was restructured to comprise the top 500 companies. The AOI is also the
ASX500. Trades in these shares represent over 95% of trades overall. Other indices used are the
ASX 100, ASX200 and the ASX300, which include the largest 100, 200 and 300 companies
respectively.
The index which is generally used to measure the performance of the New York Stock Exchange is
the Dow Jones, which includes the 30 largest companies on Wall Street. The S&P500 is a much
broader index, which includes 500 companies. The NASDAQ is a separate system which enables
Over The Counter trades between securities dealers, and the NASDAQ index predominantly consists
of “technology” stocks.
Other well known market indices include the FTSE100 (the “footsie”) in the UK, the Hang Seng in
Hong Kong, the Nikkei225 in Tokyo, the NZSE40 in New Zealand, the CAC40 in France, the DAX

in Germany, the Kuala Lumpur Composite Index (KLCI) in Kuala Lumpur and the Straits Times
Index (STI) in Singapore.

O B J E C T I V E 9
After working through this section you should be able to describe ways people choose share
investments.
6.9 Analysis of share prices
There are as many different ways choosing share investments as there are investors. However, some
techniques are more common than others, and there are a few issues that should be taken into
account in constructing any share portfolio.
6.9.1 Systematic and unsystematic risk
Shares are a particularly risky form of investment, but which can offer high returns. Risk can be
manifested as variation in dividends (with the possibility of no dividend) and variation in the capital
gain when the share sold (with the possibility of the loss of some or all of the investment). This
variation or risk can be categorised as systematic or non-systematic.
Systematic risk (also known as market risk) is risk that affects all shares in the market. Different shares
will vary in their sensitivity to market risk, but all share prices will move in the same direction as a
result of market risk. Market risk factors include macroeconomic variables such as inflation and
interest rates, political uncertainty and natural disasters. Non-systematic risk factors affect individual
companies or specific industries. Share prices can move in opposite directions as a result of non-
systematic risk.
This highlights the importance of a diversified portfolio of shares. Although systematic risk
unavoidable, non-systematic risk can be reduced by combining shares in a portfolio which, at least
some of the time, vary in opposite directions. The expected return on the portfolio will be average of
the expected returns on the individual shares, but the riskiness of a well-diversified portfolio will be
less than the risk of the shares individually because of non-systematic risk.
6.9.2 Investment analysis
The two most commonly-used methods of investment analysis are Technical Analysis and
Fundamental Analysis.
6.9.2.1 Technical analysis
Technical analysis involves analysing past share prices in an attempt to identify patterns and predict
future price movements. Technical analysts are sometimes referred to as “chartists” because of their
reliance on charts to detect patterns in the movement of share prices. Some technical analysts will try
to identify visual patterns in charts of past prices, while others will use complex computer software to
identify statistical relationships within the series of past prices. Under technical analysis it is more
important to correctly identify the direction of change rather than the size of the change.

6.9.2.1 Fundamental analysis
Fundamental analysis involves analysing information in order to determine the intrinsic value of a
share – the “true” value based on the present value of future cash flows to be received from holding
the share. If the fundamental analyst can identify an underpriced share, he will buy it, on the
assumption that the market will “correct” in the future and the share will then be accurately priced. If
he identifies an overpriced share, he will sell it, or not buy it, or short-sell it if that is legal in the
market in which he is trading.
There are two types of fundamental analysis:
The Bottom-Up Approach. This involves analysing information about the company itself,
including its financial statements. The bottom-up approach often involves calculation of
various ratios, such as the debt/equity ratio, the price/earnings ratio, the current asset ratio and
the interest coverage ratio.
The Top-Down Approach. This includes information used in the bottom-up approach, but also
adds information about the macroeconomy and the industry in which the company operates.

TOPIC 6: SUMMARY
This topic covers the main factors of the equity trading and the major products available in the share
market. It considers the reasons for forming and listing a company and examines various means a
company distributes its wealth. We also consider the investment decision and measures for share
market performance.
References:
Viney Chapters 4, 5, 6 & 7
Hunt & Terry Chapters 9 & 10
Valentine et al Chapter 9

TOPIC 7: THE DERIVATIVES MARKETS
Aim
The aim of this topic is to explain the nature of the four most basic derivatives – options, forwards,
futures and swaps – and the nature and operations of the markets in which these financial products
are traded. The main participants in the derivatives markets will be examined, along with the reasons
for the participation in the market.
Learning objectives
21. Explain what is meant by the term “derivative”
22. Describe the features of forwards, futures, options and swaps
23. Explain how and why these derivatives are used
24. Compare and contrast these derivatives and describe their similarities and differences
25. Explain the reasons why various market participants use derivatives
26. Describe the features of the markets in which each of these derivatives are traded

O B J E C T I V E 1
After working through this section you should be able to explain what is meant by the term
“derivative” and how and by whom these products can be used.
7.1 Introduction to derivatives
7.1.1 What is a derivative?
The term derivative means a financial asset which derives its value from the value of some other
asset, rate or index. It does not have value itself, but its value results from the fact that some other
asset has value.
For example, the value of an option to buy or sell an asset will be determined by the value of the
underlying asset. Variations in the value of the underlying asset will result in variation in the value of
the option. Similarly, the value of a forward contract to buy or sell an asset will be determined by the
value of the underlying asset which is to be bought or sold.
The four most basic types of derivatives are:
Forwards
Options
Futures
Swaps
The nature of each of these derivatives, and the markets in which they are traded, will be covered in
detail in this topic.
7.1.2 Nature of the derivatives market
Because there is such a wide variety of instruments and participants in derivatives markets, it is
difficult to generalise about the way in which the markets operate.
Some derivatives, such as Forward Contracts, Swaps and some types of Options, are traded in
Over-The-Counter markets, while others, such as Futures and Exchange-Traded Options, are
traded via a central exchange like the stock exchange.
Some derivative markets can be classified as direct finance and some as intermediated or indirect
finance.
Specific details regarding each type of derivative and the markets in which they are traded will be
provided in later sections.

Derivative markets are generally wholesale markets, with most transactions having minimum
amounts in the order of hundreds of the thousands of dollars.
7.1.3 Participants in the derivatives market
The main participants in derivative markets are financial institutions and corporations. Because of
the wholesale nature of the markets, it is less common for individuals to participate in these markets.
Financial Institutions and Corporations use these markets to hedge the risk of an exposed position,
and they can also be involved in speculating and arbitraging if the opportunity arises and their
dealers are authorised to undertake such transactions.
Financial Institutions (mainly commercial banks) also participate in some derivative markets by
making a market – quoting two-way prices for various products and standing ready to buy or sell at
those quoted prices.
7.1.4 How are derivatives used?
The main reason for the use of derivatives is risk management – managing the level of risk faced by
an individual or an organisation. Risk management can involve a reduction in the level of risk
(hedging) or an increase in the level of risk (speculation).
Hedging will be undertaken by someone who has an exposure to risk – ie. variation in returns – and
who would like to reduce the level of risk. This will often (although not necessarily) result in a
reduction in the overall level of return. This is consistent with the principle of risk-aversion.
Speculation is in many ways the opposite of hedging. It involves taking on additional risk in
anticipation of increased returns. If market conditions turn out as predicted by the speculator, he will
make a profit. If the market moves in the other direction, the speculator stands to make a loss.
As we will see, the two parties to a derivative transaction may be a hedger and a speculator, two
hedgers or two speculators.

O B J E C T I V E 2
After working through this section you should be able to explain the nature of forward
contracts and the operation of the markets in which they are traded.
7.2 Forward contracts
The forward contract represents the fundamental type of derivative product with the other types
(options, futures and swaps) being variations on the forward contract.
7.2.1 Basic features and uses for forward contracts
Forward contracts are simple in concept: a forward contract is an agreement to buy or sell a given
quantity of a particular asset, at a specified future date at a pre-agreed price. We have already
discussed forward contracts in the context of the foreign exchange market (See FX Topic). As well as
being used to lock in future exchange rates, forward contracts can be used to remove the uncertainty
associated with an exposed position in many different markets.
For example, anyone planning to buy or sell a commodity in the future is exposed to variations in the
price of that commodity. A wheat farmer cannot sell his wheat until it is harvested. He knows what
the price of wheat is today, or what he thinks it might be when the wheat is sold, and can plan
accordingly, but he doesn’t know what might happen to the price of wheat in the meantime, and will
suffer if the price of wheat falls.
Similarly, the prospective buyer of the wheat, such as a bread manufacturer, is exposed to variations
in the price of wheat, and will suffer if the price of wheat rises. It might be in both their interests to
enter into a forward contract to lock in the price at which the wheat will be purchased and sold. Both
parties to the contract will avoid the possibility of loss if the price moves against them, but will give
up any benefit if the price moves in their favour.
EXAMPLE
The current price of wheat is $7 a bushel. A wheat farmer is concerned that this price will fall
between now and when the wheat is harvested in 6 month time. He could buy a put option which will
lock in a floor price at which the wheat will be sold, but the premium for the option could be
expensive. A bread manufacturer, that plans to buy wheat from the farmer, is concerned that the
price of wheat will rise between now and when the wheat is available for purchase in 6 months. The
bread manufacturer could buy a call option which will lock in a ceiling price, but the premium on
this option could also be expensive.
A forward contract will eliminate risk for both parties at minimal cost. These parties could agree that
the wheat will be sold for $7 a bushel when it is harvested. (The contract price could be varied from
the current price. It will be based on the expected price when the wheat is harvested.) There is no
premium payable by either party, and each has been able to hedge their exposed position.

Whether the price of wheat in 6 months is $6 or $8, the farmer and the bread manufacturer are
contracted to trade wheat at $7. If the price of wheat turns out to be $6, the farmer has (in retrospect)
benefited from the contract, but the bread manufacturer is worse off than it would have been if it had
not entered into the contract. The opposite occurs if the bread price turns out to be $8 – the bread
manufacturer (in retrospect) benefits from the contract and the farmer is worse off than if the contract
had not been entered into. Both parties eliminate risk, which means they eliminate both “downside”
risk as well as “upside” risk – variation in price that would have been of benefit.
7.2.2 Nature of the forward contracts market
Because of the fact that forward contracts are negotiated directly between the two parties to the
contract, there is a great deal of flexibility in how they are structured. They can be based on any
commodity, be for any amount and be for any period time that is agreed upon between the parties.
They are, however, a number of disadvantages. If a party to a contract changes its mind (for
example, because it wants to take advantage of favourable price changes), it can be very difficult if
not impossible to unwind, or get out of, the contract.
Another disadvantage is that, because of the infinite variety of risks to which parties can be exposed,
it may be difficult to find a counterparty willing to enter into the desired transaction which will
perfectly hedge the exposed position. Sometimes this problem can be overcome by using the services
of a broker to find an appropriate counterparty. The broker will be paid a commission for his
services.
Another way to facilitate this type of transaction is find a financial institution willing to perform the
functions of an intermediary. An intermediary will quote two-way prices to prospective parties to
forward contracts, and then try to offset the resulting exposure by entering into other forward
contracts or using other derivative products. The spread charged by the financial institution rewards
the financial institution for taking on any residual risk, but it can make forward contracts very
expensive.
EXAMPLE
A gold trader may quote two-way prices for forward contracts to buy and sell gold. Their quoted
price for such contracts might be $360/$365. Their bid price – the price at which they will buy gold
under a forward contract – is $360, and their offer price – the price at which they will sell gold under
a forward contract – is $365. A hedger wanting to sell gold must do so at $360, and a hedger wanting
to buy gold must do so at $365. Although hedgers must take the most disadvantageous price, the
advantage they get is the service of immediacy – the fact that the intermediary is always available to
buy from or sell to at their current price.
The spread gives the intermediary the prospect of making a profit, and compensates it for risk. If
more hedgers want buy contracts than sell contracts, or vice versa, the intermediary has an exposed
position which must be managed in some other way (eg. futures contracts, discussed below).

7.2.3 Forward Rate Agreements
Forward contracts are not restricted to commodities and currencies. They can be based on any price,
rate or index, and can be used to lock in the value of any future transaction which would otherwise
be subject to risk. A common example of an intermediated forward contract is a Forward Rate
Agreement (FRA), which can used to lock in future interest rates.
An FRA is often entered into by an organisation intending to borrow or invest in the near future, and
is worried about the possibility of interest rates rising or falling, respectively. By entering into an
FRA, the parties are locking in the interest rate at which borrowing or investing will take place in the
future – almost always less than 12 months in the future.
The parties agree that the party which benefits from a change in interest rates will compensate the
party which suffers as a result of the change, so that the effective interest rate for both parties is the
rate that has been agreed to. A prospective borrower and a prospective investor would benefit from
entering into an FRA with each other, but it is more common for banks to make a market by quoting
two-way prices for FRAs.
It is important to note that the FRA is quite independent from the intended borrowing or investing
which is being protected by the FRA. No exchange of principal takes place – there is simply a
compensatory payment from one party to another, which offsets the actual interest payments that
occur under the actual borrowing or investing. The net overall effect is that the parties to the FRA
effectively are subject to the interest rate that has been agreed to under the FRA.
EXAMPLE
Company A plans to borrow $1 million, for a period of 1 year, in 6 months. Company B plans to
invest $1 million, for a period of 1 year, in 6 months. The current interest rate is 6% pa. Company A
is concerned that the interest rate will rise. Company B is concerned that the current interest rate will
fall. An FRA between the two companies can be used to eliminate the risk faced by each company.
If the 1-year interest rate increases to 7% in 6 months, Company B will benefit by $100,000 (1% of
$1 million) and Company A will be worse off by $100,000. Under the FRA, each company borrows
and invests separately, but Company B pays Company A a compensatory payment of $100,000. It
can be shown that the effective interest rate achieved by each company is 6%.
If the 1-year interest rate falls to 5% in 6 months, Company A will benefit in the market, and
Company B will suffer, but under an FRA Company A will pay $100,000 to Company B. The
effective interest rate achieved by each company is still 6%.

O B J E C T I V E 3
After working through this section you should be able to explain the nature of futures
contracts and the operation of the markets in which they are traded.
7.3 Futures
7.3.1 Basic features and terminology
Some of the problems with forward contracts have been addressed by the development of Futures
Contracts. These are essentially forward contracts, but they are standardised with respect to the
underlying commodity, size and maturity.
Contracts are only available on particular commodities, such as gold of a particular purity, wool
of a particular thickness of fibre, oil of a particular grade, etc.
Contracts are only available for particular amounts, such as 100oz of gold, 1000 bales of wool,
1000 barrels of oil, etc.
Contracts are only available which mature on particular dates, such as the 15th day of March,
June, September and December each year.
One advantage of this standardisation is that it is possible for a secondary market to develop for the
buying and selling of these contracts. This secondary market is provided by a central exchange – the
main provider of this service in Australia is the Sydney Futures Exchange (SFE).
If you buy a futures contract (or go long in the contract) you are entering into a forward contract to
buy the underlying asset for the agreed price on the maturity date of the contract. If you sell a futures
contract (or go short in the contract) you are entering into a forward contract to sell the asset in the
future.
Because of the standardisation of futures contracts, it is quite a straightforward process to unwind, or

get out of, the contract. If you have bought a contract, you just have to sell an identical contract to
close out your position. If you have sold a contract, you just have to buy an identical contract. The
exchange will match your bought and sold contracts and neutralise your position. You will then have
no further obligation.
EXAMPLE
Suppose that on 30 April 2013 you buy a 100oz gold futures contract, at a price of $360, expiring on
15 September 2015. (The “price” of $360 is not actually the price of the contract. It is the forward
price of an ounce of gold which is to be bought and sold under the contract.) You haven’t, at this
stage, actually bought anything. You have entered into a forward contract to buy 100oz of gold, at a

price of $360 per ounce, on 15 September 2015. You can, in theory, wait until 15 September and
then buy 100oz of gold, under the contract, at a total price of $36,000.
However, any time between now and 15 September, you can close out your position by selling a gold
futures contract. You will no longer have any liability under the contract, and the difference between
the price at which you have bought and the price at which you have sold will determine your profit
or loss. For example, suppose that on 30 June 2015 the price of the gold futures contract has risen to
$370. If you sell a gold futures contract at this price you will close out your position and make a
profit of $1,000 (the difference per ounce of $10 multiplied by 100oz). If the price of the contract
had fallen to $355, you would incur a loss of $500.
7.3.2 Uses for futures
7.3.2.1 Hedging
Anyone with an exposure to variations in the price of a commodity can use futures to hedge their
position. If an increase in the price of the commodity in the physical market would cause you to
suffer a loss (eg. you are planning to buy the commodity in the future), you should go long in the
futures market, because an increase in the value of the underlying commodity will result in an
increase in the value of your contracts. A properly constructed futures position will result in a profit
in the futures market that will offset your loss in the physical market.
If a decrease in the price of the commodity in the physical market would cause you to suffer a loss (eg.
you are planning to sell the commodity in the future) you should go short in the futures market – sell
futures contracts. If the price of the commodity, and hence the value of your futures contracts, falls, you
will make a profit in the futures market when you buy back the contracts at a lower price to close out
your position. Once again, a properly constructed hedge will result in a profit in the futures market that
will just offset your loss in the physical market.
EXAMPLE
A gold mining company plans to sell gold in the future, and will suffer a loss if the gold price falls. It
can hedge this exposure by selling gold futures contracts. The number of contracts will depend on
the size of expected future gold sales.
If the price of gold falls, the company will suffer a loss in the physical market, but will make a profit
on its futures contracts. The value of the contracts that it has sold will fall. When the company buys
contracts (at a lower price) to close out its position, it will make a profit, which will offset its loss in
the physical market.
If the price of gold rises, the company will be forced to buy back contracts at a higher price and will
suffer a loss in the futures market, but will make an offsetting profit in the physical market because
of the increased gold price. Incidentally, this is the reason why the share price of gold mining
companies doesn’t always fluctuate markedly in response to changes in the gold price. Often the

future gold sales are hedged using gold futures, which protects the company from falls in the gold
price but prevents it from taking advantage if increases in gold prices.
EXAMPLE
A clothing manufacturer needs to buy wool to manufacture clothing, and hence has an exposure to
the price of wool. If the price of wool increases, it will suffer a loss. It can hedge this position by
buying wool contracts to match its anticipated purchases. If the price of wool rises, the company will
suffer a loss in the physical market but make a profit when the value of the contracts it has bought
rises. If the price of wool falls, the company will lose money when it closes out its long position in
the futures market (sells contracts at a lower price) but will make a profit in the physical market.
It should be noted that one of the problems with using futures for hedging is that the standardisation
of contracts makes it difficult or impossible to perfectly hedge an existing exposure. For example:
A wheat farmer may expect to sell 2750 bushels when his crop is harvested, but wheat contracts
are only available in lots of 1000 bushels. If he sells 3 contracts, he will have some residual risk
because of the mismatch in quantities.
A wool producer may not be able to sell futures contracts based on the precise grade of wool that
he produces. He may be forced to use futures contracts based on a different grade of wool, and he
will be hoping that the price of his wool futures are closely correlated with the price that he will
get in the market for his wool.
An oil refinery may intend to purchase oil on the 1st day of October. The closest expiry date on an
oil futures contract is 15th September. If it buys oil futures it will carry some residual risk because
of possible variation in oil prices between the date on which its contracts expire and the date on
which it intends to purchase oil.
7.3.2.2 Speculation
Some market participants use the futures market in order to speculate. If you buy or sell futures
contracts without an existing exposure to the physical market, you are taking on an open position –
you are taking on risk – with the expectation of making a profit if prices move the way you expect
them to. If they move in the other direction, you will make a loss.
EXAMPLE
A speculator anticipates that the price of oil will rise. Buying futures contracts (without an existing
exposure to the oil price) will expose the speculator to risk. If the price of oil does rise, the speculator
will make a profit when he closes out his position by selling contracts at a higher price than that at
which he bought. If the price of oil falls, he will make a loss when he closes out his position.

A speculator who expects the price of a commodity to fall will sell futures contracts (go short) and
make a profit if the price does fall and make a loss if the price rises.
7.3.3 Nature of the futures market
7.3.3.1 Trading in the market
The main exchange on which futures contracts are traded in Australia is the Sydney Futures
Exchange (SFE). Many countries have a developed futures market, but they are less common than
organised equity markets. Some developing countries such as Indonesia are yet to establish futures
markets.
The futures market operates in a similar fashion to the equity market. Most futures exchange still use
floor trading or open outcry (discussed in Equity markets Topic). Traders on the floor of the
exchange agree on the price at which a futures contract will be bought and sold. The exchange then
steps in and becomes the counterparty to both traders, buying from the seller and selling to the buyer
at the agreed price. This trading establishes the current market price of the contract.
There is the potential for considerable counterparty risk (also known as default risk) when dealing in
any forward contract, because if the price of the underlying asset has moved between the date on
which the contract was entered into and the expiry date, one party will lose and one will gain by
complying with the contract. The party that will lose by complying with the contract may be tempted
to default. One advantage of operating via a central exchange is that, for the traders, counterparty
risk is eliminated – their contract is with the exchange, which can be relied upon to perform under
the contract.
7.3.3.2 Margin calls
The exchange manages its counterparty risk by a system of margin calls. When you buy or sell a
contract, the exchange requires that you deposit an amount of money, prescribed for each type of
contract, into a margin account. Each day the exchange marks to market by determining the change
in value of your contracts over the course of the day and adjusting your margin account accordingly.
If your contracts have increased in value the profit is credited to your account, and if they have
decreased in value, the loss is debited to your account.
When the balance of the account drops to half of the original deposit, you must “top up” your
account to the original balance by the next working day. If you fail to do so, the exchange can close
out your position. The original deposit is calculated to be the maximum likely variation in the value
of the contract over a single day.

7.3.3.3 Settlement of contracts
Unlike forward contracts, the vast majority of futures contracts are settled in cash, rather than by
physical delivery of the underlying asset.
A hedger with an exposure to physical commodities such as wheat and gold can use futures contracts
to hedge their position without necessarily delivering or receiving wheat or gold under the contract.
The profit or loss they make when they close out their position will offset their financial outcome in
the physical market.
A speculator will not have the underlying commodity in the first place, and relies on the fact that
most futures contracts are settled in cash. Otherwise he would be forced to take delivery of large
quantities of commodities if he has bought futures contracts, or would be forced to acquire large
quantities of commodities in the physical market in order to settle contracts which have been sold.
When the futures contract matures, if the price of the underlying commodity is higher than the
contract price, those who are long in the contract receive the difference in price and those who are
short in the contract have to pay the difference. The opposite occurs if the price of the commodity is
less than the contract price – those who are short in the contract will receive the difference and those
who are long have to pay the difference. (These payments actually occur progressively, on a daily
basis, over the life of the contract under the system of margin calls.)
Some futures contracts, such as those based on interest rates or share price indices, cannot possibly
be settled by physical delivery. Parties to these contracts are effectively betting on what will happen
to interest rates or share prices. If interest rates increase, the value of an interest rate futures contract
falls (just as the value of a debt security falls). If interest rates fall, the value of an interest rate
futures contract increases. If a share price index increases, the value of a futures contract based on
that index also increases, and vice versa if the index falls. If interest rates or share price indices
change, your margin account is adjusted by the amount that your contracts have increased or
decreased in value. Effectively, the loser under the contract compensates the winner under the
contract with cash.
Less than 2% of futures contracts are settled by physical delivery. The exceptions are futures
contracts on financial assets such as bank bills, Treasury bonds and shares, which can be settled by
physical delivery of the underlying asset.

O B J E C T I V E 4
After working through this section you should be able to explain the nature of options and the
operation of the markets in which they are traded.
7.4 Options
An Option is a contract that gives the buyer or holder of the option the right, but not the obligation,
to buy or sell an underlying asset at an agreed price on or before a particular date in the future. The
writer or seller of the option doesn’t have any options – he must perform under the contract if the
option is exercised.
The following terminology is used when describing options:
The party to the option who has the option to buy or sell is known as the buyer or the holder of
the option.
The party to the option who must perform under the contract if the option is exercised is known
as the seller or the writer of the option.
The price at which the underlying asset will be bought or sold is called the exercise price or the
strike price.
The date on which (or by which) the option must be exercised is called the maturity date or the
expiry date.
The price paid by the buyer of the option to the seller of the option is called the premium. The size
of the premium will be a function of the price of the underlying asset, but will also be influenced
by the exercise price, the time remaining before the option’s maturity date, the current level of
interest rates and the volatility of the price of the underlying asset.
If the option gives the buyer of the option the right to buy the underlying asset it is referred to as a
Call Option.
If the gives the buyer the right to sell the underlying asset it is referred to as a Put Option.
If the option can only be exercised on the maturity date it is referred to as a European Option.
If the option can be exercised any time on or before the maturity date it is referred to as an
American Option.
Although the latter terms arose for historical reasons, both types of options can be found in most
countries around the world, including Europe and the USA. The majority of options traded in
Australia are American Options.

If the difference between the price of the underlying asset and the exercise price is such that
exercising the option immediately would yield a profit, the option is said to be in-the-money.
If the price of the underlying asset is equal to the exercise price, the option is said to be at-the-
money.
If the difference is such that exercising the option immediately would yield a loss, the option is
said to be out-of-the-money.
EXAMPLE
A Call Option gives the buyer of the option the right to buy a BHP share for $25 on 1 September
2013. (ie. the exercise price is $25 and the maturity date is 1 September 2015).
Any time between when the option is written and the maturity date, if the price of a BHP share is
above $25, the option is in-the-money. For example, if the price of a BHP share is $30, the buyer of
the option could buy an asset worth $30 for $25. He can then hold the share (having purchased it for
a $5 discount), or sell it in the share market for a $5 profit.
If the price of a BHP share is $25, the option is at-the-money. If the price of a BHP share is less than
$25, the option is out-of-the-money. No rational investor will buy something worth less than $25 for $25
– it would be better to buy the share in the share market at its current price.
If the option in this example is a European-style option, it can only be exercised on the maturity date.
If the option is in-the-money on the maturity date, it will be exercised, and if it is out of the money
on the maturity date it will not be exercised.
(If it is at-the-money on the maturity date, it may or may not be exercised. The share could be
purchased directly from the share market for the same price as the exercise price. It will depend on
whether the investor wants to own the share, and which transaction will have the lowest transaction
cost.)
EXAMPLE
A Put Option gives the buyer of the option the right to sell a BHP share. The exercise price is $25
and the maturity date is 1 September 2013.
In this case, any time the price of a BHP is above $25, it is out-of-the-money. The buyer of the
option would never sell something for $25 if it is worth more than $25. If the price of a BHP share is
$25, the put option is at-the-money, and if the price of a BHP share is less than $25 the option will
be in-the-money. For example, if the price of a BHP is $20, the buyer of the option has the right sell
an asset worth $20 for $25, for a $5 profit.
7.4.2 Uses for options

The basic principle behind an option is that it allows the buyer to take advantage of price movements
in one direction, but also gives the buyer the option of allowing the option to lapse if prices move in
the other direction. For a buyer who is hedging against an exposure to risk, it allows the buyer to
protect himself against unfavourable price movements, but still allows him to take advantage of
favourable price movements.
For example, a holder of BHP shares can, by paying a premium, protect himself against a fall in the
market price of the shares by buying a put option. This gives the buyer a guaranteed floor price
which he is guaranteed to receive. If the market price falls below the exercise price, the buyer of the
option can exercise the option and sell at the exercise price. However, if prices rise, the buyer will let
the option lapse and take advantage of the higher price in the share market.
An investor who would like to buy BHP shares in the future can, in return for a premium, use a call
option to lock in a ceiling price. If the market price rises above the exercise price, the buyer of the
option will exercise the option and be able to buy the shares at the exercise price. However, if the
market price falls the investor will let the option lapse and take advantage of the lower price in the
share market.
Options can also be written over commodities, such as gold, wool and wheat. A gold-mining company
can buy a put option to lock in the price at which it can sell its gold, or a wheat farmer can buy a put
option to lock in the price at which he will be able to sell his wheat. If the price of gold or wheat falls,
exercising the option will provide a guaranteed floor price. If the price of gold or wheat rises, the
buyer of the option will allow it to lapse and take advantage of the higher price in the physical market.
A prospective purchaser of wheat (eg. a bread manufacturer) can lock in a ceiling price at which it
will buy its wheat by buying a call option.
7.4.3 Nature of the options market
There are two distinct ways in which options can be bought and sold. Over-The-Counter (OTC)
Options are negotiated directly between the buyer and seller of the option, and do not require the
services of a central exchange. Company-Issued Share Options (also known as Warrants – discussed
in Equity markets Topic) are examples of OTC Options. The features of OTC Options are highly
flexible, but the buyer of the option may be required to pay a high premium in order to perfectly
hedge his existing position.
On the other hand, Exchange Traded Options (ETOs) are standardised with respect to underlying
assets, size and maturity date, and can be traded on a secondary market such as the ASX. If you buy
an ETO on the stock exchange you are the buyer of the option, and if you sell the ETO on the stock
exchange, you are the writer or seller of the option. In both cases the exchange becomes the
counterparty to both parties. The buyer of the option pays a premium and has no further obligations.
The seller of the option is a potential source of counterparty risk for the exchange, because he has
received the premium but may refuse to perform under the contract if it is exercised. To manage this
counterparty risk, the exchange imposes a system of margin calls on the seller of the option. Margin
calls are discussed in more detail in Section 7.4.3.2 above when looking at the future contracts.

O B J E C T I V E 5
After working through this section you should be able to explain the nature of swaps and the
operation of the markets in which they are traded.
7.5 Swaps
A swap is an agreement between two parties to swap a series of payments that are calculated on
some agreed basis, to their mutual benefit.
There are many different forms that a swap can take. Some of the more common types are:
Interest rate swaps
Currency swaps
Commodity swaps
7.5.1.1 Interest rate swaps
A basic interest rate swap (sometimes referred to as a “Plain Vanilla Swap”) involves two parties
agreeing to exchange a series of interest payments. This will be of mutual benefit if each party has
a comparative advantage in one debt market but would prefer to borrow in the market where
the other party has a comparative advantage.
For example, if one party can get the best interest rate by borrowing at a fixed interest rate, but
would prefer a floating rate, while another party can get the best rate by borrowing at a floating rate,
but would prefer a fixed rate, a swap can be constructed so that each borrows in the market where
they can get the best rate and then swaps interest payments.
Each party pays to the other the type of interest they would prefer to pay (fixed or floating) and
receives from the other party the type of interest they are paying in the market in which they have a
comparative advantage. The net effect is that teach party finishes up paying the type of interest they
would prefer to pay, but at a lower rate than if they approached their preferred market directly.
In this type of swap there is no exchange of principal (the money borrowed in the first place) – just the
interest payments are swapped. Usually the interest payments under the swap are set off against each
other so that only the difference between the two payments actually changes hands.
EXAMPLE
Company A would prefer to borrow at a fixed rate of interest. Company B would prefer to borrow at
a floating rate of interest. (These preferences are likely to be based on the type of cash flow that the

respective companies receive from their investments. Company A probably receives income which is
independent of the interest rate, whereas Company B probably receives income that varies with the
prevailing interest rate. This can be seen as an element of the matching principle.)
The following table shows the best rate of interest that each company can obtain in the fixed and
floating rate markets:
Available interest rates
Company Preference Fixed Floating
A Fixed 10% LIBOR + 1.5%
B Floating 9% LIBOR + 2.5%
The floating rates are based on LIBOR – the London Interbank Offered Rate – which is a standard
benchmark of the type used to determine the prevailing interest rate on a floating rate loan.
Company A would prefer to borrow at a fixed rate, but it has a comparative advantage in the floating
rate market: ie. it can get a better rate in the floating rate market than Company B. Company B
would prefer to borrow at a floating rate, but it has a comparative advantage in the fixed rate market.
A properly constructed swap will allow each company to effectively pay its preferred type of
interest, but at a lower rate than if it approached the market directly.
For example, suppose each company borrows in the market in which it has a comparative advantage
and then exchanges cash flows so that they are effectively paying each other’s interest bill.
It is important to note the following points:
Each company still pays interest on the loan it has taken out. There is a separate exchange
of cash flows between them. They do not literally pay each other’s interest.
There is no exchange of principal under this type of swap. Only the interest payments are
swapped.
Only the net difference between the interest payments is swapped. Which party pays a net
amount to the other party will depend on the prevailing floating interest rates.
The following diagram illustrates the cash flows which might occur under such a swap:
///
9% Fixed
//
///// Company A LIBOR + 1.5% Company B
LIBOR 9%
+ 1.5% Fixed
//
Market Market

The net effect of this arrangement is that each company gets access to their preferred type of interest,
but each is paying 1% less than it would if it had approached the market directly.

7.5.1.2 Currency swaps
A currency swap is similar to an interest rate swap, but is a little more complicated – the amounts
borrowed are in different currencies. The parties still borrow where they have a comparative
advantage, and then agree to swap both principal and interest payments. Comparative advantages are
likely to occur where companies desire access to a currency from another country.
The principal must be swapped in this case because the parties enter into a currency swap in order to
gain access to another currency. In addition, the value of each currency with respect to the other
currency will probably change over the life of the swap. At the end of the swap, the principals are re-
exchanged at a previously agreed exchange rate.
It is important to note that a currency swap is NOT the same as an FX swap, as discussed in the
Foreign exchange Topic. A currency swap is a derivative involving an exchange of currencies and
interest payments over the life of the swap. An FX swap is the simultaneous purchase and sale of a
currency in the spot and forward foreign exchange markets.
Suppose an Australian company is planning to invest in Japan. It might be able to borrow the
necessary funds (in Australian Dollars) at a low interest rate in Australia, and then convert Australian
Dollars to Japanese Yen at the prevailing exchange rate, but then it will face foreign exchange risk
every time it converts Japanese cash flows back to Australian Dollars to make a loan repayment. It
can try to borrow Yen in Japan, but will probably face a higher interest rate because it is not known
to Japanese lenders. A Japanese investor planning to invest in Australia has the opposite problem. It
will be able to borrow more cheaply in Japan than Australia, but will then be subject to foreign
exchange risk. It faces a higher interest rate in Australia because it is not known to Australian
lenders.
Under a currency swap, each party borrows funds in its own country, at the cheapest interest
rate it can, and then swaps the currencies with the other party. The Australian investor gets
access to Japanese Yen at a lower rate than it could on its own, and the Japanese investor gets access
to Australian Dollars at a lower rate than it could on its own. They swap interest payments,
effectively (but not literally) paying the interest bill that the other party has incurred in the market,
and then swap the principal amounts back again at the end of the swap at a previously agreed
exchange rate.
EXAMPLE
Company C is an Australian company wanting to borrow and invest NZ$1.5 million in New Zealand.
Company D is a New Zealand company wanting to borrow and invest A$1 million in Australia.
The following table shows the best rate of interest that each company can obtain in each country.
Available interest rates
Company Country Preference AUD NZD

C Australia NZD 8% 10%
D New Zealand AUD 10% 8%
Company C would prefer to borrow in New Zealand Dollars, but it has a comparative advantage in
Australian Dollars: ie. it can get a better rate in Australian Dollars than Company D. Company B
would prefer to borrow in Australian Dollars, but it has a comparative advantage in New Zealand
Dollars. A properly constructed currency swap will allow each company to get access to the currency
it desires, but at a lower interest rate than if it approached the market directly. For example, each
company borrows in the currency in which it has a comparative advantage, and then exchanges the
principal and interest payments.
Part of establishing a currency swap involves determining the exchange rates at which the principal
amounts will be exchanged at the beginning and end of the swap. For simplicity, we will use an
exchange rate of AUD/NZD = 1.5 for both exchanges. However, the exchange rate is not necessarily
the same for both exchanges. The exchange rate of the exchange of principal at the end of the swap
will be based on expectations about the future spot rate. The following diagrams illustrate the cash
flows which might occur under such a swap. Each company gets access to its preferred currency at
8% pa.
1. Initial exchange of principal
A$1 m.
Company C NZ$1.5 m. Company D
A$1 m. NZ$1.5 m.
Market Market
2. Exchange of interest payments
A$80,000
Company C NZ$120,000 Company D

8% or 8% or
A$80,000 NZ$120,000
Market Market
3. Re-exchange of principal
A$1 m.
Company C NZ$1.5 m. Company D
A$1 m. NZ$1.5 m.
Market Market
7.5.1.3 Commodity swaps
A commodity swap can give protection against disadvantageous movements in commodity

prices. The parties to the swap agree to swap an agreed fixed amount (known as the swap rate) for a
floating amount which is based on an observable benchmark rate which is designed to measure
changes in the price of the commodity.
When the payments are actually made they are set off against each other so that only the difference
in the amounts actually change hands. The net effect is that the party that has been disadvantaged
by changes in the price of the commodity is compensated by the party that has benefited by changes
in the price of the commodity, so that each party effectively fixes the price of the commodity.
For example, an oil producer is likely to benefit if the price of oil rises but will suffer if the price of
oil falls. An airline, being a major user of aviation fuel, will benefit if the price of oil falls and suffer
if the price of oil rises. The two companies can use an oil swap to reduce the risk they each face as a
result of exposure to the oil price.
Under an oil swap, the benchmark will be chosen that is an easily observable measure of the price of
oil, such as the price of West Texas Crude Oil, which is published daily. The agreed swap rate might
be the price of West Texas Crude on the day that the swap commences. That way, each time a
payment is calculated, if the price of the benchmark has risen above the swap rate (ie. the price of oil
has risen, benefiting the oil producer but hurting the airline), the oil producer will effectively
compensate the airline. If the benchmark has fallen below the swap rate (ie. the price of oil has
fallen, benefiting the airline but hurting the oil producer), the airline will effectively compensate the
oil producer.
EXAMPLE
Let us say that Company E (an oil producer) and Company F (an airline) enter into an oil swap. On
the day that the swap commences, the price of West Texas Crude Oil is $55 a barrel. This is chosen
as the swap rate. Payments are to be calculated annually and are based on 1 million barrels of oil.
(This might be the expected production of the oil producer and the expected consumption of the
airline per year.) Payments could be based on the price of oil on the anniversary of the
commencement of the swap, or the average price of oil over the preceding 12 months. Let us assume
the former for simplicity.
On the first anniversary of the commencement of the swap, West Texas Crude is selling at $58 a
barrel. Because the price has risen, the oil producer benefits in the physical market but the airline
suffers. The oil producer pays the airline the floating benchmark rate of $58 a barrel, and the airline
pays the oil producer the fixed swap rate of $55 a barrel. These two payments are set off against each

other, and the net effect is that the oil producer compensates the airline $3 million ($3 a barrel times
1 million barrels).
A year later, the benchmark has fallen to $50 a barrel. The oil producer still pays the airline the
floating benchmark rate (which is now $50 a barrel), and the airline still pays the oil producer the
fixed swap rate of $55 a barrel. The net effect is that the airline compensates the oil producer $5
million ($5 a barrel times 1 million barrels).
In each case, both parties have reduced the risk associated with fluctuating oil prices. As was the
case with forward contracts, they have avoided downside risk, but they have also denied themselves
the prospect of enjoying upside risk.
One of the problems with an oil swap is that the parties may not be buying or selling precisely the
same commodity, and hence the benchmark will be based on a slightly different commodity to that
which is bought or sold by one or both of the parties to the swap. This is known as a grade mismatch.
The oil being produced by the oil producer is a different commodity to the aviation fuel used by the
airline. The swap will only provide a perfect hedge if the benchmark is perfectly correlated with the
price of the oil produced by the oil producer and the price of aviation fuel. If these prices are not
perfectly correlated with each other there will be some residual commodity price risk faced by one or
both parties to the swap.
7.5.2 Nature of the swaps market
The above examples might be difficult to construct, because it may not be possible to find another
party with the desired risk exposure. The services of a broker can be used to match the parties to a
swap. The broker will be paid a fee or commission for matching the two parties and constructing the
swap.
It is more common for these swaps to be intermediated, with commercial banks offering to become
the counterparty to any party wanting to enter into such a swap. They will then try to match each
swap so that the risks offset. Any residual risk must be borne by the bank or managed in some other
way, such as with futures. The bank will incorporate a spread into the prices it quotes in order to
make a profit and compensate it for any risk that it is forced to carry.

TOPIC 7: SUMMARY
Derivatives are financial products which derive their value from some other underlying asset, rate or
index. They are used primarily for risk management – to hedge an existing exposure or risk, or to
speculate by taking on risk with the expectation of making a profit.
The four basic types of derivatives are forward contracts, options, futures and swaps.
A forward contract is a contract to buy or sell a commodity for a particular price on a particular date
in the future. They can be used to hedge an exposure to fluctuating prices, but they eliminated both
downside and upside risk. They are very flexible, and can be tailored to meet the needs of the parties,
but are difficult to unwind. Examples include forward foreign exchange contracts and Forward Rate
Agreements.
A call (put) option gives the buyer of the option the right to buy (sell) a particular asset at a particular
price on or before a particular date. This limits downside risk to the premium paid for the option, but
gives unlimited upside risk. Options can be traded over-the-counter (OTC options) or via a central
exchange (ETOs).
A futures contract is a forward contract which is offered via a futures exchange. Futures contracts are
standardised with respect to the underlying asset, the amount and the expiry date, which makes it
easier to establish a secondary market. To unwind or close out a futures contract position, it is simply
necessary to buy or sell the same number of contracts that were initially sold or bought, respectively.
Futures can be used to hedge an existing exposure or speculate. The counterparty risk faced by the
exchange is managed by a system of margin calls.
A swap is an agreement to exchange cash flows. An interest rate swap allows parties with a
comparative advantage in one interest rate market can get access to funds in another market, at a
cheaper rate than if they had approached that market directly, by entering into an arrangement
whereby they effectively pay each other’s interest. A currency swap is similar, but the funds are
initially borrowed in different currencies, and the principal that has been borrowed is exchanged at
the beginning and end of the swap. A commodity swap allows parties to reduce their exposure to
commodity prices by entering into an arrangement whereby one party compensates the other party if
there is a change in the price of the commodity.

TOPIC 8: THE CHANGING FINANCIAL
SYSTEM AND ROLE OF
FINANCIAL INSTITUTIONS
Aim
The financial services industry, or financial system, represents one of the fastest changing industries
both domestically and globally. This topic commences by examining the causes of change and its
effects on the financial system.
The topic also aims to provide an overview of the role of financial institutions in financial
intermediation and provision of financial services. The topic considers a number of strategic
management issues arising from financial intermediation. This is followed by an examination of the
institutional and regulatory features of the Australian financial system and of banks.
Finally the topic explains keys features of the sub-prime housing loan crisis in the USA and how it evolved
into a global financial crisis.
Learning objectives

1. Outline and explain the main institutional and regulatory features of the Australian financial
system.
2. Outline and explain the main causes (drivers) of change in the financial system, as well as the
main effects that change is having on the financial system.
3. Outline the structure of the Australian banking system along with the functions of, and main
challenges facing, banks.
4. Explain some of the features of the recent global financial crisis in credit.

O B J E C T I V E 1
After working through this section you should be able to outline the main institutional and
regulatory features of the Australian financial system
8.1.1 Changing government regulations
The case for government intervention into, and regulation of, financial markets is founded in the
existence of undesirable events and factors that create difficulties for governments in achieving their
economic and social objectives. Thus, the attainment of specified objectives provides the rationale
for government intervention into financial markets. In particular, government intervention is
undertaken for the following purposes:
to achieve macroeconomic stabilisation objectives
to promote financial safety
to ensure fair, competitive and efficient financial markets
Along with changing customer behaviour and technology, changes to government regulation and
government activities have influenced the financial system. Over the past fifty years, the Australian
financial system has experienced the following three different periods of government regulation:
Regulation (1940s - 1970s)

Deregulation (1980s)
Post deregulation (1990s and beyond)
8.1.1.1 Regulation
The main features of this period were:

Monetary policy controls of Reserve Bank over banks. These controls included:
Control over the interest rates that banks could pay on deposits and receive on loans.
Reserve asset controls designed to ensure financial safety. Specific examples of these controls
include:
Statutory reserve deposits (SRD) ratio, which required banks to keep a certain proportion of
funds on deposit with the RBA.
Liquid and government securities (LGS) ratio, which required banks to keep a certain
proportion of their assets in highly liquid assets such as notes and coin and government
securities.
Controls over bank lending. These controls were both quantitative (how much money could be
lent) and qualitative (to whom money could be leant).

External policy controls, including a fixed (adjustable peg) exchange rate and controls over
capital inflow and outflow.
Other controls, including restrictions on bank entry.
8.1.1.2 Deregulation
Although the main causes of deregulation could be traced back to earlier events, it was during the
first half of the 1980s that the main changes associated with the process of deregulation occurred.
The main causes of deregulation were:
Domestic institutional developments:

The declining share of financial assets held by banks.
Increasing competition between financial institutions.
An increase in the depth of the market for government securities.
The introduction of the tender method of sale for government securities.
International institutional developments:
The breakdown of the Bretton Woods system of exchange rate determination.
The development of global international finance markets.
Technological developments:
The development of more advanced information and communications systems.
The creation of innovative financial products and competition.
Official reports requested by the Government:
The Campbell Committee (1981)
The Martin Review Group (1984)
The main effects of deregulation were:
The remove of direct controls over interest rates, the exchange rate, SRD ratios, LGS ratios,
lending, etc.
Open market operations became the only instrument of monetary policy as direct controls were no
longer available.
Reliance on the market forces of demand and supply to determine interest rates and the exchange
rate.
Entry of new banks, both domestic and foreign
Increasing competition in financial markets
8.1.1.3 Post deregulation – Current regulatory structure

Following deregulation, Australia’s financial system has experienced further regulatory changes
during the 1990s and into the 2000’s. Results from the Wallis Committee of Inquiry into the
Australian financial system, requested by the Australian government, recommended significant
changes to the, then, existing regulatory framework. The report lead to the establishment in 1998 of a
new regulatory structure, this is our current structure:
The establishment of a new regulatory structure comprising three main regulators:
The Reserve Bank of Australia is responsible for monetary policy, systemic stability and the
payments system. The RBA, as the central bank, is responsible for macroeconomic stabilisation
through the implementation of monetary policy. The RBA has set an inflation target (2 – 3% pa)
and uses open market operations as the monetary policy instrument for this purpose. In its
endeavours to achieve this inflation target, the RBA has an explicit interest rate target. This was
examined in the topics 2 and 3.
The Australian Securities and Investment Commission (ASIC), ASIC is responsible for
achieving fair, efficient and competitive financial markets and has responsibility for consumer
protection, market integrity and corporations law.
The Australian Prudential Regulations Authority (APRA) is responsible for the prudential
supervision of banks, insurance companies, superannuation funds, building societies, credit
unions and friendly societies.
This new regulatory framework was design to strengthened regulation. Although different in
nature and purpose from the direct controls that had existed during regulation, an extensive
regulatory framework of official intervention and controls had become established by the late 1990’s.
The establishment of prudential supervision (or regulation) requirements of APRA to replace
direct regulation of financial institutions. With the removal of direct controls it was necessary to
implement some regulations to ensure financial safety, including protecting depositors funds and
ensuring financial institutions are managed in a prudent manner.
The main prudential requirement is that banks and other financial institutions must establish sound
systems for internal controls and risk management. They are accountable to APRA for these systems
and can be audited by them. It also relies on the market forces of demand and supply to determine
interest rates and the exchange rate.

O B J E C T I V E 2
After working through this section you should be able to outline and explain the main causes
(drivers) of change in the financial system. You should also you should be able to explain the
main effects that change is having on the financial system.
From the early 1980’s the financial system has been undergoing continuous and rapid change, that is
primarily driven by the three interlinked forces of changing customer needs, new technologies and
changes to regulation.
8.2.1 Drivers of changes
The evolution of nation-state financial systems into an integrated global financial system has
occurred, and continues to occur, due to a number of specific factors.
Changing customer needs—greater consumption, increased asset accumulation, need for

retirement savings, demand for more financial services, aging populations
Technology driven innovation—integration of technology into business and social lifestyles,
electronic information and product delivery systems, ATM and EFTPOS networks, internet
banking and broker services, competitor innovation
Changing financial landscape—increased global competition, much tighter margins in capital
markets, takeovers (industry rationalisation), financial conglomerates (banking and insurance),
more sophisticated product ranges (derivatives)
Deregulation—significant deregulation of financial systems (floating of exchange rates, removal
of interest rate controls), standardisation of many aspects of nation-states regulations (capital
adequacy), restructure of regulatory frameworks within major nation-states.
8.2.2 Main effects on the financial landscape
The three inter-related forces of changing customer needs, changing technologies and changes to
regulation have been the causes of change in the domestic and global financial systems. The main
effects on the financial landscape have been:
Increased emphasis on competition and efficiency.

Globalisation
Conglomeration and market widening
Disintermediation and securitisation.
8.2.2.1 Increased emphasis on competition and efficiency

In Australia, as in many other countries, the financial markets have become very competitive
economic markets. The main financial market prices, interest rates and exchange rates, are
essentially determined by the market forces of demand and supply. While there is some central bank
influences of the relevant markets, this is through market operations rather than over-riding the
markets and fixing prices.
8.2.2.2 Globalisation
Globalisation is a process describing the international integration of markets and the increasing
interdependence of national economic systems. Globalisation of the Australian financial system has
meant:
funds
The Australian dollar is the worlds seventh most frequently traded currency with over 60% of
trades occurring offshore.
now compete with Australian providers to offer services to local users
A large number of Australian financial services providers are pursuing activities in overseas
markets. For Australia’s 30 largest financial institutions, assets overseas represent around 24% of
their groups operations.
The implications of financial market globalisation include:

Exposure to foreign competition provides for more efficient resource allocation and promotes
innovation in the domestic economy.
Such opportunities present a competitive challenge to Australian providers of financial services
and products. That is, provide internationally competitive products and services or lose market
share to overseas providers.
In order to ensure that Australia remains a participant in global financial markets it is often
necessary for regulations in Australia to be in harmony with international regulations: e.g. capital
adequacy standards.
The possibility of “regulatory competition” between competing jurisdictions, to which Australian
regulators must respond.
8.2.2.3 Conglomeration and market widening
Conglomeration refers to the development of large financial institutions providing a wide range of
financial products and services to meet their customers’ needs rather than a restricted range such as

traditional banking products or insurance products. In the days of regulation, it was relatively easy to
distinguish between the different types of financial institutions in terms of the products they
provided. Banks provided banking products (e.g. deposits and loans), insurance companies provided
insurance products and fund managers managed customers funds. They were all different types of
financial institutions delivering different types of financial products.
Market widening refers to increasing the number and types of business organisations that provide
financial products and services. In particular, it refers to the provision of financial products and
services by business organisations whose core business is not financial services. For example, a firm
may be a retailer or a telecommunications company or even a sporting club, but they also provide
some financial products and services alongside their core business.
8.2.2.4 Disintermediation and securitisation
Topic 1 outlined that in recent years there has been increased reliance by borrowers and lenders on
direct rather than indirect (intermediated) finance. The term disintermediation is used to describe this
process. Disintermediation has resulted from:
Value conscious financial market customers seeking .to raise funds at the lowest cost of funds or
maximising their investment returns have turned towards the direct markets.
The development and growth of managed funds, and other direct finance products, that removes
many of the tradition advantages of intermediated finance e.g. Asset value transformation,
maturity transformation.
The development of a range of risk management products that has reduced risk in the direct
markets.
Accompanying disintermediation has been securitisation. Securitisation is the process of raising
funds by selling financial securities, such as bonds and discount securities, rather than taking out a
loan. As a general rule, financial assets that are created in direct financial markets are more likely to
be financial assets in that they can be traded in a secondary market. The process of disintermediation
has consequently facilitated securitisation. A later section of this topic further discusses securitisation
and its relationship with the Global Financial Crisis.

O B J E C T I V E 3
After working through this section you should be able to outline the structure of the Australian
banking system along with the functions of, and main challenges Australian banks.
The question of what distinguishes a bank from other financial institutions has become more difficult
to answer as a result of changes associated with deregulation of the financial system and the
development of financial services conglomerates. In terms of banking operations, banks have
traditionally operated in intermediated markets by accepting deposits and making loans. Today
however, it is difficult to distinguish between banks and non-bank financial institutions (NBFIs).in
terms of the types of products and services provided.
Officially, a bank is “any body corporate which is granted authority as a bank under the Banking
Act, plus enterprises established under State government legislation to carry on the business of
banking”. A bank holds a banking license and is subject to various regulatory requirements. e.g.
prudential regulation requirements.
8.3.1 Banking structure
At the present time there is no restriction on the number of bank licenses that can be granted.
Currently, there are over 50 authorised banking groups in Australia comprising:
Major banks i.e. the “Big Four”: ANZ, Commonwealth Bank (CBA), Westpac, NAB
Regional banks e.g. Adelaide Bank, Bendigo Bank
Foreign banks e.g. HSBC
The four major banks hold approximately 65% of bank assets. The regional banks manage
approximately 25% of bank assets and foreign banks holding approximately 10% of total bank
assets.
The role and type of financial services provided, by banks, in the Australian financial system, varies
enormously from the four majors, which are financial services conglomerates, to the single branch
specialist foreign banks.
8.3.2 Current developments and issues
During the period of regulation, Australian banks were directly regulated by the RBA. Then, during
the period of deregulation, these direct controls were removed and banks found themselves operating
in increasingly competitive markets relatively free of regulation and control. By the late 1980’s,
Australian banks were aggressively trying to increase market share particularly by expanding
corporate lending. The consequence was a large increase in non-performing loans and decline in
profitability.

During 1992, the four major banks experienced a combined loss of over $1 billion due to bad loans
associated with corporate failures. Since then, the four major banks have returned to high levels of
profitability with combined profit of over $6 billion. However, banks are currently confronting
significant challenges resulting from the combined effects of increased competition, rapid
technological change and further globalisation.
In responding to these challenges banks have placed greater emphasis on sales and service,
efficiency and cost control. With respect to efficiency and costs there is a focus by banks on cost-
income ratios. Banks have set a benchmark of 50% but some commentators believe a lower ratio will
be necessary to compete with overseas banks and mortgage originators. Midland Direct, a U.K.
based bank which operates fully on telephone banking, has a cost-income ratio of 25%.
Over recent years the major banks have decreased staffing levels significantly and rationalised their
branch structures. This is matter of ongoing controversy as branch closures in small country towns
deny rural citizens of access to banking services. Some types of customers are unable or unwilling to
use new technology such as ATMs and internet banking, making them subject to high fees for over-
the-counter transactions. The conflict between the desire of bank shareholders for increasing profit
levels, demands by customers for adequate levels of service and the reluctance of many people to
embrace new technology promises to be a source of tension for some time to come.
8.3.3 Banks’s off balance sheet business
Viewing banks only in terms of their assets and liabilities greatly underestimates their role in the
financial system. As a financial intermediary, banks also conduct significant off-balance-sheet
business.
a transaction that is conducted by a bank that is not recorded on the balance sheet
a contingent liability that will only be recorded on the balance sheet if some specified condition or
event occurs
The value of off-balance-sheet business is over four times the value of the accumulated assets of
the banking sector.
Off-balance-sheet business comprise of four main type of activates:

Direct credit substitutes—support a client’s financial obligations, such as a stand-by letter of
credit or a financial guarantee
Trade and performance related items—support a client’s non-financial obligations, such as a
performance guarantee or a documentary letter of credit
Commitments—a financial commitment of the bank to advance funds or underwrite a debt or
equity issue. For example, the unused credit limit on a credit card, or a housing loan approval
where the funds have not yet been used

Foreign exchange, interest rate and other market rate related contracts—principally derivative
products such as futures, forwards, options and swaps used to manage foreign exchange and
interest rate risk exposures

8.3.4 Domestic Banking regulation
Until 1998, Australian banks were directly regulated by the RBA. These regulations were extensive
during the period of regulation but significantly reduced during the period of deregulation. In 1998,
following the report of the Wallis Committee, Australian banks were no longer directly regulated by
the RBA. The RBA’s monetary policy stance still impact on the activities of banks as do other
central bank policies and actions.
Banks are now said to operate in a deregulated market. Relative to previous regulatory periods
this is a reasonable description; however, there still remains quite a degree of regulation that affects
participants in the financial markets, including the banks. The main regulator impacting on the
activities of the banks became APRA with its prudential supervision requirements to minimise risks
taken by the banks in the conduct of their business. These regulations include capital adequacy and
liquidity management requirements. Australian banks are also affected by regulations of ASIC
particularly with respect to consumer protection. Each nation-state is responsible for the regulation
and supervision of its own financial system. In particular, central banks and prudential supervisors
are responsible for the maintenance of financial system stability and the soundness of the payments
system.
While acting in intermediate finance in banks and other financial institution have to deal with certain
management issues. Financial intermediation involves borrowing funds and lending them as the
institution’s funds Borrowed funds represent liabilities (financial obligations) of the financial
institution while loans represent assets (financial assets) of the institution. In performing the function
of financial intermediation, financial institutions need to address a number of strategic management
issues. Three of these are liquidity management, interest rate management and capital management:
Liquidity management: liquidity management requires that a financial institution conduct its
business in a manner that ensures the financial institution is able to meet the claims that surplus units
hold on them: e.g. repay depositors funds as required. One aspect of liquidity management is
maintaining some match between the average maturity of assets (loans) and average maturity of
liabilities (deposits). For example, if a financial institution holds a large proportion of assets in the
form of long-term loans while most deposits are at call, they have a mismatch between the maturity
of assets and liabilities and potential liquidity problems.
Interest rate management: The main source of income from financial intermediation is net interest
income. This is interest income, from assets such as loans, less interest expense from liabilities such
as deposits. Interest rates on both the asset and liability sides of the balance sheet must be managed
to ensure the target net interest income (margin) is achieved. One aspect of this is to maintain a
match between fixed and variable interest rates. For example, if a large proportion of loans are at
fixed rates of interest while deposits are mainly at variable (or very short term fixed rates) then an
increase in the level of interest rates will reduce the net interest income.
Capital management: Financial institutions established as corporations (e.g. banks) hold equity
capital similar to corporate trading enterprises. Central banks around the world, including the

Reserve Bank of Australia, recognise the need for corporate financial institutions to maintain
minimum ratios of capital to assets. This is to provide some security to depositors in the case of
failure and some buffer to the institutions in the case of liquidity problems. Thus, banks and other
financial corporations must manage their capital/asset ratio for reasons of financial prudence. Also
see section 2 and 4 in this topic, for the domestic and international regulation on financial institution.
The Basel II capital accord provides guidelines regarding capital management.
8.3.5. International Banking regulation
At the global level, the Bank for International Settlements takes an active interest in the stability of
the international financial system. To this end, the Basel Committee on Banking Supervision has
developed an international standard on capital adequacy for banks to control for capital risk.
Capital risk is the risk that a corporation will not have sufficient capital to expand the business and
maintain the desired debt to equity ratio. For example, a corporation’s capital base may be eroded if
rapid business growth is funded with increased levels of debt. Alternatively, the capital base may be
eroded from the increased write-off of bad debts associated with business activities.
The current capital adequacy standard is known as the Basel II capital accord. The Basel II capital
accord comprises three pillars. Pillar 1 provides guidelines regarding capital adequacy ratio (to
manage capital risk) and the management of three main areas of risk risks:
§ credit risk (e.g. default of loan)
§ operational risk (e.g. internal fraud)
§ market risk (e.g. interest rate risk)
Operational risk is a risk generated by fraud, failure of internal systems or staff error e.g. internal
and external fraud, employment practices and workplace safety, clients, products and business
practices.
Pillar 2 provides guidelines to regulators for the supervision of the bank.
Pillar 3 discusses the disclosure requirement of the banks. Bank should be transparent and
disclose information regarding their balance sheet but also risk management processes.

O B J E C T I V E 4
After working through this section you should be able to outline some of the features of the
recent global financial crisis in credit.
The so-called global sub-prime credit crisis has had a significant impact on the international financial
markets. The sub-prime crisis evolved in the USA and manifested itself in late 2007 when housing
loan default rates reached very high levels and property values fell significantly. Two important
factors that led to the crisis were very low interest rates in the USA plus loose government policy
that encouraged mortgage lending to low income families Increasing interest rates caused a
substantial increase in loan defaults. The government provided implicit guarantees on the housing
loan lending through the Fannie Mae and Freddie Mac institutions which encouraged questionable
lending practices; also driven, in part, by large commissions paid to loan originators. Financial
institutions were lax in monitoring lending practices because they were able to securitise much of the
mortgage lending in the international financial markets. This risk transfer created a large pool of risk
globally.
Financial institutions failed, the securitisation market contracted, nervous banks restricted lending.
This led to an economic downturn which further worsened the problems of liquidity and credit in the
global and domestic markets. Governments bailed out some institutions, others were allowed to fail.
Huge fiscal stimuli were applied to try and pump start consumer spending, infrastructure spending
and economic growth.
8.4.1. The development of the Global Financial Crisis
In the details of the crisis are provided below:
Step 1: Government policies in the USA. The government policies in the USA is said to have
encouraged sub-prime lending practices. The Federal Reserve had maintained an expansionary
monetary policy for an extended period (very low interest rates). The USA government had
implemented policies that encouraged lenders to provide housing loan finance to lower socio-
economic groups. Low honeymoon interest rates were often attached to these loans, that is, low
interest rates to start, but they increased to market rates after the honeymoon period finished. These
policies encouraged lending and lenders began to drop loan credit assessment standards in order to
increase their lending volumes. The massive increase in housing lending led to a property price
boom.
Step 2: Property bubble and a culture of debt funded consumption. The relationship between the
global property bubble and a culture of debt funded consumption also contributed to the crisis. The
property price boom meant that households had an ever increasing level of equity in their residential
property. Property owners were encouraged to borrow further against this increased equity. This
fuelled a culture of consumption through debt accumulation (that is, borrowing against the increased
value of residential property). Property owners accumulated enormous amounts of debt to fund non-

essential life-style consumer items such as new cars, swimming pools, holidays, modern home
appliances. The debt accumulation structures were predicated on the belief that property prices
would always continue to rise.
Step 3: The contagion through collateralised debt obligations and securitisation. The
collateralised debt obligations and securitisation lead to a contagion of the crisis. When a bank gives
a customer a loan, the bank is required to fund part of that loan with capital (Basel II). In order to
reduce the amount of capital required to be held, the banks securitised a large proportion of housing
loans into collateralised debt obligations throughout the global financial markets. Securitisation is a
process whereby a financial institution bundles up a parcel of non-liquid assets (e.g. mortgages) and
sells the assets to the trustee of a special purpose vehicle. The SPV pays for the mortgage assets by
issuing new debt securities (e.g. bonds) to institutional investors. The trustee receives future
mortgage loan repayments and uses those funds to pay interest coupons on the bonds issues and to
repay the bonds at maturity. The bonds issued by the SPV are known as collateralised debt
obligations (CDO) because they have attached the security of the mortgages held by the SPV. The
diagram below detail the basic securitisation process:
/
Sell loan assets Receive funds
Financial Special purpose Investors
Theintermediary
combination of a large number of housing loan
vehicle (trustee)
borrowers defaulting on sub-prime loans, plus
the bursting of the property price boom meant that the Issue
Receive funds expected cash flows into securitised CDO
securities
structures fell and at the same time the underlying value of the security fell. As these securitisation
structures began to fail confidence was lost in the financial
Creditsystem as the largest holders of these
enhancer
assets were other financial institutions located throughout the global markets, such as insurance
offices and superannuation funds.
Service
Step 4: Governments reaction: Stimulus packages. The financial crisis spread and very quickly
Cash flows from loan asset manager Cash flows to investors in
across markets (from the debt market to equity derivatives…) and around the world, rapidly
repayments asset-backed securities
expanding into economic recessions in most major economies. Banks in the major financial centres
were under severe stress. Countries such as the USA and the UK bailed out some banks, but others
were allowed to fail (e.g. Lehman Brothers). This precipitated a loss of confidence in the markets. As
economies moved into recession, governments implemented stimulus packages in different forms to
try and encourage economic activity. Stimulus packages included new government spending on
infrastructure projects (e.g schools and hospitals), targeted expenditures on specific market segments
(e.g. financial support to householders to install insulation batts), and cash payments to taxpayers to
encourage retail spending.
As a result of the stimulus initiatives, many governments now hold large amounts of public debt that
will need to be repaid. The level of government debt added a new dimension to the global financial
crisis as it became uncertain whether governments would be able to repay these debt obligations. In
order to calm the markets, many countries introduced a range of austerity measures which included
large reductions in government spending, freezing or reducing public service salaries and raising the
base retirement age.
8.4.2. Securitisation and the Global Financial Crisis

Many argue the securitisation contributed greatly to the global financial crisis. Up until mid-2007,
the growth in the securitisation of assets in the international capital markets had been enormous. We
can identify few reasons why this form of funding had become so attractive.
• Increased return on equity: business growth is increased without the need to dilute shareholders’
funds, instead asset backed securities are sold.
• Improved return on assets, particularly where, through the securitisation process, assets with
lower credit ratings are upgraded with credit enhancement. The asset appeared to bear low risk
yet it provides high returns.
• Reduced credit exposure: the sale of assets may transfer the credit risk associated with the
pooled assets to the SPV and ultimate investors.
• Regulatory advantage for banks: banks in particular are required to maintain minimum capital
requirements based, in part, on their balance-sheet assets. Securitisation, where there is no
recourse back to the bank, removes assets from the balance sheet (e.g. by selling loans) and
removes the capital cost imposition.
• Increased balance-sheet liquidity for banks, reduced asset concentration and credit exposure:
assets which previously were non-liquid and remained on the balance sheet are converted to cash
(e.g. again by selling loans for instance). Securitisation also led to a reduced asset concentration,
for example, banks tend to provide a large proportion of their asset portfolio in mortgage
finance. Securitisation allows the bank to divest itself of some of these assets and to give new
mortgage finance without increasing its overall mortgage asset concentration.
• Accelerated income for banks: by divesting assets through securitisation, an institution
effectively brings forward returns that would otherwise have progressively occurred over time
8.4.3. The slow down of Securitisation growth
After mid-2007, securitisation market growth slowed down significantly. The initial event that
occurred that had a negative impact on the securitisation market was the sub-prime crisis in the
USA.
The market has now partially recovered. The reason for this is that once global economic growth and
international financial market credit conditions returned to normal, confidence started to slowly
return to the securitisation market – now also called structured finance. However, it is expected that
the risk structure of future securitised issues will change; that is, investors will seek greater
transparency and protection from default losses.

TOPIC 8: SUMMARY
Over the past 40 years the financial system has experienced significant and fundamental change. The
main forces driving this change have been changing customer needs, changing technologies and
changes to regulation. These forces have resulted in the financial services industry becoming one of
the fastest changing industries in the economy. The effects of these changes are an increased focus
on competition and efficiency, globalisation, conglomeration and market widening and
disintermediation and securitisation. Dominant in our market the Banks manage the largest share of
financial assets held by financial institutions. Within the banking group, the four major banks
account for approximately two-thirds of all assets held. Special supervisions, such as the Basel
accord, are in place to mitigate their risk.
Despite the regulatory framework the international financial market experience in 2008-2009 a
global financial crisis. Loose government policy and securitisation were keys features of this US
born crisis. Today, financial institutions, markets and nation-state’s financial systems are inextricably
intertwined into the global financial system. As such, a failure in one major institution will have
ramifications for a domestic financial system and probably the global financial system. While
markets seem to be recovering, the issue of regulation is now back on the agenda and new regulatory
arrangement such as Basel III and being drafted to attempt to mitigate the risk of a new crisis.

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TOPIC 1: INTRODUCTION TO FINANCIAL

After working through this topic, you should be able to:

1. Describe the main features of the financial system.

2012 Topic 1 – Introduction to Financial Markets 1

1.1 The financial system

The main functions of a nation’s financial system are to facilitate the:

trade of existing financial assets in secondary financial markets

1.1.1 Surplus economic units

2012 Topic 1 – Introduction to Financial Markets 2

1.1.3 Financial institutions

1.1.4 Financial assets

time pattern of return or cash flow

Deposits - eg bank deposits

Contractual savings- eg life insurance, superannuation

2012 Topic 1 – Introduction to Financial Markets 3

Fixed interest securities - eg bonds, debentures

1.1.5 Financial markets

• The Money Market (topic 3)

2012 Topic 1 – Introduction to Financial Markets 4

1.2 Direct and indirect finance

1.2.1 Direct finance

1.2.2 Indirect finance

2012 Topic 1 – Introduction to Financial Markets 5

1.2.3 Advantages of financial intermediation

2012 Topic 1 – Introduction to Financial Markets 6

1.2.4 Disadvantages of financial intermediation

Increased cost of funds for borrowers

Reduced return from lending for savers.

In addition to this, there is a further disadvantage in that, as a general rule:

2012 Topic 1 – Introduction to Financial Markets 7

1.3.1 Nature and role of financial institutions

A financial institution is a business organisation whose core business is financial intermediation

In indirect financing, a financial institution performs the function of financial intermediation by

1.3.2 Current Institutional features

2012 Topic 1 – Introduction to Financial Markets 8

2012 Topic 1 – Introduction to Financial Markets 9

1.3.3.1 Commercial banks

1.3.3.2 Building societies and credit unions

1.3.3.3 Investment banks and merchant banks

2012 Topic 1 – Introduction to Financial Markets 10

1.3.3.4 Managed funds

1.3.3.5 Life insurance offices and general insurance offices

1.3.3.6 Finance companies and general financiers

i.e. AGC, CBFC and ESANDA

2012 Topic 1 – Introduction to Financial Markets 11

1.4 The financial and economic systems

1.4.1 The economic system

efficient allocation of resources

equitable distribution of income and wealth

1.4.2 The financial system and economic objectives

1.4.2.1 Economic growth

2012 Topic 1 – Introduction to Financial Markets 12

1.4.2.2 Full employment

1.4.2.3 Price stability

1.4.2.4 External balance

External balance refers to a desirable position in terms of a nation’s international transactions, as

1.4.2.5 Efficient allocation of resources

2012 Topic 1 – Introduction to Financial Markets 13

1.4.2.6 Equitable distribution of income and wealth

2012 Topic 1 – Introduction to Financial Markets 14

1.5 The government and finance markets

1.5.1 Reasons for government intervention

• An efficient, fair and competitive financial system.