AN INTRODUCTION TO

GLOBAL FINANCIAL

MARKETS

8th edition

Stephen Valdez

& Philip Molyneux

laasaas palgrave

Contents

List ofFigures xvi ListofTables xviii List ofBoxes xx Preface xxii Companion Website xxv Acknowledgements xxvi Abbreviations xxix

PART 1: Introduction 1 1 The Money Merry-go-round 2

RAISON D'fiTRE OF THE MARKETS 2 Lenders 2 Borrowers 3 Securities 4

RAISING CAPITAL 5 Bank Loans 5 Bonds 5 Equity 5 Gearing/Leverage 6

CONCLUSION 8 SUMMARY 9 REVISION QUESTIONS/ASSIGNMENTS 9 FURTHER READING 9

PART 2: Banking 11 2 Banking Background 12

HISTORY 12 BANKING SUPERVISION 15 TYPES OF BANK: DEFINITIONS 16

Central Banks 16 Commercial Banks 17 Merchant/Investment Banks 18 Savings Banks 18 Cooperative Banks 20 Mortgage Banks 21 Giro Banks 22 Credit Unions 23 Islamic Banks 24

OTHER BANKING TERMINOLOGY 25 Clearing Banks 25 State or Public Banks 26 International Banking 27 Skadow Banking 27

vi

CONTENTS vii

A BANK'S BALANCE SHEET 27 THE CREATION OF CREDIT 29

Banking Depends on Confidence 30 The Money Supply 30 Liquidity Ratlos 32

CAPITAL RATIO 32 The Basel Committee 33 Basel III 36 European Capital Regulation 37 Increasing Capital Ratio 38

CENTRAL BANK REPORTING 39 THE EU'S SECOND BANKING DIRECTIVE 40 MAJOR WORLD BANKS 41 SUMMARY 45 REVISION QUESTIONS/ASSIGNMENTS 46 REFERENCES 46 FURTHER READING 47 Appendix 1: Top US bank mergers and acquisitions 48

3 The Role of the Central Bank 49 HISTORY OF THE MAJOR CENTRAL BANKS 49

Brazil 49 China 49 France 49 Germany 50 India 50 Japan 50 Russia 51 United Kingdom 51 United States 52 The European Central Bank 54

CENTRAL BANK ACTIVITIES 54 Supervision of the Banking System 55 Monetary Policy 56 Banknotes 57 Banker to the Other Banks 60 Banker to the Government 61 Raising Money for the Government 61 Controlling the Nations Currency Reserves 62 Acting as Lender of Last Resort 63 Liaison with International Bodies 64

THE POSITION OF CENTRAL BANKS TODAY 65 SUMMARY 67 REVISION QUESTIONS/ASSIGNMENTS 68 REFERENCE 68 FURTHER READING 68

4 Commercial Banking 69 INTRODU CTION 69

VÜi CONTENTS

RETAIL BANKING Types of Service Money Banking: Deposits New Payments Technologies Loans Other Services Delivery Channels Clearing Systems Key Retail Banking Issues Use of IT

WHOLESALE BANKING Uncommitted Facilities Committed Facilities Syndicated Facilities The Loan Agreement

WHOLESALE BANKING ISSUES SUMMARY REVISION QUESTIONS/ASSIGNMENTS REFERENCES FURTHER READING

5 Investment Banking INTRODUCTION INVESTMENT BANKING

Accepting Corporate Finance Securities Trading Investment Management Loan Arrangement Foreign Exchange Miscellaneous Activities

INVESTMENT BANKS AND THE CREDIT CRISIS REGULATION SHADOW BANKING SUMMARY REVISION QUESTIONS/ASSIGNMENTS REFERENCE FURTHER READING

6 Regulation AFTER THE CRISIS FREQUENCY OF CRISES AND THEIR COSTS RATIONALE FOR BANK REGULATION INFORMATION ASYMMETRIES IN BANKING AND FINANCE GOVERNMENT SAFETY NET PROBLEMS FOR REGULATORS THEORIES OF BANKING CRISES FEATURES OF SYSTEMIC RISK

What Is 'Systemic Risk'? Solvency, Liquidity and Maturities Funding Liquidity and the 'Domino Effect'

69 69 70 72 74 76 78 82 84 90 91 91 92 94 98

100 101 102 102 102

103 103 103 103 106 110 111 112 112 112 113 114 115 118 118 119 119

120 120 120 121 122 123 124 125 125 125 126

CONTENTS ix

'Mark to Market' and Asset Price Effects 127 The 'Haircut' Spiral 127 Systemic Risk: Spirals and the Rationale for Regulation 128

THE RISE OF SYSTEMICALLYIMPORTANT FINANCIAL INSTITUTIONS (SIFIs) 128

Which Are the SIFIs? 129 Why Worry about Big Institutions? 129

US REGULATORY RESPONSE TO THE CRISIS: DODD-FRANK ACT 2010 133 UK REGULATORY RESPONSE TO THE CRISIS 135 EUROPEAN REGULATORY RESPONSE 135 INTERNATIONAL ACTION 141 SUMMARY 142 REVISION QUESTIONS/ASSIGNMENTS 143 REFERENCES 143 FURTHER READING 144

PART 3: Securities Markets and Investment Companies 145 7 The Money and Bond Markets 146

THE RATE OF INTEREST 146 Risk 146 Maturity 147 Expectations 148 Liquidity 148 Supply and Demand 148 Inflation 149 Yield 149 Par Values 149 Interest Yield 150 Gross Redemption Yield 150 Accrued Interest 152

CREDIT RATINGS 153 DOMESTIC MONEY MARKETS 155

Call Money 155 The Interbank Market 155 Money Market Securities 158

CENTRAL BANK ROLE 161 DOMESTIC BOND MARKETS 163

Government Bonds (Sovereigns) 165 Local Authority/Public Sector Bonds 168 Mortgage and Asset-backed Bonds 168 Corporate Bonds 171 Hybrid Bonds 174 Foreign Bonds 175 Junk Bonds (High-yield Debt) 176 Islamic Bonds 177

INTERNATIONAL MARKETS 177 Background: Eurocurrencies 177 The Syndicated Loan Market 179 The International Debt Crisis 179 The Eurobond Market 183

X CONTENTS

Coupon Stripping 185 Other Variation« 186 Medium-term Notes 188 The Money Markets 188 Repos 188 Participants and Top Traders 189

SUMMARY 191 REVISION QUESTIONS/ASSIGNMENTS 192 REFERENCES 192 FURTHER READING 192 Appendix 1: Announcement of result of a UK bid price auction for government bonds

8 Equity Markets HISTORY OF ASSOCIATIONS FOR TRADING THE ROLE OF A STOCK EXCHANGE STOCKS AND SHARES EFFICIENT MARKETS INDICES THE LISTING PROCESS: GOING PUBLIC RIGHTS ISSUES SCRIP ISSUES, SPLITS AND SCRIP DIVIDENDS INTERNATIONAL EQUITY TRADING IN THE MEDIUM AND LONG RUN: WHO OWNS SHARES? 208

Small Investors versus Institutions 208 Pension Funds: Funding versus Unfunding 209 Equity Investment 212 Share Buy-backs 213 Mutual Funds 214 Active versus Passive Management 217 Custodians 218

TRADING IN THE SHORT RUN: DEALING SYSTEMS 219 Order-driven Systems 219 Quote-driven Systems 221 Hybrid Systems 223 Interdealer Brokers 224 Stock Borrowing and Lending 224 Bought Deals/Block Trades 225

THE TRADING PROCESS: CLEARING AND SETTLEMENT 226 SECOND MARKETS 227 ANALYSTS' RATIOS 227 US STOCK MARKET: THE NEW PARADIGM AND THE BURSTING OF THE DOT-COM AND SECURITIZATION BUBBLE 229 EU RULES 230

Investment Services Directive 230 Markets in Financial Instruments Directive 230 Capital Requirements Directive 232 Mergers and Acquisitions 232

CHALLENGES TO TRADITIONAL STOCK EXCHANGES 233

193

194 194 195 196 198 199 202 204 206 207

CONTENTS Xi

SUMMARY 235 REVISION QUESTIONS/ASSIGNMENTS 236 REFERENCES 236 FURTHER READING 236

9 Hedge Funds and Private Equity 237 INTRODUCTION 237

Hedge Funds 238 Private Equity 239

HEDGE FUNDS 242 Leverage and Short Selling 243 Strategies 245 Range and Activities of Hedge Funds 248 Investors 250 Returns 251 Regulation 252

PRIVATE EQUITY 254 Investors 255 Leverage 257 Hedge Funds and Private Equity Coming Closer 258 Profits on Private Equity 258

SUMMARY 259 REVISION QUESTIONS/ASSIGNMENTS 260 REFERENCES 260 FURTHER READING 261

PART 4: Financial Crisis 263 10 Financial Crisis 264

INTRODUCTION 264 WHAT WENT WRONG? 265

Macroeconomic Factors 265 Microeconomic Factors 266

STAGES OF THE CRISIS 268 SECURITIZATION AND HOW IT FUELLED THE CRISIS 268

Start of Securitization 268 Role of the US Government-sponsored Enterprises 272 Sub-prime Lending 273 Modern Securitization Business 273 Securitizing the Securitizations: Recent Developments 276 The Role of Rating Agencies and Monoline Insurers 277 The Impact of Securitization and its Future 279

CREDIT CRISIS IN THE US 282 CREDIT CRISIS IN EUROPE 286

United Kingdom 286 Switzerland 288 Iceland 289 Germany 290 Spain 291 Belgium, the Netherlands and Luxembourg 291 Other European Countries 292

xii CONTENTS

CREDIT CRISIS IN JAPAN 294 CREDIT CRISIS IN CHINA AND INDIA 295 WHAT HAVE WE LEARNED FROM THE CRISIS? 296

Bank Recapitalizations and Cleansing of Bank Balance Sheets 297 Capital and Liquidity Regulation 298 Scope of Regulation, and Separation of Bank Functions 299 Systemic Risk 300 Credit Rating Agencies 300 Credit Derivative Markets 300 Cross-border Supervision and Regulation 301

SUMMARY 302 REVISION QUESTIONS/ASSIGNMENTS 304 REFERENCES 304 FURTHER READING 304

PART 5: Foreign Exchange, Europe and the Eurozone 307 11 Foreign Exchange 308

INTRODUCTION 308 The Market 308 Buyers and Seilers 308 Bank Profits 310

WHAT DETERMINES EXCHANGE RATES? 310 BRETTON WOODS 313

Exchange Rate Stability 313 International Monetary Fund 313 The World Bank 314

FLOATING RATES 315 EUROPEAN ECONOMIC AND MONETARY UNION 318 FOREIGN EXCHANGE RISK FOR CORPORATES 319

Types of Risk 319 Transaction Risk: Forward Rates 320 Transaction Risk: Options 322

FOREIGN EXCHANGE DEALING 325 Quotations 325 Cross-rates 326 Foreign Exchange Swaps 326 Brokers 328 Settlement 329

ARBITRAGE 331 CENTRAL BANK SURVEYS 332 WHY LONDON? 334 SUMMARY 334 REVISION QUESTIONS/ASSIGNMENTS 335 REFERENCES 335 FURTHER READING 336 Appendix 1: Foreign exchange turnover by currency pairs, daily averages in April 2004, 2007 and 2010, in billions of USD 337

CONTENTS xiii

12 Europe and the Eurozone 338 INTRODUCTION 338 HISTORY OF THE EUROPEAN UNION 338

Early History 338 1945 339 The Council of Europe 339 The European Coal and Steel Community (1952-2002) 340 'All Roads Lead to Rome' 340 The European Economic Community (1958-93) 341 Wider Membership 342 The de Gaulle Stalemate 342 The European Council 343 The Single European Act 343 European Free Trade Area 344 The Maastricht, Amsterdam and Nice Treaties 344

THE INSTITUTIONS OF THE EUROPEAN UNION 346 The European Council 346 The Council of Ministers 346 The European Commission 346 The European Parliament 346 Ecofin 347 The European Central Bank (ECB) 347

STEPS TO EMU AND THE CREATION OF THE EURO 350 The Werner Report 350 European Monetary System 350 Changes to the ERM 351 The Delors Plan 351 The Maastricht Treaty 351 EMU 352 The Stability and Growth Pact 353 ERM II 355 Next Members? 355 EMU Statistics 356 Payment Systems 356 EMU: The Benefits 357 The Counterarguments 359 The UK Position 360

EUROZONE SOVEREIGN DEBT CRISIS 362 Solving the Sovereign Debt Crisis 366

EUROPEAN BANKING UNION 368 EUROPEAN COMMISSION DIRECTIVES IMPACTING THE FINANCIAL SECTOR 371 BANKING TRENDS 373 SUMMARY 376 REVISION QUESTIONS/ASSIGNMENTS 378 FURTHER READING 378

XIV CONTENTS

PART 6: Derivative Products 379 13 Traded Options 380

DERIVATIVE PRODUCTS 380 TRADED OPTIONS: EQUITIES 381

Calls and Puts 381 Option Writers 382 Trading Options 383 Intrinsic Value and Time Value 384 Calculation of the Premium 385 Exercise or Trade? 387 Other Terminology 388 Options on Indices 388

TRADED OPTIONS: OTHER OPTIONS 391 Currencies 391 Bonds 391 Interest Rates 392

OPTION STRATEGIES 393 SUMMARY 396 REVISION QUESTIONS/ASSIGNMENTS 396 FURTHER READING 396

14 Financial Futures 397 FUTURES TRADING 397

Background 397 Hedgers versus Speculators 397 Commodity Futures 398 Financial Futures 400 Index Futures 404 Bond Futures 406 Interest Rates 407 Currency Futures 408 Some Problems of Futures Exchanges 409 Open Outcry or Computers? 409 Contract Volumes 410

SUMMARY 412 REVISION QUESTIONS/ASSIGNMENTS 412 REFERENCE 412 FURTHER READING 413

15 Other Derivative Products 414 INTRODUCTION 414 FORWARD RATE AGREEMENTS 414 SWAPS 416

Comparative Advantage 416 Interest Rate Swaps 417 Making a Market in Swaps 418 Users of Swaps 419 Swaps and Futures 420 Other Swaps 421 Swapnotes and the Swaps Yield Curve 421

CONTENTS XV

CURRENCY SWAPS 422 CAPS, FLOORS AND COLLARS 423

Collars 424 CREDIT DERIVATIVES 425 THE MARKET IN DERIVATIVE INSTRUMENTS 429 SUMMARY 434 REVISION QUESTIONS/ASSIGNMENTS 434 REFERENCES 435 FURTHER READING 435

PART 7: Emerging and Growth leading Economies (EAGLEs) 437 16 Emerging and Growth leading Economies (EAGLEs) 438

INTRODUCTION 438 EAGLES AND NEST COUNTRIES 438 CHINA AND INDIA 443 FINANCIAL MARKETS 446

Banking: General 446 Banking: China 446 Banking: India 453 Capital Markets 456

INSURANCE: CHINA AND INDIA 460 CHINA AND INDIA: A COMPARISON 461 CHINA AND INDIA: A THREAT? 464 SUMMARY 465 REVISION QUESTIONS/ASSIGNMENTS 467 REFERENCES 467 FURTHER READING 467

PART 8: Trends in the Global Financial Markets 469 17 Key Trends 470

GLOBAL BANKS, DODD-FRANK, VICKERS AND LIIKANEN 471 EUROPEAN BANKING UNION - ON ITS WAY? 473 BANK REGULATIONS AND FINANCIAL MARKETS 475 SOCIAL, ENVIRONMENTAL, ETHICAL AND TRUST (SEET) ISSUES 475 ALTERNATIVE ENERGY INVESTMENTS 478 DIVIDEND PAYING STOCKS 479 MEASURING AND MANAGING RISK 480

Regulating the OTC Derivatives Markets 481 Gold and Precious Metals 482 Islamic Finance 482

CONSOLIDATION AND BANKS AS PUBLIC UTILITIES 484 (STILL) RETHINKING ECONOMIC PARADIGMS 488 CONTINUING CRISIS IN THE EUROZONE 490 REVISION QUESTIONS/ASSIGNMENTS 491 REFERENCES 491 FURTHER READING 491

Glossary 493 Index 508